Expert Guidance: Choosing mutual funds With Marc LackritzChoosing mutual funds If you participate in an employer-sponsored retirement plan, have an individual retirement account (IRA), or invest through an education savings plan, chances are you own one or more mutual funds. And, like many investors, you may include mutual funds in a regular taxable account.

Despite the scandals that have haunted parts of the mutual fund industry in recent years, funds continue to be widely used for the same reasons that have attracted investors since the 1970s. You have access to an enormous variety of funds, all of which provide a statement of their investment objectives and investing styles, as well as regular updates on performance history, fees, and other relevant issues. You can invest relatively small amounts of money initially, reinvest or add new assets easily, benefit from professional money management, and sell quickly — though the price may be more or less than you paid to buy.

Funds are also highly regulated, an effort meant to ensure that investors who do their homework and exercise reasonable caution won't be exposed to inappropriate risk. That scrutiny has increased in response to evidence that some funds had permitted favored clients the opportunity for market timing and late trading, practices that penalize long-term shareholders by raising portfolio expenses.
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Understanding mutual funds Mutual funds, like the individual stocks or bonds that make up a fund's portfolio, or list of holdings, have the potential to provide varying levels of investment return and carry different levels of risk.

When you invest in stock mutual funds, you expect a return similar to what you'd have if you owned a comparable portfolio of individual stocks, and you face the risks that are typical of stock investing. For example, because small-cap stocks tend to be volatile, you might expect a small-cap stock fund to outperform other categories of mutual funds when stock markets are strong, but lose a significant portion of its value in a market downturn, just as a portfolio of small-company stocks might.

But other types of stock funds, such as broadly diversified large-company equity income or growth and income funds, which invest in dividend-paying stock, are less likely to suffer a dramatic short-term decline than more narrowly defined funds that invest in a particular sector of the economy, such as biotechnology or pharmaceuticals, or in small company stocks.

Similarly, when you invest in bond funds, you anticipate interest earnings in line with the type of fund you choose: corporate or government, long-term or short-term, high quality or high yield — which means bonds that pay a higher interest rate to compensate for greater risk. With both stock and bond funds, net asset value (NAV) per share is based on the market value of the securities the fund holds.

You may also choose money market mutual funds for the cash-equivalent portion of your portfolio. Unlike bank products, such as CDs, these funds are not insured — any more than the assets in stock or bond funds are. But money market fund managers do try to maintain the value of each share at $1.
From The Expert
The most critical determinant of the performance of an equity mutual fund is the performance of the stock market as a whole. On average, what's happening in the marketplace explains about 85% of the total return of most growth, value, and equity income funds. The investment decisions the fund manager makes and the timing of those decisions explain most of the remaining 15%.
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Understanding your investing style Choosing the right mutual fund for your portfolio requires evaluating the investments you already own, how the new mutual fund can help you achieve your financial goals, and how much risk you are willing to take. In the financial world, it's your tolerance for risk that determines your investing style.

Your risk tolerance is the product of a variety of factors: your age, personality, personal experience, and financial circumstances are among the key ones. For instance, if you're approaching retirement, are responsible for the financial security of other people, have lost money on investments, or don't feel confident making investment decisions, chances are you may be a more risk-averse, or conservative, investor.

At the other end of the scale, if you're young, earning a comfortable income, and have few financial responsibilities other than your own well-being, you might be inclined to take more investment risk to reach your goals more quickly. While there are as many investing styles as there are investors, most people fall more or less into one of four broad categories:

• Conservative, or those who are uncomfortable putting any money at risk
• Moderate, or those who want to increase the value of their portfolios while protecting themselves from major losses
• Aggressive, or those who are willing to take investment risk with the expectation of higher than average returns
• Contrarian, or those who invest in what's currently unpopular with other investors in the belief that the markets will turn around and they'll be in the best position to reap the profits

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Realistic expectations Part of making intelligent mutual fund selections is having a realistic perspective on the potential return a fund could provide. For example, if you're investing for the long term and want your portfolio to increase in value, you may want to concentrate on funds whose investment objective is long-term growth rather than current income.

Evaluating the funds that meet your initial criteria means using a two-step process: first looking at the average annual return of an appropriate benchmark for the type of fund you are considering and then at the historical performance of the fund itself — ideally over a minimum of ten years if the fund has been in existence that long.

While past performance doesn't guarantee future results, knowing what has happened in the past gives you a sense of the most you can reasonably expect to gain and a sense of what can happen in a downturn. For example, if you're considering a diversified large-company equity fund, you could get a sense of how that asset subclass as a whole has performed by looking at the annualized average return of the Standard & Poor's 500 Index and the Lipper Large-Cap Core Index. Then you could check the annualized return of the fund.

