For the do-it–yourself investor, it’s important to understand how to effectively choose investments for your portfolio. Some people like to invest in individual stocks but a great many choose to utilize mutual funds and exchange traded funds (ETFs), which provide broader diversification and professional management. In this, the first of two posts, we will discuss some of the key things to look for when picking a mutual fund. Part II will focus on other more specific things to consider when picking equity and fixed-income funds.

As fee-for-service-based advisors, we help clients develop investment strategies tailored to their individual risk tolerance, utilizing no load mutual funds (including index funds) and ETFs. Periodically, we do extensive research to identify no-transaction-fee funds that we can recommend to our clients. Although we consider a large number of criteria to select our recommended funds, over the years we have come to find some aspects more important than others.

The Morningstar® rating is a good place to start. Generally, we recommend funds with a minimum of a three-star rating. It’s tempting to always focus on 5-star rated funds but all too often this year’s five star fund becomes next year’s three-star fund and vice versa. You can utilize Morningstar®’s online tools to select fund candidates that fit specific fund category (e.g. large stock, world stock, short-term bonds, etc.) and style criteria (e.g. value, growth, and blend).

Next, we focus on fees. For our clients, we ensure there are no front loads or deferred loads and look for no transaction fee funds (these vary with each brokerage company). Once you have eliminated funds with loads, focus on fund net expense ratio. Generally speaking, the higher a fund’s expense ratio, the worse it performs over the long term compared to it’s lower cost peers. Strive for an expense ratio near or below 1%. Expense ratios tend to vary across different fund categories, with international and small-cap funds usually with higher expenses.

The next factor we focus on is the five to ten-year category rank which measures how the fund has performed relative to other funds in the same category. We have found that long-term performance is generally more indicative of future performance than recent performance. Short-term poor performance coupled with a change in a fund’s managers could indicate a red flag.

A third factor we review is the Morningstar®’s evaluation of a fund’s risk. We tend to be fairly conservative and therefore prefer lower-risk funds for our clients. Investment risk is often measured by standard deviation, a statistical concept that measures the variability of a fund’s returns over time. The higher the variability or volatility of a fund, the riskier it tends to be. We prefer lower-risk funds in order to help provide clients with some downside protection. We believe it is important to focus not just on providing returns but also to avoid losses to the extent possible. We often like to quote Warren Buffett who said:

“Rule number one is: Never lose money.
Rule number two is: Don’t forget rule number one!”

Picking funds that Morningstar rates as “low risk” or “below average risk”, we believe, will serve you well over the long run.

The four criteria above will do well to get you started in your quest to identify good funds in which to invest your hard-earned money. Our next post will discuss some other factors you also need consider.