Questions To Ask Before You Choose A Mutual Fund

With thousands of mutual funds to choose from, picking the one that’s right for you means you need to do your homework.

Regardless of the specific fund you’re attracted to — sector funds that specialize in a particular industry, or index funds, which duplicate the yardsticks of the economy, like the Dow Jones Industrial Average — here’s a list of questions you should ask about any mutual fund before you make out a check.

What is the fund’s total return? Most mutual fund advertisements tout the annual yield of a fund, which is inaccurate since it doesn’t take into consideration dividends, capital losses or gains, or any change — up or down — in a fund’s share price. A fund’s total return is the best way to size up a fund’s performance.

What is the five-year return of the fund? When evaluating a potential mutual fund, many investors just look at of the previous year’s results. While many managers base an entire marketing campaign on a stellar one-year gain, they may be downplaying the negative returns of the year before. Year-to-year returns may gyrate radically — especially when managers feel pressured to frequently buy and sell fund holdings. Inconsistent annual returns may also signal inner turmoil at the firm.

If it’s a no-load fund, why do I have to pay an annual management fee? No-load doesn’t mean no fee. Load funds charge shareholders to buy or sell shares in the fund, while no-loads waive that fee. However, both types of fund still charge an annual management fee, which helps pay for the manager’s salary, the cost of administering the fund, and distributing checks to shareholders.

What’s a 12b-1 fee? All funds charge 12b-1 fees, which are used to offset marketing costs. The next time you see an advertisement for a mutual fund that you own, you’ll know that your 12b-1 fee helped pay for it. Though it may seem unfair, it’s the cost of doing business. For instance,.when you buy a McDonald’s hamburger, a percentage of the cost goes towards the thousands of ads you’ll be exposed to in the next year. A 12b-1 fee is the same, except because of strict SEC rules, mutual fund managers are required to disclose all costs associated with running a fund. Hey, at least they’re honest about it.

What’s the turnover rate for this fund? Turnover means the percentage of stocks sold over one year in the fund. Fund managers often buy and sell stocks frequently to generate capital gains, which increases the tax you’ll pay at the end of the year. In order to avoid paying high capital gains tax, annual turnover on a fund should remain below 75%.

How long has the fund manager handled the fund? Sometimes, when new managers come on board, they may be tempted to buy and sell stocks to put their personal stamp on the fund, which can lead to high turnover rates. If the manager is new, try to check out his or her track record at previous positions.

Does the manager’s investment style match the philosophy described in the prospectus? Needless to say, before you invest in any mutual fund, request a copy of the prospectus so you know what to expect. Compare the investment strategy in the prospectus with the current fund holdings, and if they don’t line up, pick another fund. Even fund managers have a rebellious streak.

If it’s a load fund, are the fees front-end or back-end? With a front-end load fund, the fee will come out of your initial investment the day you sign up, and can amount to two to six percent of your total investment. With a back-end load fund, you’ll pay the fee when you sell your shares in the fund. Both types are designed to discourage you from selling your shares soon after you buy them. Some investors believe that load funds generate higher returns than no-loads — but one look at the history of load funds vs. no-load funds doesn’t bear this out.

What’s the expense ratio of the fund? An expense ratio is the percentage of the fees shareholders pay related to the total amount invested in the fund. Acceptable expense ratios range from 1% to 1.5%. Large-cap stock funds — large corporations, with market values of $8 billion or more — tend to have lower expense ratios, while mid-cap (corporations with market values of $1 to $8 billion) and small-cap funds (market values under $1 billion) have higher expense ratios.