If over a number of years the fund has done at least as well as (and ideally somewhat better than) the benchmark, you might conclude it is worthy of further consideration. But if the comparison is disappointing, you might decide to look for another fund.
From the Expert
To invest with success, you must be a long-term investor. The stock and bond markets are unpredictable on a short-term basis, but their long-term patterns of risk and return have proved durable enough to serve as the basis for a long-term strategy that leads to investment success. Although there is no guarantee that these patterns, no matter how deeply ingrained in the historical record, will prevail in the future, a study of the past, accompanied by a self-administered dose of common sense, is the intelligent investor's best recourse.
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Mutual fund characteristics In addition to past performance, you may want to consider the following elements of any mutual funds you're considering to help form a realistic perspective on a fund's past — and potential future — performance:

• Portfolio characteristics. You'll want to review each fund's prospectus for the details on its investment objective, style, and risk profile to evaluate whether it is compatible with your goals. You may also want to check the most recent list of fund holdings.
• Size of fund. You may want to avoid funds with assets of less than $50 million because of the relatively higher expenses associated with small funds, along with the possibility that a small fund may be more vulnerable to takeover. On the other hand, very large funds are sometimes less agile in part because they have so much money to invest.
• Age of fund. There's a consensus that a fund should generally have proven its merit over a period of at least five to ten years, though there are some exceptions. Similarly, if strong returns depend on one or two outstanding years, with results trailing the market in other years, that's rarely a good sign.
• Tenure of portfolio manager. You may want to find out how long the current manager has run the fund and how consistently the fund has met its objective — a few months, a few years, or a few decades — to get a sense of the fund's stability.
• Cost of ownership. It's wise to compare funds' advisory fees, operating expenses, and marketing or 12(b)-1 costs, which together make up the fund's expense ratio, since these costs will have an impact on what you actually earn in the fund. You'll also want to consider any loads, or sales charges, and the fund's transaction fees. Expense ratios and loads are reported in the fund prospectus, but transaction fees may not appear as a separate figure.

Apples to apples
To make an accurate comparison of the performances of different mutual funds, you'll want to look at funds that have similar objectives and make the same types of investments. For example, you learn more by comparing small-cap stock funds to each other than to a bond fund or even a large-cap stock fund. It also helps to compare performances over identical time periods.
Fund fees make a difference
If you invested $10,000 in a fund that earned a 9% annual return with total annual fees of 2.5%, you would have about $35,200 after 20 years. But if the fund had expenses of only 1%, you would have more than $46,600. That's a difference of $11,400.
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Allocation & risk When you invest for the long term, you're seeking growth over time and can ride out periods of short-term volatility, which is a measure of how quickly and how much a security's price changes. So you may choose to invest a larger part of your portfolio in equity funds. But as a way to manage risk, it's a good idea to consider the role of income investments as well. When you're using mutual funds, income investing generally refers to bond funds, though you may also consider equity income or growth and income funds, or real estate investment trusts (REITs).

One characteristic of bond funds is that they are more likely than equity funds to pay distributions monthly. You can reinvest that money in the fund to buy additional shares or, if you own the fund in a regular taxable account, take the distribution as cash. And bond funds, like the bonds they buy, often provide their strongest returns in periods when stocks and stock funds are depressed. The opposite is true as well. So by owning both types of funds, you may be able to moderate losses in one asset class with gains in another.

From the opposite perspective, if you're investing primarily for income, as you may be when you've retired, you'll want to consider including some equity funds in your predominately bond fund portfolio. Their potential for growth can help ensure that you have financial resources as long as you need them.

Balanced funds

Balanced funds are another way to allocate your assets. Balanced funds own a combination of stock and bonds, and are designed to provide some growth and some income while offering some protection against the risks of owning either asset class on its own. In fact, if you're just beginning to invest or if you have a relatively small mutual fund portfolio, a balanced fund may be the most appropriate choice.
Safety in bonds? When the stock market takes a dive, many investors flee toward bond funds. But piling a large portion of your investment dollars into bonds doesn't eliminate all investment risk. Before you make a major change in your asset allocation, you should become familiar with the risks bond funds carry:

• When interest rates rise — a sign of a recovering market — existing bonds tend to decline in value, and bond funds may see periods of negative total returns
• Unlike individual bonds, bond funds don't pay a fixed interest rate and they don't promise a return of principal

From the Expert
The data make clear that, if risk is the chance of failing to earn a real return over the long term, bonds have carried a higher risk than stocks.

