How to Choose the Best Mutual Funds

A woman looks over her mutual funds.
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If you want to choose the best mutual funds, there are only a few simple things to know. After identifying your investment objective (growth, income, or both) and tolerance for risk, you're ready to begin building a portfolio. Fortunately, the two greatest strengths of mutual funds are their accessibility and simplicity: They are both easy to buy and easy to understand.

Use a Good Fund Screener

Before you begin looking for the best mutual funds, you'll need a good tool to help you do your research. There are several different mutual fund research sites you can use to find the best funds. You can locate and choose all of the usual mutual fund selection criteria with Morningstar's Basic Fund Screener. This fund screener is free if you sign up for the basic membership.

Use the Appropriate Benchmark for Measuring Performance

To choose the best mutual funds, you'll need to know how to judge performance. Compare each fund's historical returns to an appropriate benchmark, such as the average for funds in the same category or an index. For example, performance for most U.S. large-cap stock mutual funds is compared to the S&P 500 Index.

Keep in mind that mutual funds are best used for long-term investing: more than three years. Put the heaviest weight in your selection criteria on the five-year return. Also, look at the 10-year return if the fund has been around that long. If the fund outperforms the benchmark for five-year return, keep it on your radar. If it doesn't, remove it from your search.

Check Length of Manager Tenure

Many investors overlook manager tenure, which is how long the manager has been overseeing the fund. Look for a tenure of at least three years, and be sure the return time frame you are reviewing represents the same time frame the manager has been at the helm of the fund. If, for example, you've found a fund that has a great five-year return, but the manager tenure is only one year, it means the current manager receives no credit for four of the past five years of performance.

Keep Fees and Expenses Low

Fees and expenses are a direct drag on investment returns. That means funds with low fees and expenses tend to perform better over long periods of time than those with higher relative expenses.

The average expense ratio for stock funds in 2020 was 0.50%.

Consider only mutual funds with a low expense ratio. And avoid sales charges (loads) by buying only no-load funds.

Look for Low Turnover

Turnover is a measure of a fund's trading activity: how often the manager is buying and selling the stock or bond holdings in the fund. Turnover is often expressed as a percentage, called the turnover ratio. A low turnover ratio (20% to 30%), which is generally better for investors, indicates a buy-and-hold strategy and low trading costs. A high turnover ratio (more than 100%) indicates a lot of buying and selling of securities, which results in higher relative trading costs.

Check the Number of Holdings

By nature, mutual funds are diverse investments; they hold dozens or hundreds of stocks and/or bonds all in one basket. To make sure a fund is diversified enough, you should look for the number of securities it holds at a given time. If, for example, a fund is invested in only 20 stocks, there is an increased risk of high volatility: sharp swings up or down in price.

For proper diversification and lower relative risk, check to be sure that the fund has at least 50 holdings before you buy shares.

A Quick Tip on Index Funds

The previous tips apply more to mutual funds that are actively managed, which means that the fund manager is trying to outperform the broad market return, as measured by an index such as the S&P 500. However, over long periods of time, especially five years or more, the majority of actively managed funds do not outperform their benchmark, which is why many investors like to buy shares of index funds instead. These funds seek to track, not exceed, the performance of their benchmark. Because they are passively managed and require less work from their managers, their expenses should be lower than those for actively managed funds.

Disclaimer: The information on this site is provided for discussion purposes only, and should not be misconstrued as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities.