How to Pick a Mutual Fund?

By Amit Rupani

In the United States, there were 9,599 mutual funds in 2018, managing assets worth approximately 20 trillion dollars. These 9,599 mutual funds include debt, equity, and other asset class mutual funds. Today, a DIY mutual fund investor will have to scan through thousands of mutual fund prospectus to create a well diversified portfolio of mutual funds. Also, it is like a maze hunt to dissect through opaque disclosures and financial jargons of mutual fund companies.

My goal of this article is to help a DIY mutual investor, who is willing to invest some time and effort to ensure that their hard earned savings is entrusted to right people to invest their money. Below are some of the important factors that I would look for before investing my money in a mutual fund:

Cost: Invest in “direct mutual funds". This means to buy mutual funds directly through the investment companies that offer and manage your money and to cut the middleman (distributors and brokers). Most of your investment dollar goes into the fund and right to work for you. Investing in direct mutual funds would save approximately 0.50 percent every year on your total cost of owning the mutual fund. An investment of $100,000 in direct mutual fund giving 9 percent annual return for 30 year horizon would grow to $1,326,768. Whereas, same investment in regular mutual fund would grow to $1,155,825. It is a whopping difference of $170,943!

Skin-in-the-game: The managers of the mutual fund should put significant personal dollars on the line alongside yours. If they don't invest money in their own fund, why should you? With mutual fund managers investing side by side with other investors, everyone's interests are fully aligned. Everyone is eating from the same cooking.

Low Turnover Rate: Every time mutual fund manger makes buy and sell transactions, it incurs transaction costs. All these costs add up very fast and the investor is paying for it. The annual turnover rate is shared in the annual report of the fund. Look for funds with low turnover rate, typically 25 percent or less. 100 percent is average for most of the mutual funds. Low turnover means mutual fund manager is confident of their investment picks and is invested with long-term orientation and not there to play the momentum game.

Long term track-record: Don't be swayed by chasing mutual funds which have generated good returns in last 1-2 years. Its good consistent returns over long term horizon; preferably 10 plus years that matters. Even best of the mutual funds will underperform during some point of market cycles. As long as their long-term track-record to beat S&P 500 is intact, one should be fine.

S&P 500 index as benchmark: S&P 500 is considered best diversified index of top 500 businesses of the US. Look for mutual fund that has S&P 500 or any other broader market index as its benchmark. It's beating the market (S&P 500) that matters to the investor. There is no point in buying 10 different mutual funds of 10 different sectors and industries for proper diversification. Let the manger use their expertise to pick any businesses that they think are available at attractive price given current uncertainties. Pick appropriate broader benchmark for debt or other asset classes.

Experienced Manger: Financial markets run in cycles. These cycles can be longer than a decade some times. It's good to have mutual fund manager who has experienced at least couple of cycles and has seen both bull and bear runs in the market. An investor can count on experienced manager to learn from their experience and not repeat any previous mistakes. “There are old investors, and there are bold investors, but there are no old bold investors." – Howard Marks.

Close fund doors at right time: The biggest reason why a mutual fund company will decide to close its fund's doors is that the fund's strategy is being threatened by the fund's increasing size. Many new investors pour new funds when fund has performed well. According to Jack Bogle, legendary founder of Vanguard, a one billion dollar fund could expect to find as many as 2500 stocks of sufficient size to accommodate a meaningful investment. However, for a ten billion dollar fund, the universe shrinks to as few as 250 stocks. So look for rationale mangers who understand their limitations very well and are not after increasing AUM (assets under management) to garner more fees.

It can get overwhelming to create your own portfolio of Mutual Funds on your own, but if one is willing and patient to learn something new and do the hard work, several thousands of dollars can be saved. I highly recommend the book The Investor's Dilemma by Louis Lowenstein to better understand the workings of the Mutual Fund industry.

Happy Investing!

Disclosure: Author of this article doesn't hold any mutual funds, but invests directly in stocks and bonds.

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Amit Rupani, CFA is an Independent Investor, practices Value Investing principles, manages money for long-term wealth creation through Equities asset class. Email: rupaniamit@yahoo.com