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How to Choose Mutual Funds

June 15, 2007

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In the last podcast I explained the “WHEN, WHERE, and HOW” of investing, but based upon a few of the emails that I received I need to review a few basic concepts of investing.

First let’s play the definition game (definitions provided by www.about.com ):

Stocks – Instruments that signify an ownership or equity in a company. These are purchased as shares whose value can increase or decrease as the value of the company’s assets increase or decrease.

Bonds – A written promise to repay the principal amount upon maturity and to make specified interest payments to the bond holder.  A bond is a debt of obligation and the interest and principal, when due, are payable to the holder.

Mutual Funds – An investment tool that allows investors to participate in a diversified portfolio with other investors.  A company collects the funds of several investors and then uses the funds in a variety of investments.  Each investor shares in the gains and/or losses.

No-Load Funds – A mutual fund that does not charge any commissions.

Index Funds – A mutual fund whose portfolio of stocks is weighted the same as the stock exchange index. An index fund is set up to mirror the performance of the stock index.

In the last podcast I gave you my opinion that for those that have less than $200,000 should consider using Fidelity’s Freedom Funds or Vanguard’s Target Retirement Funds. Both of these fund companies (Fidelity and Vanguard) are mutual fund companies. I had several people that wrote to me that were confused as to what type of investments these asset allocation funds were. If you go look them up and research them through www.Morningstar.com or some other research site you will find that they are funds that are made up of other funds. This provides you with a great deal of diversification with one simple investment.

Now let’s get back on track and discuss “HOW TO CHOOSE MUTUAL FUNDS”…..

First you guys need to know my thoughts on what is known as Efficient Market Theory

Efficient Market – Since everyone has the same information about a stock, the price of a stock should reflect the knowledge and expectations of all investors. The bottom line is that an investor should not be able to beat the market since there is no way for him/her to know something about a stock that isn’t already reflected in the stock’s price.

I feel that this Theory holds true for Large Cap. US Companies.  There are really only 1,000 Large Cap Companies (Cap Value > $10 Billion).  Meanwhile there are pundits, analyst, and advisors like myself on every street corner to evaluate these 1,000 stocks.  With the vast amounts of information and the speed that information now reaches us through the Internet, Cable Business Channels, AM Business Talk Radio how could you know anymore than anyone else?

Plus the average mutual fund charges 1.5% of internal expenses versus a good index fund that only charges .10%. The resulting 1.4% difference in fees is the amount that an active manager has to outperform the broad large cap index.  There is a reason that on a running 10 year history the S&P 500 outperforms approximately 70% of the actively managed large cap mutual funds.

So with all of this explanation I believe that most investors should use Index Funds and ETFs to cover their Large Cap US Investments (The S&P 500).  The only exception is if you have access to great funds like Dodge & Cox Stock (DODGX) and other great funds that consistently beat the Index.  Unfortunately, most great funds like this are closed to new investors.

Inefficient Markets – Foreign (International Stocks) and Small Cap Stocks are what I consider to be inefficient markets.  You would be much better served if you used really good managers that consistently beat their benchmarks.

Let’s Recap and Review:
1) Buy Index Funds for your US Large Cap Exposure
2) Buy good managed Funds for International and Small Company Exposure

A good tool to help you determine which funds to invest with is the “Mutual Fund Screener” available through Yahoo Finance (click here) This tool will allow you to sort and filter through the ever growing mutual fund universe.  A few key areas that you may want to consider when using the tool:

** Category
** Rank in Category
** Manager Tenure
** Morningstar Rating
** 3 & 5 Year Return Annualized (The 5 year will be really helpful to see how the fund handled the Bearish 2002)
** Min. Initial Investment
** Front Load (this is where you will want to adjust the filter to only allow “No-Load” Mutual Funds
** Expense Ratio

All of this data can be a tremendous help in determining which funds will fit nicely into your diversified portfolio.

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