U.S. Markets closed

How to Pick and Choose the Best Mutual Funds

John Divine

With about 8,000 mutual funds on the market, picking the right one can be a chore. And once you've made the decision that you want an actively managed fund -- rather than passive management -- the choices can be overwhelming.

Thankfully, abiding by a few important criteria can help you in your decision-making process to get the best mutual fund -- and the best mutual fund management -- to fit your particular situation.

The lower the fees, the better. Over time, fees charged by mutual fund managers can drag on investor returns, and there's no evidence that exceptionally high fees are routinely accompanied by exceptionally high returns. More frequently, they accompany big names, flashy strategies and a heavy marketing spend.

[See: 8 Stocks to Buy For a Starter Portfolio.]

Jon Ulin, certified financial planner and managing principal of Ulin & Co. Wealth Management in Boca Raton, Florida, notes that exceptional active mutual fund managers are hard to find.

"Most managed investments do not live up to their promises and unique names and themes provided by their managers. In fact, only 20 percent of active investment managers beat their benchmarks in any given year," he says.

That means you should look at the expense ratio, or the percentage of assets that an investor pays annually to cover fund expenses, like a price tag. The higher the price tag, the lower the chance you'll beat the market, plain and simple. Expense ratios less than 1 percent are highly preferable.

Paul Jacobs, certified financial planner and chief investment officer of Palisades Hudson Financial Group, advises that the turnover ratio is another useful metric for the discerning investor to seek out. A 100 percent turnover ratio means positions are held for one year on average, while a 200 percent ratio means positions are held for an average of just half a year.

Again, high turnover rates are not a good thing, Jacobs says.

"High turnover rates lead to higher trading costs, and also higher year-end capital gain distributions," he says. "Both of these can be a drag on after-tax returns for investors. If you have identified a fund you like that has a turnover ratio of 100 percent or more, you'd be better off holding it in a retirement account so you won't owe tax on any capital gain distributions."

Beware great performance over short time periods. For better or worse, performance is usually the first metric that investors turn to when deciding which mutual funds to buy.

But choosing a mutual fund manager simply by screening for the best one- to three-year returns isn't the best way to do things; in fact, it's a good way to stack the deck against yourself.

If you have a good idea about where we are in the market cycle and you're not easily convinced to buy a mutual fund merely because it's outperformed in recent years, you're halfway there. "Let's say you are evaluating a large-cap growth fund in March of 2000," says Matthew Tuttle, certified financial planner and CEO of Tuttle Tactical Management in Riverside, Connecticut. Your fund likely would've returned 30 to 40 percent a year for the last five years, he says.

If you use forward-looking due diligence and know the average return on markets are 8 to 12 percent, then you can "safely assume that there is no chance that you can earn 30 to 40 percent going forward" in the same fund, he says.

[Read: 7 Stocks That Should Grow With Millennials.]

In fact, by looking back on trailing returns an investor can safely predict losses to a portfolio. "Past performance does not predict future results," Tuttle says. "In fact, the biggest investment blowups have been because investors looked at solid past performance and believed it would persist."

Know what type of focus you want the fund to have. Every one of the 8,000 mutual funds out there has a focus of some sort. As an investor, you need to know what that focus is and whether it fits in your strategy.

Are you seeking a large-capitalization value fund, a small-cap growth fund, mid-cap growth and value fund, municipal bond fund, corporate bond fund, sector- or industry- specific funds, distressed asset funds? The options are practically never-ending.

"Before investing, take time to read all information available online on a service such as Morningstar regarding a funds process and management style, as well as go to the investment company's website to review the prospectus and provided marketing material," Ulin says.

There's some overlap here with minding fund fees, because if a fund is trading in and out of positions all the time, any advantages its focus gives it are swallowed up by trading fees -- and the fact that the manager arguably has less conviction in each decision.

[See: 8 of the Most Incredible Investments of the 21st Century.]

"We generally prefer to invest with managers that trade less often, and have more conviction in their investment decisions," Jacobs says.



More From US News & World Report