By allocating and diversifying your mutual fund portfolio, and holding that portfolio through the market's cycles, you should be in a stronger position both to accumulate profit and withstand adversity.

Similarly, if you want to use mutual funds as a holding place for emergency funds or for the money you are waiting to invest, you may want to choose a money market or short-term bond fund where there's little inflation risk and similarly little risk to principal . While these funds don't provide enough return to meet long-term goals, they can serve short-term needs well.
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Diversification & risk Diversifying your mutual fund portfolio may be the most fundamentally effective strategy for staying afloat during market downturns — and for staying on course toward your long-term goals, such as paying for a college education or providing a regular source of retirement income. By diversifying, or choosing a variety of investments within each asset class, you'll soften the blow to your overall net worth if a specific investment, such as a high profile stock, or a particular sector, such as technology or energy, takes a hard hit.

Since most mutual funds are already diversified in the sense that they typically own several dozen securities, they're often viewed as a convenient way to reduce risk. But keep in mind that funds tend to focus on the segment of the market that fits their investment objectives. A fund whose objective is long-term growth through large-company stock buys primarily that type of stock. As a result, the fund is likely to suffer in a period when large-company growth is depressed.

To really protect the value of your investments, you'll have to diversify within each of the assets classes you include in your total portfolio — typically stocks, bonds, and cash, though you might also include real estate through a real estate investment trust (REIT) or other asset categories. You might achieve diversification by investing in a range of mutual funds that invest in different segments of the total market. Or you might select mutual funds that concentrate in asset classes that you're not investing in individually or in segments of an asset class where you don't own individual investments.

For example, if you own some individual large-company stocks, you might choose mutual funds that invest in small or mid-sized companies. Or if you own some short-term Treasury bills, you might select a long-term corporate bond fund. But remember that owning several mutual funds that make the same type of investments doesn't increase your diversification as much as owning a variety of funds with different objectives and investing in different segments of the market.
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Investing internationally International funds — those that invest entirely outside the U.S. — provide another level of diversification for your portfolio and another way to manage risk.

International funds may reduce the volatility of your domestic portfolio because the prices in overseas markets may move in different directions or at different times than the prices on U.S. markets. For instance, when the U.S. stock market is flat, strong economies in other countries may move stock prices on their markets higher. Or during a downturn in the U.S., international markets may fall as well, but perhaps not as far or as fast.

Among the potential problems with international funds is that you take on a certain amount of currency risk, though some funds use hedging strategies to moderate its effect. And, if you're investing in countries that face potential political instability, the economic consequences of that turmoil can affect the value of your investment.

Higher risk may bring higher returns On the flip side, developing countries that may be unstable at certain times also may provide periods of rapid growth. They may offer opportunities to invest in companies producing new products or services. While it can be difficult for individual investors to identify promising companies in such markets, a number of mutual funds specialize in regional or country-specific small-company growth.

World Funds Like international funds, world funds — also called global funds — can help you diversify abroad. But while international funds invest exclusively in non-U.S. companies, as much as 75% of a world fund portfolio may be invested in U.S. securities.
From the Expert
When the total returns in overseas markets are converted from local currency to U.S. dollars, returns become much more variable, reflecting the wide fluctuations in the value of the U.S. dollar versus other currencies. This currency risk means that a weakening U.S. dollar will enhance the returns earned by U.S. investors in international markets and a strong dollar will reduce them.
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Using index funds An index fund aims to replicate the performance of a target index, such as the Standard & Poor’s 500 Index or the Russell 2000 Index , by holding the same securities that make up that index. While not all index funds are exactly alike, choosing index funds to create a diversified portfolio is easier than differentiating among actively managed funds. Index funds are also an appealing choice if you're seeking cost-efficient investments. The management fees and transaction costs are typically substantially lower than for an actively managed mutual fund . For example, the average equity fund has an expense ratio of about 1.5% plus turnover costs of about 0.9%, while many index funds are operated for less than 0.2% in annual expenses with negligible transaction costs, since the funds' investments change only when the index holdings change.

For instance, the following chart compares two hypothetical mutual funds — an index fund and an actively managed fund. While both funds earn a gross return of 8% annually, the index fund has annual expenses of 0.2%, while the actively managed has annual expenses of 2.4%.

Type of fund	Gross return	Expenses	Net return	Total gains: 1 year	Total gains: 10 years
Index fund	+8.0%	0.2%	+7.8%	$780	$11,200
Actively managed fund	+8.0%	2.4%	+5.6%	$560	$7,200

After one year, you would have about $220 more in the index fund than in the actively managed fund. And after ten years, you would have about $4,000 more in the index fund.

