The Four-Factor Test for Mutual Funds

mutual funds

For most Americans, mutual funds are the centerpieces of their investment vehicles. If you have a 401(k) your mutual fund options may be limited, but for those of you who have an IRA (or Roth IRA), you’ll most likely have the option to choose any mutual fund that you want.

Choices are good, but too many mutual fund options leads to choice paralysis. You end up staring at a list of mutual funds wondering if you’ll pick the right one. Inevitably, a lot of investors will resort to looking at strictly the performance of the fund for the last five years and ignore everything else.

4 Factors to Consider when Selecting a Mutual Fund

Your mutual fund pick should be based on at least four factors: fees, fund management philosophy, experience, and performance.

1. What are the fees?

Every mutual fund will have a fee, so make sure you know what your costs are to invest in that fund. The lower a fund’s fees, the more money that stays in your pocket. With the average mutual fund cost having been somewhere around 1.2% in the past couple years, aim to find funds that are lower. With a little research, you can find funds that are much lower. Take these funds as an example:

2. What’s the fund’s management philosophy?

You can get a feel for a fund company’s management philosophy in relationship to their shareholders by looking at Morningstar’s grading system. This grading system will take into consideration the fees along with fund manager compensation, corporate culture, and board independence. This is important to consider when you’re looking at actively managed funds. If you’re considering index funds, this factor won’t affect you since index funds don’t have someone trying to beat out the stock market.

3. What’s the experience of the fund managers?

From what I’ve seen, the typical fund manager will flip the entire portfolio over in less than a year. Look for experienced fund managers with a consistent investment strategy. You want someone who has experience with all market types and a long track record of sound investment decisions.

4. What’s the fund’s performance history?

Finally, you still need to consider performance history when choosing a mutual fund. There’s no definite way to predict how a fund will perform, but past performance will help you decide if this fund has what it takes to keep up with other similar funds. In order to get an idea of how much a certain sector has performed, take a look at Morningstar’s Index Performance chart to get a good picture of historical returns for different sectors.

Have you changed mutual funds lately? Did you take these factors into consideration? Leave a comment!











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4 Comments
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  1. Hey Tim, great article on how to pick a mutual fund. I like your comment about index funds as well – I’ve found index funds to be preferable to me as I’m not out to beat the stock market so much as ride its wave so to speak. Thanks!

  2. Nice job Tim…those are the big four in my mind. I’d also add when picking multiple funds not to have too many invested in the same basket of stocks. Need a mixture of funds that cover stocks that are large cap, mid-cap, small-cap, international, etc. That helps the investor diversify properly.

    • Read The Solomon Portfolio by Robt. Katz……….he covers this in detail….great book.

  3. Tim – At first glance, these 4 factors seem to make a lot of sense. And, the one about fees does make sense if comparing two similarly designed funds like an S&P 500 index fund from two different companies. However, when pursuing a strategy that attempts to beat the market (as opposed to meeting the market with an index fund), we have found that performance is far more important than fees.

    When it comes to a fund’s philosophy or the manager’s experience, these also matter very little. After all, the market dictates which philosophy or investment style is in or out of favor at any point in time. Managers that excel under one set of market conditions tend to be only average (or worse) under other market conditions. As for performance history, the typical historical reporting periods, such as past 5 years, have little to do with how a fund will perform over the next 5 years.

    What has proven to predict at least short-term future performance is short-term recent past performance, such as a fund’s performance over the past 3, 6, and 12 months. That’s the most important factor we have found in selecting mutual funds.

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