How to Evaluate a Mutual Fund Before Investing

Mutual funds are a popular way for investors to build diversified, easy-to-manage portfolios. However, there are thousands of funds to choose from and no two funds are exactly the same. Understanding how mutual funds work and how to evaluate them is important.

If you want to invest primarily in stocks, buying a fund that holds a lot of bonds won’t let you accomplish your goals. Investing in a fund that’s designed for retirement savers when your goal is short-term investing is also a poor fit.

Knowing how to research funds and identify their goals can help you choose the right mutual fund for your portfolio.

What Is a Mutual Fund?

A mutual fund takes money from many different investors, pooling it and using the funds to buy investments. Investors in a mutual fund only have to buy shares in the fund to effectively have a stake in all of the securities in the fund’s portfolio.

This makes life much easier for individual investors. Instead of choosing dozens of different securities to invest in, you can get instant diversification into hundreds or thousands of securities while only having to buy shares in one fund.

Mutual funds can have all sorts of different investing strategies and management styles. They also tend to charge varying fees for their services, usually a percentage of the investor’s assets invested in the fund.

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How to Evaluate a Mutual Fund

When evaluating mutual funds, investors should consider a few different factors.

1. Investment Strategy

One of the most important parts of a mutual fund is its investment strategy.

Every fund should have a stated strategy and goal that investors can use to decide on whether to invest in a fund. For example, one fund might invest primarily in large companies’ stocks while another focuses on government bonds, and a third focuses on small international businesses.

Depending on an investor’s goals, any of the above funds could be a good fit for their portfolio.

Before you start comparing mutual funds, you should consider your investing goals. Someone with a long-term investing plan can better handle the volatility of stocks, so they may want to focus on stock mutual funds. Someone who has a lower risk tolerance or who has a shorter-term investing goal might want to stick with investing in bonds.

Once you know your goals, you can start your search for mutual funds based on strategies that match up with those goals.

2. Fees

Nothing in life is free and mutual funds are no different. Investing in mutual funds involves paying fees, which can have a significant impact on your investment’s outcome.

Expense Ratios

Mutual funds have an expense ratio, usually expressed as a percentage. A fund’s expense ratio shows the cost of investing in that fund for a single year. For example, if a fund’s expense ratio is 0.5%, investors must pay 0.5% of their invested assets each year in fees.

The fund automatically accounts for these fees when calculating the price of a share of the fund after each trading day. Investors don’t have to keep money set aside to pay the fees.

Expense ratios can have a massive impact on investment performance, especially over the long term.

For example: Jane invests $500 every month in a mutual fund that produces 10% returns per year and has an expense ratio of 0.5%. She keeps investing $500 each month for 40 years. At the end of that period, she’ll have $2,781,018.19 in the account.

John invests $500 each month in a mutual fund that also returns 10% per year. He also continues investing for 40 years. However, the fund he chooses has an expense ratio of 1% instead of 0.5%.

After 40 years, John has $2,390,424.14 in his account. A difference of 0.5% in fees cost him almost $400,000 over the course of his investing career.

Loads

Some mutual funds also charge transaction fees called loads. Investors typically pay these fees when working with a broker or financial advisor that charges commissions instead of a flat fee.

Mutual funds with loads can charge them when an investor purchases shares, when an investor sells shares, or — like expense ratios — for as long as the investor holds shares in the mutual fund.

For example, a mutual fund may charge a 2% upfront load. If you want to put $1,000 into a fund with a 2% load, your $1,000 investment will only buy $980 worth of shares. The other $20 goes toward paying the load cost.

Mutual funds with loads also have expense ratios, so investors in funds with loads pay multiple types of fees when investing.

3. Holdings

Mutual funds should publish their holdings, which gives investors a chance to look at what they’re investing in.

While two funds might have similar strategies, such as investing in large businesses, how they go about executing their strategy might differ. Looking at a fund’s holdings can help investors get a closer look at a fund’s investment strategy.

For example, you might notice that a fund holds more shares from companies in a specific sector of the economy, like technology or finance. Maybe you agree with that approach, or you might want to choose a similar fund that doesn’t overweight that industry.

4. Performance Compared to Benchmarks and Competitors

Past performance doesn’t indicate how a fund will perform in the future, but looking at performance is still an important part of evaluating a mutual fund.

Investors can compare mutual funds against different benchmarks and against other, similar funds to see how they perform. For example, an investor who wants to buy shares in a fund that focuses on intermediate-term bonds might compare the fund’s previous performance to other mutual funds that also focus on intermediate-term bonds.