The downside?

When you invest in an index fund, you won't own the mutual fund with the best current record of performance. Based on the results of past decades, generally, two out of five equity mutual funds outperform the total stock market index over time. But, it's also typical for index funds to outperform at least 40% of equity funds in any given year.

The catch is that while a managed fund may provide marginally better returns with relatively the same amount of risk as an index fund, investing in an aggressive fund that may become a performance star for a period of time means incurring significantly greater risk. If you want to own a fund that ranks among the top 10% of all stock funds at the time you buy, you should also be prepared for it to rank among the bottom 10% at some point in the future. This risk doesn't mean you should avoid managed funds. You should simply understand — and feel comfortable with — the amount of risk you're taking.
From the Expert
There's an active and ongoing debate between people who advocate index funds as the best choice for most investors and those who advocate a balanced portfolio of actively managed funds. The first group points to the long-term merits of passive investing with index funds: broad diversification, weightings paralleling those of the stocks that comprise the market, minimal portfolio turnover, and low cost. Advocates of active management argue that successful mutual fund managers provide a real way to beat the market.
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Timing the market Although choosing mutual funds certainly requires looking at the conditions of the economy and markets as a whole, making decisions to buy or sell by trying to time the market rarely yields satisfactory results.

Market timing means regularly attempting to shift assets to that part of the market that's currently providing the best return. For example, a market timer might move from stock funds to bond funds or money market funds in hopes of escaping a stock market dip, then shift the assets from bond or money market funds back to stocks in an attempt to ride the next stock market wave. But what usually happens is the opposite: You end up in the market for the dips, but out of the market for the rallies.

The problem is that there's no infallible signal that says when you should get into or out of stock or bond funds. And when your money is at stake, it's easy to be swayed by impulses, such as emotional reactions to market swings and hasty reactions to reports from the financial press. It can be difficult to keep perspective. You just have to remember that the media's conventional wisdom of the day isn't always an accurate indicator of future market conditions.

The other problem with trying to time the market is that it may mean rapidly turning over your fund holdings, which can be costly. You should always consider how much you'd pay in sales loads, redemption fees, and capital gains taxes — especially on short-term gains — before you make changes to your portfolio.
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Reversion to the mean When selecting mutual funds, it's important to look beyond current performance records that may be mildly — or even significantly — different from the fund's long-term history.

Though many mutual funds perform significantly above average over the course of a single year, very few succeed in doing so over longer periods of time. In the very long term, higher performing funds tend to come down and lower performing funds tend to come up — often in direct proportion to fluctuations in the overall market's return. This phenomenon, called reversion to the market mean, is a dominant factor to consider in long-term mutual fund returns.

How should this pattern affect investing decisions? If reversion to the mean applies to all types of investments, from growth funds to value funds, from large-cap funds to small-cap funds, then weighting your portfolio too heavily in any one area — with the hope of staying above the curve — is likely to prove fruitless.

An alternative strategy is to invest in funds that represent a broad cross-section of the U.S. stock market. An index fund, for example, might provide a more reliable long-term return than a managed fund, since it invests in the market as a whole. The principle of reversion to the mean suggests that an index fund's long-term returns will closely parallel those of the total market, giving investors a chance at earning returns that approach 100% of the market return.
From the Expert
There is a powerful tendency for total returns on financial assets to regress to the mean. The question is, which mean?

• Common stock returns tend to regress to the average historical long-term rate of return
• Bond returns — short-term, intermediate-term, and long-term alike — tend to regress, not to the historical norm, but to the interest yield prevailing at the time you make your investment
• Treasury bill returns tend to take on a life of their own, because their rates are reset so frequently. During the post-World War II period, T-bill returns show some tendency to regress to a real return (the nominal return less the rate of inflation) in the 1% range

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Using tax-efficient funds A number of tax-managed funds — funds specifically designed to be tax-efficient — appeal to investors who have been dismayed by having to pay short-term capital gains taxes on distributions from funds, especially in years when their investment in the fund has lost value.

Other funds may be tax efficient without committing themselves to that objective in their prospectuses. Index funds, for one, are tax efficient, in large part because their portfolio is determined by the index they track and they tend to have low turnover rates. Some actively managed funds may be tax-friendly as well if part of the manager's strategy is to offset capital gains by selling investments that may have lost value and produce capital losses. Just remember that if that manager leaves, and there's no provision in the prospectus stating the fund's commitment to tax management, the new manager may not practice the same tax strategy.

