What Criteria Should I Consider When Choosing Mutual Funds

With so much market volatility, it can be difficult to determine the best investments to use in a 401(k) account or IRA. With such a limited selection, what should we do when they are all going down?

Our immediate emotional response would be to move to the sidelines - a cash or money market account. We can rationalize that it is better to not make anything than to see a loss. However, that is a form of market timing, and it does not work for long term investing. Most investors miss the biggest opportunities while sitting in a money market account.

Today, we will look at five of the most common criteria advisors use to evaluate mutual funds. Using these criteria individually can be helpful in maintaining a quality investment portfolio.

Performance against the benchmark

Performance alone is not something to consider. Too often, investors look at the investment return tables and choose the funds that have the largest numbers. That's not quite the right method to use. While we do want funds that are performing well, if we only choose all of the top performers on the list, we are very likely to pick most of the higher-risk options and none of the more conservative choices.

We need to compare apples to apples. We want to evaluate a fund against its own peer group. Large cap value funds should be compared to other large cap value funds. Intermediate term bond funds should be compared to other intermediate term bond funds.

Funds should be compared against their own peers and their respective benchmarks.

Five-year performance

While any fund in any category can have a good year, we want to make sure that a great return is not simply a fluke - a bet that paid off well.

Looking a five-year performance can give us a better idea of whether the manager is able to sustain good performance. There will usually be one or two bad years in a five-year cycle, so this will help us evaluate a manager in both good and bad years.

This performance should also be considered against peers and the respective benchmark.

Manager tenure

Performance doesn't mean much if a manager is new. We cannot give much consideration to a fund's 10-year performance record if the manager has only been with the fund for the past two or three years. That would mean that another manager is responsible for the majority of the fund's history.

Funds with new managers need to be monitored carefully. Sometimes they are brought in to replace a manager with a bad record. Other times, managers retire or move on to other opportunities. Nevertheless, it will take awhile to get a good idea of whether or not the new manager will be a valuable addition to the fund.

Style drift

Funds have investment objectives. They are designed to invest in a specific way. For example, large cap growth mutual funds are supposed to buy stock in large companies that still have growth potential. If they start buying value stocks or mid and small cap stocks, then they are not remaining true to their objective. This is called style drift.

Some managers drift, hoping improve performance. However, it is not appropriate because it ultimately misleads the owners of the mutual fund shares. How can we create a balanced portfolio if the mutual funds we select are able to buy in whatever category they want?

Fees

While some investment products are less forthcoming with their fee structure, it is still important for an investor to understand the costs involved in owning the funds. Fees should be comparable to other peers and not excessive.

While this list is far from complete, it does describe the most common criteria that are used to evaluate retirement plan mutual funds. It can be used as a starting point to help determine whether we should consider making changes to our current retirement account portfolio.