Seven Steps for Picking the Right Fund

In AAII’s new Essential Investing (EI) Course, I lead discussions on foundational investing, investment selection and wealth management. Also, check out countless other industry experts like Raymond Rondeau, Wayne Thorp, Bruce Johnstone, Paul Merriman and Ken Fisher as they dive into a wide array of different investing topics. Discover what the EI Course has to offer.

It can be challenging to pick the right mutual fund. There are approximately 23,000 funds available. Even after eliminating the many funds that aren’t easily accessible to individual investors, there are still over 6,000 mutual funds to choose from.

The good news is that you can quickly narrow down your investment options to the candidates most suitable for your portfolio. Better yet, most of these steps can also be applied to selecting exchange-traded funds (ETFs). I give you the high-level steps here. The more detailed steps, plus much more, can be found in my “Mutual Funds 101” segment of our new Essential Investing Course.

1. Determine What Hole You Are Trying to Fill in Your Portfolio: The very first step is deciding what kind of fund you want. Are you looking for growth of capital, portfolio income or a mix of both? How about size and market? Are domestic large-cap stocks your preference? Do you want to add international exposure to your portfolio instead?
2. Is There a Style of Investing You Prefer?: Many investors find comfort in owning index mutual funds or ETFs. Others prefer active managers who have the potential to beat the market benchmarks. When it comes to stocks, are you a growth or value enthusiast? Bond fund investors may want the safety of government debt or the larger distributions made by high-yield funds. Identifying your preferred style will narrow down the list of funds you will want to consider.
3. Consider the Fund’s Expense Ratios: The higher the expense ratio, the higher the gross return a fund must realize just to match the performance of a lower-cost fund. This holds true for funds of all types. We suggest favoring mutual funds with A+ Investor expense ratio grades of A or B. These are mutual funds whose expense ratios rank in the cheapest 20% and 40%, respectively, for their category. (The same guidance applies to ETFs.)
4. Analyze the Fund’s Returns Against Its Peers: We recommend doing category peer analysis when analyzing funds because a manager’s performance is tied to the category of investments they are required to own. Even the most talented fund manager will struggle if their category is underperforming.
5. Look at Both Annual and Annualized Performance: Annual (calendar year) returns show whether a fund had a few years with large gains or losses that would affect its annualized returns. Annualized returns show how a fund has performed over time and smooths year-by-year volatility. The above chart, which is from our Fund Evaluator, displays annualized returns for the Fidelity Contrafund (FCNTX). 
6. Take the Tax-Cost Ratio Into Consideration: Fund distributions are taxable even if your fund holdings have decreased in value. This is why you should take the tax-cost ratio into consideration if you are seeking mutual funds to hold in a taxable account. The tax-cost ratio shows how much of returns are lost to taxes when assuming the highest marginal tax bracket. Lower is better. (Note that some ETFs also have high tax-cost ratios.)
7. Read the Fund’s Objective and Prospectus: Never judge a fund by its name; look at the prospectus. It will tell you whether the fund’s actual strategy and objective match your expectations. The golden rule here is to never buy a fund if you don’t understand its strategy.

I provide additional steps for finding the right mutual fund and give rules for determining when to sell in our new Essential Investing Course. The course also includes expert insights on ETFs, dividend investing, building retirement portfolios, technical analysis and more. Learn more about the Essential Investing Course.

No Investor Update on July 4

The AAII office will be closed on Thursday, July 4, and Friday, July 5 for the Independence Day holiday. The next Investor Update will be published on July 11.