If you wish to invest in mutual funds as a long-term investment, There are a number of factors to evaluate so you can choose the right fund.
Three of the most important considerations include the mutual fund expenses, whether the fund is passively or actively managed, and whether you are looking to generate capital gains or income from the mutual fund.
Mutual Fund Expenses
Look at the fees for a mutual fund before buying shares. Fees can take a chunk out of your potential returns for even the best-performing mutual funds. Consider whether the fund has a sales load and consider the expense ratio for the fund.
When you buy a mutual fund from an advisor or broker, it often charges a load fee. This commission compensates the advisor or broker for his time and alleged expertise in selecting the correct mutual fund for you.
A front-end load is a commission or charge when you initially buy shares in the fund. Front-load fees are usually around 5% of the amount you invest in the fund. These are identified as Class A shares.
A back-end load is a fee that you pay upon selling your shares in a mutual fund. You are charged this fee when you sell the shares within a time frame of five to 10 years of buying into the fund.
The amount of the fee usually goes down the longer you hold the shares. The fee is the highest for the first year you hold the shares. These are called Class B shares.
The third type of fee is called a level-load fee. The level load is an annual charge amount deducted from assets in the fund. These are called Class C shares.
As a practical matter, many studies have shown that there is no difference in performance between load funds and no-load funds.
Unless you really need advice from a broker or advisor, it does not make sense to pay the high fees for load funds, as they only consume your profits.
The expense ratios is the percentage of assets deducted on an annual basis for fund expenses. Fund expenses include management fees, administrative fees, operating costs and other costs. These fees often include 12b-1 fees.
Passive Vs. Active Management
Determine if you want an actively or passively managed mutual fund. Actively managed funds have managers that make decisions regarding which securities and assets to include in the fund.
Managers do a great deal of research on assets and consider sectors, company fundamentals, economic trends and macroeconomic factors when making investment decisions.
Active funds seek to outperform a benchmark index, depending on the type of fund. Fees are often higher for active funds. Expense ratios can vary from 0.6 to 1.5%.
Passively managed funds seek to track the performance of a benchmark index. The fees are generally lower than they are for actively managed funds, with some expense ratios as low as 0.15%.
Passive funds do not trade their assets very often, unless the composition of the benchmark index changes. This results in lower costs for the fund.
Passively managed funds may also have thousands of holdings, resulting in a very well-diversified fund. Since passively managed funds do not trade as much as active funds, they are not creating as much taxable income.
This can be important for tax considerations.From 2004 to 2014, only 24% of active managers beat the returns of the overall market.
This lack of performance can be attributable to the higher fees that active funds charge. It may also reflect the state of the economy since the 2008 financial crisis.
There are some mutual funds that do outperform the market. However, these funds are dependent on their star managers.
If the manager leaves the fund, the future performance of the fund is in doubt. For most investors, a passively managed fund may be a better option.
Income Vs. Growth
Another major consideration is your goal with the investment. You may be seeking to create value through the growth in value of the assets in the fund.
On the other hand, you may be seeking to generate income through dividends, interest payments and other distributions.
Your goal depends on your risk tolerance and your place in life. If you’re only a few years from retirement, you may have different objectives than if you are just out of college.
The primary goal for growth funds is capital appreciation. These funds generally do not pay any dividends.
The assets in the fund may be more volatile due to the nature of high-growth companies. You must have a higher risk tolerance due to the volatility. The time frame for holding the mutual fund should be five to 10 years.
If you’re seeking to generate income from your portfolio, consider bond mutual funds. These funds invest in bonds that have regular distributions.
These funds often have significantly less volatility, depending on the type of bonds in the portfolio. Bond funds often have low or negative correlation to the stock market.
You can, therefore, use them to diversify the holdings in your stock portfolio. Diversification is a good method to protect your portfolio from volatility and draw downs.Bond funds generally have low expense ratios, especially if they track a benchmark index.
Bond funds often narrow their scope in terms of the category of bonds they hold. Funds may also differentiate themselves by time horizons such as short, medium or long term.
Bond funds carry risk despite their lower volatility. These risks include interest rate risk, credit risk, default risk and prepayment risk.
Interest rate risk is the sensitivity of bond prices to changes in interest rates. When interest rates go up, bond prices go down.
Credit risk is the possibility that an issuer could have its credit rating lowered. This adversely impacts the price of the bonds.
Default risk is the possibility that the bond issuer defaults on its debt obligations. Prepayment risk is the risk of the bond holder paying off the bond principal early to take advantage of reissuing its debt at a lower interest rate.
Investors are likely to be unable to reinvest and receive the same interest rate. However, you may want to include bond funds for at least a portion of your portfolio for diversification purposes, even with these risks.
Curated from A Guide For Picking Long Term Mutual Funds