Evaluating the Most Important Criteria for Selecting an Appropriate Mutual Fund

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Mutual Fund Education

Evaluating the Most Important Criteria for Selecting an Appropriate Mutual Fund

David Dierking Dec 19, 2017

In case if you are wondering whether mutual funds are right for you at all, you should read why mutual funds, in general, should be a part of your portfolio.

The Importance of Using Screening Criteria

Investors should always start by applying a handful of simple screens to help narrow down the available choices. This helps ensure that the funds you consider are aligned with your objectives and risk/return expectations. Here are five criteria that you should be looking at before you invest a single dollar.

Click here for a list of seven important questions you should be asking before choosing a mutual fund.

1. Fees

The amount you pay for a mutual fund is the easiest thing you can control, and potentially makes the biggest difference in realized returns. Most studies conclude that funds with lower fees, in general, outperform funds with higher fees over virtually all time frames measured.

Expense ratios differ across different products, so it’s important not to use just one number for all fund types. The average active equity fund expense ratio is around 0.65%, while bond funds fall in at roughly 0.50%. Index funds make an even better option, with many carrying expense ratios of 0.20% or less. Watch out for excessive loads and commissions, as well. Many funds can be bought with no transaction fees on platforms such as Fidelity, Vanguard and Schwab.

Ever wonder what goes into a mutual fund expense ratio? Click here to learn more.

2. Risk Measures

Mutual fund returns only matter in the context of the risks taken to achieve them. A fund that returns 10% that has taken a lot of risk isn’t necessarily better than one that returns 8% with relatively low risk.

Metrics such as the standard deviation of returns and value at risk are more absolute-risk measures, while beta and the Sharpe ratio give a sense of risk/return versus a given benchmark. Over-reliance on these numbers isn’t necessarily a wise decision, but they can help give a directionally correct idea of which funds may be excessively risky.

Click here to learn about the 10 biggest mutual fund investing myths debunked.

3. Fund Ratings

Mutual fund screeners from sites such as Morningstar and Zacks can be especially helpful in working through lots of data all in one place. What’s better is that you can use these to compare funds to others within their own peer group, so you’re not comparing apples to oranges.

Both of these sites use their own proprietary scoring methods to rank funds, so you’ll want to be careful to make sure you understand the methodology involved. Since these sites use a combination of both historical returns and risk, it’s easier to narrow down your search to only the highest-rated funds.

4. Historical Performance

It’s often said that historical performance is not predictive of future results. While that is certainly true, looking at how the manager of a fund has performed versus its benchmark in the past can indicate whether or not he or she has a good track record as a stock picker.

Manager tenure should also be a consideration, since strong performance over a period of a few years or less may not give a good indication of how a manager can perform in multiple market environments. However, note that historical performance is less a concern for passively managed index funds, since they aim to simply match an index’s return and don’t require active management.

Mutual fund expense ratios are trending downward. Click here to learn more.

5. Dividend Yields

For income investors, a fund’s dividend yield is another factor that is incomplete without context. Higher yields generally come with higher risk, so selecting an investment based on the dividend alone can yield unfortunate results. As with fund returns, look at what type of risk comes with a dividend yield to help determine if it’s a good risk/return tradeoff.

The Bottom Line

Be sure check out our News section to keep track of recent fund performances.

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