Day-to-day investment decisions are left to professionals who are trained to evaluate potential investments. How do you evaluate fund management? The following information will help you:
One alternative to searching for managers is investing in index funds. These simply buy the exact stocks of various indices like the S&P 500 (the 500 largest U.S. stocks), the Wilshire 5000 (an index of the total stock market), the Russell 2000 (an index of small stocks) the Barclays Capital Aggregate Bond (an index of investment-grade bonds), and even the EAFE (an index of stocks in Europe, Australia, and the Far East). Their cost is low, there's no management needed because it is just an index, and you know what you're getting.
IMPORTANT NOTE: The S&P 500, Wilshire 5000, Russell 2000, Barclays Capital Aggregate Bond, and EAFE indices cannot be purchased directly by investors, and cannot depict or predict the performance of any investment. Indices are regarded as an indicator of the stock or bond market's performance.
Because index fund costs are lower than actively managed funds (funds run by fund managers), and if you agree with those people who feel you can't outperform the market anyway, index funds might be a good choice when deciding what kind of investments to include in your portfolio.
The cost structure of buying and owning a mutual fund is somewhat complicated. First, determine if the fund has a load or sales charge. No-load funds do not have a sales fee, however other fees and expenses may apply to a continued investment in this type of fund and are described in the fund's current prospectus.
Funds with a sales fee can structure the fee in a number of ways. The most common type of load is a front-end load. You pay a few percentage points to buy a fund. If you have $10,000 to invest, and your fund has a front-end load of 6%, then only $9,400 will go into your account and earn money.
There are also back-end loads, which are sales charges you pay when you withdraw money from a fund. Your fund may also have different classes of shares. These are usually called "A," "B," and "C" shares; they distribute their loads and charges in different ways, so that the exact same fund can be sold to different groups in different ways.
Many people are unaware that these fees exist until they try to sell, although these charges are disclosed in the fund's prospectus. 12b-1 fees represent money spent on sales and marketing and are passed along to the consumer. Both load and no-load funds may or may not have a 12b-1 fee.
Gaining popularity are redemption fees. These are charges levied against investors who leave a fund before a certain period of time, usually six months. A short-term redemption fee is an incentive for market-timers to practice a long-term investment strategy. It could work to your advantage by stopping you from making hasty moves. However, it is another fee to consider when investing in mutual funds.
At least as important as whether a fund has a load is your fund's expense ratio, which you can find in the prospectus. The expense ratio is the percentage of a fund's assets that is used to cover the costs of managing, administering, and operating a mutual fund. If a fund earns 6% before the expense ratio of 2%, then net earnings will be 4%. You may want to look for a fund with an expense ratio below 1.5%, and preferably below 1%, especially for bond funds, which are easier to research and manage. Keep in mind that a few percentage points can have a huge effect on your return. Limit your search to the best funds with reasonable expense ratios. Another type of cost that needs to be looked at when deciding which mutual fund to invest is the fund's trading cost.
Every mutual fund loses some money every year to trading costs—money spent on brokerage commissions or lost to the bid-ask spread. (The bid-ask spread is the difference between the highest price a buyer is willing to pay and the lowest price a seller is willing to accept.) Trading costs are not reflected in the fund's expense ratio. That number only will tell you how much money you're paying every year for the management and operation of the fund. But any money spent on trading comes directly out of the fund's net assets. And unfortunately, it can amount to quite a lot.
Another unfortunate thing is that investors have no easy way to quantify the amount that is spent by the fund manager on trading every year. The number isn't disclosed separately for you in a fund's prospectus or annual report. One way to try to estimate the amount being spent on trading is to look at a fund's turnover for the year. The higher this number, the more a manager is trading in the portfolio and potentially losing money to those transaction costs. But one thing worth mentioning is that turnover is still a very imperfect way to figure out how much a manager is trading. Turnover is calculated by taking the lesser of purchases or sales and dividing by the average net assets. A fund could have zero sales and $500 million in purchases and still have turnover of 0%. But that fund is still spending money to buy securities. For now, the turnover ratio is the only thing you've got to estimate how much money your fund is losing every year to trading.