Choosing a Mutual Fund – Avoid These 6 Mistakes

As of July, 2012 there were 7,699 U.S. mutual funds.  As a financial professional who does this for a living I have access to a number of data bases and screening tools to help me choose the right funds for my client’s portfolios.  I often wonder how individual “do it yourself” investors choose from among the available options for their portfolios. Choosing the right mutual fund is always tough, but picking the wrong fund can have dire consequences. Here are a few mutual fund selection mistakes to avoid.

Always assume that a “brand name” translates into a good mutual fund. This fallacy has never been more evident than during the recent arbitration award against JP Morgan in connection with its brokers pushing their proprietary high-fee, low performing mutual funds over those of other fund providers.  Even excellent fund families such as Vanguard have had problem funds over the years.

Relying on lists of top funds.  There is nothing wrong with these lists per se.  However, looking in the rearview mirror constantly is not a safe way to drive, nor is it a good way to choose a mutual fund. The common disclaimer in the investment world is that “past performance is not an indication of future results.” Last year’s top fund might continue to deliver top performance, or it might not.

Ignoring a fund’s history.  At the risk of contradicting my last point, it is instructive to look at how a fund performed in both absolute terms and relative to its peers during various types of market conditions.  For example did the fund lose more than other funds of the same investment style during the market drop of 2008?  Did it also gain less than its peers during the 2009, a year of recovery in the markets?  Also look at qualitative history.  Is the same manager who compiled the fund’s stellar track record still managing the fund?

Avoid funds you’ve never heard of. The 2011 Morningstar Domestic Equity Managers of the Year are from Artisan, a smallish fund shop based in Milwaukee. These managers run the large, mid, and small-cap value funds offered by Artisan. While the award was for 2011, this team has done a solid job over the past ten years under difficult market conditions. Unfortunately for new investors (but not for existing shareholders), two of the three funds managed by this team are closed to new investors.   Selecting a mutual fund is about research and fit with your investment objectives, not about the fund ads you might see in the press.

Assume all index funds are created equal. Nothing could be further from the truth. Different funds tracking the same index can vary greatly in their expenses and structure, which will impact their performance. Additionally there may be transaction costs for some funds at various custodians which can eat into your returns, especially for smaller transactions.

Assume that the fund companies have your best interests in mind. I’m not saying that any fund company is out to hurt investors, but on the other hand they are in business to make money. A number of fund companies are publicly traded.  Their first duty is to make money for their shareholders in hopes of increasing their share price.   New fund offerings are often the result of recent market trends, good or bad. Don’t invest based on the hype fund companies might create around these new offerings. Rather, invest with your goals, risk tolerance, and your overall plan in mind.

Choosing the right mutual fund, individual stock, or ETF is difficult. Make sure you select investments based upon solid research and based upon their fit with your overall portfolio.

Please feel free to contact me with your investing and financial planning questions.

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