What is a Good Mutual Fund?

 Recently my wife and I updated the investments in her ROTH IRA from the stocks and mutual funds that she picked in college to mutual funds targeted for long-term growth. Her new portfolio is likely to grow at an average rate of about 17% a year.

I could share about the whole process of screening, narrowing down, and finally selecting the funds, but I want to start with the end. We had all of the funds selected and just needed to buy them once the old investments sold, but one of them had an unexpected load, that we wanted to avoid so we wanted to pick another one quickly before the market closed. So my wife ran another search and picked a few likely candidates and had me verify that there was nothing wrong with her new choices. So what did I look at to decide if they were good funds?

Identifying a Good Growth Stock Mutual Fund!

Performance:

The first thing I look at when deciding which mutual funds are worth further investigation is the funds’ performance over the last 10 years. Now keep in mind that past performance is no guarantee of future results, but it is a good indicator of what the fund is capable of. I look at 10-year performance first, because I am investing for the long haul, I want a fund to show me that it has outperformed the competition and the stock market indexes. I also look at the 5, 3, and 1-year performance as compared to the competition and the market indexes to make sure that the fund manager has been making good decisions lately.

Management:

The next thing I look at is the fund manager. This is the person that is making all the decisions about when to buy and sell the stocks held in the mutual fund’s portfolio. How long has the manager been managing this portfolio?

If the current manager hasn’t been running this fund for at least five to ten years, I will usually stop right there and look for another fund. I can’t look at the performance data as an indication of the kind of decisions the current manager is going to make if they were not responsible for the fund back then.

Fees:

After management, I look at the fees. I avoid funds that come with a load. A load is a fee (often around 5%) that you pay when buying into or selling your shares of a mutual fund. The longer you hold a mutual fund, the less significant the load becomes relative to other fees, but if you want the option to easily rearrange your investments in the future, you should avoid loads or other transaction fees.

There is also the expense ratio (about 0.5 to 2%). This fee comes out of your annual growth to pay the manager(s) and cover other operating costs. I prefer to keep this cost low, but I am willing to let this be higher if the fund’s performance is good.

For example, I could invest in a market index fund, “Fidelity^® 500 Index Fund” which seeks to match the S&P 500 stock market index. The expense ratio is only 0.015% because the manager doesn’t need to make decisions, they just match their holdings with the stocks in the S&P 500. But the performance will only ever match the performance of those stocks. Which over the last ten years have grown an average of 13.7% per year.

So it can be worth it to pay someone to manage the portfolio and find and invest in companies that are growing.

Diversification:

The next thing I will look at is diversification. The point of buying mutual funds is to spread out your risk, so if one company loses value you don’t lose money. I saw a few mutual funds with high returns that depended on one stock for most of their value. For instance, one fund was over 60% Tesla, which quadrupled in value this year, so on the face that was a good move, but what if hadn’t, Tesla could have stagnated or shrunk this year. Conditions in the real world change and can have big effects on which companies grow or shrink even when things start in their favor.

So when I am looking at a fund’s diversification, I generally want to see 40 to 100 or more companies with none of them making up more the 5-6% of the portfolio. I also like to see diversity in market sectors represented in the portfolio: energy, tech, finance, etc. And I want to make sure at least some of my mutual funds include international stocks.

Minimum Initial Investment:

Make sure to check that the minimum initial investment is something you can afford. When you are dividing your investments several ways, you might find that a fund requires more than you were planning on investing there.

What Sort of Mutual Funds Should You Buy?

Now that you can pick out the wheat for the chaff, let’s talk about what kind of mutual funds you want in your portfolio. Keep in mind that my investing strategy is for long term growth, don’t use this strategy for all of your retirement if you are going to need to use that money in the next two to four years. That said, you can always set aside what you might need for the next two to four years in a safe and stable position, like CDs, money market, or a savings account. Your invested money may take a loss at any time and need three months to two years to recover (The Great Depression’s recession lasted three years and seven months, but most recessions are under two years.) You need to be able to be patient during a recession and not pull your money out at the bottom or you will lose money.

Aggressive Growth:

Look for Small or Micro-Cap Growth Stock Mutual Funds. (Cap or Capitalization indicates the size of the company or more specifically the total value of all the stocks the company has sold.) Small companies have the most growth potential so you can see big gains from these funds. They also have the most risk of shrinking or completely failing, your money will see higher highs and lower lows.

Over the long term this may be the most profitable group of funds.

Growth:

These are the Medium-Cap Growth Stock Mutual Funds. Medium-sized businesses are more stable than small ones but often still have a lot of room to grow. These funds will probably have middle of the road returns in your portfolio.

Growth and Income:

Large-Cap companies face additional obstacles to growth. They may have saturated the market already and need the economy to expand or to take market share from competitors in order to grow. However, good fund managers can still find those companies that are growing despite their size. Also, larger, more stable companies are more likely to pay out dependable dividends, so even if they are not growing quickly, the fund will grow with their dividends.

International Growth:

It is also good to have some international growth mutual funds in your portfolio. The US economy is strong right now, but there is no guarantee that that will be dominant forever. And it doesn’t hurt us if another economy starts growing faster, but it might help you in the future if you have some of your investments spread out to the rest of the world.

Look for funds that meet the criteria of the first three categories. For my portfolio, I picked more funds in the international category than in the other three combined (though each has much less invested in them). It can take some effort to find the right mix of good funds that include many regions around the world.

Don’t Panic!

Don’t panic over short term loss. There will come a time when your gains, look like they are wiped away in a recession. Don’t panic! Don’t sell! Growth stocks take the greatest hit at the beginning of a recession, but they are often the first ones out of it. If you sell, you lock in your losses. The only reason you might sell during a recession is if you see a better performing growth stock mutual fund to ride out of the recession. But the better option is don’t look at your portfolio for a few months. This money is for years from now. Live your life and don’t look at it too often.