Some investors are still skittish about investing in mutual funds after the sharp declines in 2008-09. However, many funds have shown strong performance since the market began its rebound in March 2009. Mutual funds are still an efficient and cost effective way for most people to grow their portfolios over the long term – the key is to choose the right funds.
“Careful scrutiny is now the name of the game. Due diligence is not just for institutional investors. When choosing a fund, individual investors need to make sure they look carefully at all the basics – commission levels, expenses, manager style, performance and risk protection features,” according to Jeremy Welther, principal and senior financial advisor at Brinton Eaton, a wealth advisory firm based in New Jersey.
Here are some simple guidelines Welther recommends to help you avoid some common mistakes:
Understand the Expenses Involved
Before investing in any mutual fund, you should research the expenses involved in participating in the fund. There are two types of expenses to scrutinize: the commission, or “load” that is paid to the seller of the fund, and the gross expense ratio, which covers the costs of running the fund.
Load. Loads, or commissions, provide revenue to the selling agent from which someone can purchase mutual funds. This is typically the case when a mutual fund is purchased through a brokerage firm. Loads can be very costly to the investor: If you do not know these loads exist, you can end up paying for them without ever realizing it. Some loads are charged at the front end, when you purchase a fund, and some are at the back end, which requires you to pay upon redemption of your shares. Some funds have no loads, while others have loads that can run more than 5%.
Gross Expense Ratio. The gross expense ratio covers the cost of running a fund. This includes fund manager compensation, administrative costs, and the marketing/distribution fees, called 12b-1 fees. These fees can all vary widely, so it is worth comparing different funds to see how the expenses differ.
The gross expense ratio is not something that will appear on your statement as a fee. It’s reflected in your annual return. So, if the expense ratio on your fund is 1%, and the actual return for a given year is 10%, you will get 9%.
In any given fund, the gross expense ratio may vary based on the share class in which you are investing. Mutual funds have different levels of share classes that can be based upon the size of the investment in the fund or the type of account in which the fund is being purchased (such as a retirement plan offered by an employer). An employee of a small company that chooses from a fund menu may only have the option of investing in a more expensive share class, which can mean high annual fees. This is also true for the individual investor who buys into a fund with a modest amount of money, versus an institutional investor with millions to invest.
Watch for Style Drift
It is important that the fund in which you are investing does what it says it is going to do. When a fund deviates from its stated strategy, it is called style drift.
An investor may choose a fund specifically to have exposure to mid-cap companies. If the fund deviates from that strategy and starts investing in small-cap companies, your portfolio may be more heavily weighted to small-cap then you would like, or even be comfortable with.
Before investing in a fund, check how closely the manager stays in line with the fund’s stated parameters. Ensuring that your fund investments stay focused is important when you are trying to build a diversified portfolio.
Compare Your Fund with its Peers
Many people assume that comparing a fund’s performance to the S&P 500 or some other major index is a good way to gauge the success of the fund. However, this is not always a good strategy because the fund may not be trying to follow those indexes.
The better indicator is how well the fund did compared with other funds with the same objective. If the fund trails its “peers,” you probably want to stay away because the fund is underperforming in a group of funds that have the same goal.
Consider a Fund’s Safety Controls
In the wake of the financial crisis, many investors have been drawn to funds that have been specifically designed to offer above-average returns with less risk, or built-in protection against volatile markets. These mutual funds may be a good choice for investors who are seeking the comfort of greater transparency and stability.
“The basics of mutual fund investing haven’t changed – balancing low costs with good performance – but if the financial crisis of a few years ago taught us anything, it’s to more carefully scrutinize the financial products we are buying, and to consider funds that incorporate risk protection features,” says Welther.
Some good resources for checking expenses, a style drift and overall performance are Morningstar (www.morningstar.com) and Lipper (www.lipperweb.com).
About Brinton Eaton:
Based in Madison, NJ, Brinton Eaton is an advisory firm with a long history of serving individuals and their families across multiple generations. The firm helps its clients protect, grow, administer, and ultimately transfer their legacy of wealth through a full range of integrated services, including lifetime cash flow projections, financial/tax/estate/retirement planning, investment management, charitable giving, and business succession planning. Brinton Eaton’s clients tend to be corporate executives, professionals, entrepreneurs, retirees, and multi-generational families. For more information, visit www.brintoneaton.com.
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