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 basic things to know. After identifying your investment objective 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: Almost anyone can buy them and they are 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 the research. There are several different mutual fund research sites you can use to find the best funds. You can find and use all of the basic mutual fund selection criteria with Morningstar's Fund Screener. This fund screener is free if you sign up for their 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 fund's relative category average or an index. For example, performance for most 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). Therefore 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 the five-year returns, keep it on your radar. Otherwise, remove it from consideration.

Check Length of Manager Tenure

Many investors overlook manager tenure, which is how long the manager has been managing the fund. Look for a manager tenure of at least three years and be sure the 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 an outstanding 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' performance.

Keep Fees and Expenses Low

Fees and expenses are a direct drag on investment returns. So, funds with low fees and expenses tend to perform better over long periods of time than those with higher relative expenses. Only consider mutual funds with a low expense ratio. Note: The average expense ratio in 2020 was 0.50%. Also, avoid sales charges (loads) by using only no-load funds.

Look for Low Turnover

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

Check Number of Holdings

By nature, mutual funds are diverse investments; they hold dozens or hundreds of stocks and/or bonds all in one basket. However, it is still a good idea to check the fund's holdings, which is how many stocks or bonds are held in the funds you are researching. If, for example, a fund only invests in 20 different stocks (holdings), there is an increased risk of high volatility (fast movements up or down in price).

You might see high gains as well as significant declines in value over short periods of time. For proper diversification and lower relative risk, check to be sure that the fund has at least 50 holdings before investing.

A Quick Tip on Index Funds

The previous points are primarily for selecting mutual funds that are actively managed, which basically means that the fund managers are trying to outperform the stock market average returns, 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 consistently outperform the stock market indexes, which is why many investors like to use index 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.