A number of financial Web sites contain after-tax performance data for mutual funds, and since February 2002 funds have been obligated by law to disclose after-tax returns in their prospectuses. Taking the time to examine these numbers can help save you money in the long run.
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Purchasing mutual funds When you have decided on the mutual fund or funds you want to add to your portfolio, you're ready to authorize the transaction. The registered representative you work with to make investment selections at your brokerage firm or bank can handle the purchase for you. You should expect to pay a sales commission unless you have a fee-based account, which means you pay an annual asset-based fee that covers transaction expenses.

In some cases, investment companies sell the funds they sponsor directly to investors without using an intermediary. The sales representatives you speak to on the phone can provide information but not specific advice or recommendations. That means you'll have to be confident in your own financial judgment, and able to make investment decisions independently. Typically, direct distributors don't charge you a sales commission.

If you invest in mutual funds through a retirement savings plan at work, such as a 401(k), you may or may not have access to investment advice through the plan sponsor — typically your employer. The funds offered through the plan should provide enough choice to allow you to allocate your principal across the major asset classes. In some cases, there may be a dozen or more funds to select among. The guidelines that apply to choosing a fund for a regular taxable account apply to tax-deferred accounts as well.
Load or no-load?
Mutual funds that are sold directly from the sponsor to the investor without sales charges are known as no-load funds, though some may charge a redemption fee if you sell your shares within a specific period of time after you buy them. Funds that carry sales charges are called load funds.
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Dollar cost averaging When you buy mutual fund shares through an employer-sponsored plan, you're using an investment technique known as dollar cost averaging. That means you're investing the same amount of money — in this case the percentage of your salary that you're deferring into the plan — into the same funds on a regular schedule.

Dollar cost averaging has a double advantage. Not only are you adding to your account on a regular basis, which has the potential to boost its value. But when you continue to buy as the price of the mutual fund goes up and down to reflect the changing market value of its underlying investments, your average cost per share over time is less than the average price per share, since you buy more shares when the cost is lower and fewer shares when the price is higher.

You can use the same technique for buying mutual funds in taxable accounts as well, with the same advantages. It makes investing easy, as you may be able to authorize a direct transfer from your paycheck or bank account to buy the shares. But you must stick with your purchasing plan when the market drops, or you'll end up paying only the highest prices.

Remember, though, that dollar cost averaging, despite its advantages, doesn't guarantee a profit or protect you against losses in a falling market.
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Share classes When you purchase a load mutual fund, you may have to decide which class of shares to buy. The class you choose — A, B, or C shares — determines when you pay the sales charge and the cost of holding the fund for different lengths of time. You can find the comparative costs for each class of shares a fund offers in its prospectus.

Choosing the best class for your situation can help minimize your costs. If you're a long-term investor, for example, paying a front-end load and a lower annual fee may be a better choice. These shares, generally known as Class A shares, may also entitle you to a reduced sales charge if you invest a certain amount of money in the fund. The qualifying investment levels are known as breakpoints, and will be specified in the prospectus if the fund offers them.

Mutual fund ABCs

With Class B shares, you don't pay a sales charge up front, but you do pay a percentage of the amount you invested if you sell within the first seven years in most cases. This is called a back-end load or contingent deferred sales charge. The annual operating expenses of Class B shares are higher than Class A shares during the period when the back-end load applies. After that period ends, Class B shares convert to Class A shares, and you don't pay a sales charge when you sell.

Whether or not Class B shares are more cost effective than Class A shares depends on the rate that applies to the back-end load and the difference between the operating expenses.

Class C shares are called level-load shares. You don't owe a sales charge when you buy, and you'll usually owe a contingent deferred sales charge only if you sell the fund within the first year of purchase. You pay an annual percentage of the value of your fund account in each year you own the fund, typically at a rate similar to the expenses on Class B shares.
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Mutual fund risks When you select them carefully, mutual funds can make a substantial contribution to the success of your investment portfolio. But there is always the risk that a mutual fund won't meet its investment objective or provide the return you're seeking. In a market downturn, for example, falling prices for a fund's underlying investments may produce a loss rather than a gain.

Changes in a fund's management after you've invested may also affect whether a fund achieves its objective. The fund company may, for one reason or another, replace a fund manager, or the manager may resign. This change may be significant since the manager controls the fund's investment portfolio. For example, a stock fund that has realized regular gains under one manager may become more volatile if the fund's new manager seeks more robust growth. And if a fund's investment style changes, it may no longer be aligned with your investment objectives in any case.

What this means is that however carefully you select mutual funds, you and the investment professionals you work with must monitor their performance regularly and be prepared to replace them if they don't measure up to your expectations.
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