Comparing funds against a benchmark is especially easy for index funds, which aim to track the performance of a specific index, like the Dow Jones Industrial Average or the S&P 500. You can look at a chart of the fund’s performance and the index performance to see how similar they are.

When comparing funds to other funds or to benchmarks, it’s usually best to look at long-term trends, such as performance over the past five or 10 years. This gives a better idea of how the fund is likely to perform compared to competition over the long term.

5. Management

Mutual funds are managed by finance professionals. Fund managers are tasked with following the fund’s strategy and making sure it accomplishes its stated investing goals.

In general, there are two management styles for mutual funds.

Some funds are actively managed. These funds typically aim to beat the market, with managers focusing on buying low and selling high by making regular moves into and out of positions.

Critics of active management say that there are few people who can consistently beat the market as a whole, especially after accounting for the increased costs of active investing.

Proponents argue that good fund managers can perform better by making regular trades than by focusing on passive investing.

Passively managed funds do much less buying and selling of securities. They build their target portfolio and hold their investments for the long term. Investments such as index funds are a popular type of passively managed fund.

Proponents of passive funds argue that it’s better to try to track the market because it is hard to beat the market over time. Passive funds also tend to have lower costs.

Critics say that passive investors are leaving money on the table by not taking an active role in trying to time the market.

Another consideration to look at is each mutual fund’s manager or managers. Fund managers can build a reputation over time, so you can look at other funds that manager has worked on to see how they’ve performed. You can also look for red flags, such as a management team with high levels of turnover.

Where to Find Information About Mutual Funds

If you’re interested in investing in mutual funds and want to start researching them, there are plenty of resources you can use.

Fund Provider Websites

Mutual fund companies want investors to invest in their funds, so they offer a lot of information about their funds on their websites.

For example, if you visit Vanguard’s website, you can view a full list of the company’s mutual funds and search through them based on their investing strategy, the sectors they focus on, and what type of securities they hold.

Each fund’s page includes information on its specific holdings, management, and fees.

A fund provider’s website is one of the best places to start when researching funds because it can give you an overview of the most important aspects of the fund.

Morningstar

Morningstar is a major provider of investment analysis and research, especially for mutual funds.

Anyone can visit the website and use it to compare mutual funds and examine their performance in comparison to each other and to various benchmarks. Regular users can also see Morningstar’s mutual fund ratings, which can be highly influential in the world of finance.

If you sign up for Morningstar Premium, which costs $199 per year, you get full access to the website’s analyst reports. These reports offer a deep dive into different mutual funds and can help you pick the one that’s right for you.

Morningstar Premium also comes with other features, such as portfolio analysis and investment picks from finance professionals which you can use to guide your investing.

Zacks

Zacks is another provider of investment research that investors can use to analyze and compare mutual funds.

Like Morningstar, free users of Zacks can search for mutual funds to compare them against each other or against benchmarks. You can also read some news articles and analysis about different funds, which can help you make investing decisions.

Signing up for Zacks Premium, which costs $249 per year, unlocks the company’s full analysis and new offerings. This includes buy and sell recommendations for stocks and funds, a stock screener that can help you find stocks that meet your investing goals, and research reports on companies and funds.

FINRA’s Fund Analyzer

The Financial Industry Regulation Authority (FINRA) is a private company that helps the financial industry regulate itself. It helps protect investors and consumers from fraud and malicious actors by regulating brokerage firms and securities brokers.

FINRA has an online fund analyzer that you can use to research mutual funds or to compare multiple funds against each other. You can search for funds based on name, ticker symbol, or various keywords.

Clicking on a fund will bring you to its profile page, which includes a variety of information including historical returns, its investment objective, its investing style, and its fees. The profile page also lets you compare some of these factors against similar funds to see how they stack up in terms of fees and historical returns.

If you aren’t sure which mutual funds you want to invest in, the fund analyzer also includes a powerful fund screening tool.

You can filter funds based on their investing objectives, strategy, minimum purchase amounts, Morningstar rating, and more, making it easy to find a list of mutual funds that meet your requirements. You can then use that list of funds to guide your research.

Final Word

Mutual funds are an incredibly popular way for investors to build diversified portfolios while only having to hold a few securities. However, choosing the right fund can be difficult given the sheer number of options available.

If you want a truly hands-off investing experience, like many people who choose to invest in mutual funds do, you might want to consider working with a robo-advisor like SoFi Invest.

Robo-advisors manage your investments based on your investing goals and timeline and choose the mutual funds to invest in for you, saving you the effort of having to research funds.

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