Gallery:Step 1|Step 1: Active Investors

What Makes A Good Mutual Fund?

Gallery:Step 1|Step 1: Active Investors

As you build your portfolio, once you have decided on your asset allocation between stocks and bonds, and then picked your investment categories within the equity markets, it's time to select the mutual fund for each category. With over 7,000 domestic equity mutual funds out there, how can you narrow the choices? Fortunately, there are any number of web or PC based software programs to screen the universe of funds.

Here are some criteria that you might employ:

Diversification - Pick a fund with as many firms represented within the category as possible. Diversification is the primary investor defense against all the things that might go wrong in the investment process. So, you will want to avoid sector funds, or concentrated portfolios of any kind.

Costs - In a world where investment returns are finite and limited, investment costs of all kinds reduce the return to the investor. It follows that you should never pay a sales load of any kind (front end, back end, level load, etc.), and keep management fees to the lowest possible within the sector.

Turnover - The costs associated with turnover are difficult to quantify and not disclosed in the prospectus. These costs include commissions, bid-ask spreads, and market impact. In addition each transaction generates a taxable event for the shareholder. Cumulatively, these costs can be huge. Stick to funds with the lowest turnover possible.

Un-invested cash - Many mutual funds hold large amounts of cash to fund potential redemptions, or as part of their investment policy. These un-invested funds are a drag on performance over the market cycle. Choose funds that are fully invested in the market segment that you are targeting.

Style drift - Investors should set the target allocation, not the fund managers. For instance, if you purchase a small company fund, you don't want to find that the manager has purchased General Motors or Microsoft. The fund's prospectus should clearly define the market, size company, and growth or value tilt for the portfolio. As an example, if you are looking for a domestic small value fund, screen for funds with the all of their assets invested in the U.S., the smallest average company size, and the highest book-to-market (or lowest price-book) ratios.

Passive investing - There is just no credible evidence that active management increases returns over a pure passive buy-and-hold strategy. Indeed, the overwhelming data clearly shows that over time, attempts to either select individual stocks or time the market under-perform the appropriate benchmark by wide margins. Sure, some funds are always beating the benchmark. Random chance would predict that there will always be some above average. But, they are seldom the same funds from one period to the next, and it's just not possible to know which ones they are in advance.

If you have built your screens right, what you should get is a list of index funds - at least in the markets and market segments where they are available. Index funds are the lowest cost, lowest risk, most consistent performers in the mutual fund universe. They are by definition as widely diversified as possible, stay fully invested, keep costs to a bare minimum, never have style drift, and generate the lowest tax aggravation for their owners. However, if for some reason they are not available to you (for instance in your 401(k) plan), choose a fund that looks as much as possible like an index fund.

Frank Armstrong, CFP, is the author of Investment Strategies for the 21st Century as well as the forthcoming investment guide The Informed Investor. He is the President of Investor Solutions, Inc. a fee-only Registered Investment Advisor, and Chief Investment Strategist of DirectAdvice.com.

*This article is the property of Investor Solutions, Inc. and is reprinted with permission.