In each category of mutual funds there may be hundreds to pick from. How can you choose among them? Here’s what to look for:
Historic performance within its class. In the past few years, virtually every growth fund has been a money-loser, now that the tech-stock bubble has burst, but some funds have lost less than others. Similarly, a small-cap value fund might have had only a small profit during 1998 and 1999, yet that may have been among the best in its class.
Consistent performance. Compare how a fund has done in its category, over the short and long term. A fund’s one- and three-year record will show how it has done in the recent market decline while a five- or even a 10-year record will give you an idea of how a fund can perform in good times. There probably is a reason that a fund has performed among the tops in its category, good years and bad. Such funds might continue to do well in the future.
Remember, one or two good years do not necessarily make a good fund. You need to look at a fund’s volatility, too. Depending on your tolerance for risk, you may prefer to give up some potential upside by investing in a fund that doesn’t drop as much during down years.
Experience of a fund’s management. If a fund has a good record, you’ll want to see that the people managing the fund now are the ones responsible for that good record, for the past several years. If management is relatively new, look for a record of having successfully managed a fund elsewhere.
Expense ratio. Over the long term, a low expense ratio can make a major difference in your return. Again, you need to check a fund’s expense ratio against others in its category. Small-cap funds often have higher expenses, for example, because the work involved in tracking down and analyzing a little-known company may be greater than deciding whether or not to buy a blue chip.
According to Morningstar Inc., Chicago, the average U.S. diversified stock fund has an expense ratio of 1.48 percent: you pay $14.80 each year to manage $1,000 of your money. Those averages range from 1.28 percent for large-blend funds (a category dominated by cost-efficient index funds) to 1.68 percent for research-intensive small-cap growth funds.
Within each category, moreover, expenses can vary widely. Often, top-rated funds have expense ratios far below the category average.
Low expenses can be especially important in international funds, where expense ratios tend to be high, and in fixed-income funds. According to Morningstar, the average fixed-income fund now yields around 4 percent. With yields at historic lows, paying 1 percent or more each year to a manager will take a sizable bite from your total return so look for much lower expenses.