Your Goals and Risk Tolerance
First of all, it is important to understand that the best mutual fund for you may not necessarily be a good choice for someone else. You have to make a comparison between funds from your investment strategy point of view. Are you looking for current income or capital appreciation? What is your risk tolerance? Are the heavy swings in portfolio value acceptable for you or do you prefer a more conservative investments?
If you have a long-term investment horizon and can accept a moderate amount of risk, long-term appreciation fund may be appropriate. In contrast, if you need current income, it may be better to invest in income fund, which have government and corporate bonds as main holding in the fund. Alternatively, when you have a long-term horizon but desire lower volatility, balanced funds can be a good option. These funds invest both in stocks and bonds.
So the first step in filtering from thousands of mutual funds is to look at how closely your risk/return characteristics much with the fund.
After determining your investment strategy, you can differentiate the funds based on their style and type and choose the ones that match your desired characteristics. Start with the asset mix of stocks, bonds, and cash and differentiate among company size, style, credit quality or several other criteria within these classes.
While the past performance of the fund doesn’t guarantee similar returns in the future, it is still a good idea to take a look at recent return figures. But don’t just make your decisions based on the recent year return; analyze past 3 to 10 years relative to the benchmark and check their consistency.
Expenses associated with investing in a certain fund is a very important consideration. Funds with low expenses and fees usually do better than others in a long term. Expense ratio is probably the best measure to compare the funds. It is the ratio of total annual expenses to the fund’s average net assets.
There are some funds that charge a load fee, which is a sales fee taken either upon initial investment known as front-end load fee or upon sale of investment, known as back-end load fee. It is better to avoid these costs by choosing a no-load fund, however, be aware that this alternative may charge other administrative fees that may be very high.
The turnover ratio, or a measure that shows how often the manager is buying or selling assets in the fund, is also a factor to take into account when picking a mutual fund. Higher turnover ratio indicates higher trading activity and thus higher trading costs. It may be possible that a fund making a 20% annual return will actually earn you less money after-tax than a fund with 15% return that has lower turnover ratio. So if you are not investing only through tax-free account, the turnover ratio is an important factor to take into consideration.