Finance: Advice On Picking Top Mutual Funds

How to find the best mutual funds for you.

There are two steps to picking the best mutual fund. First, you have to decide what type of fund to get. This is a personal decision that depends on your financial goals. Second, you need to compare the different funds within the category you've selected.

There is a tradeoff in investing. The greater the possible reward, the greater the risk. As a general rule of thumb, the younger you are, the more risk you can take on. But you should also consider how you feel about risk. If the price of your fund were to swing widely, would it keep you up at night? Or do you enjoy taking a chance in order to have a shot at making more money?

Stock funds are more risky than bond funds. Sector funds are more risky than diversified funds. Small-company funds are more risky than large-company funds. Along with the risk, though, comes the potential for greater returns. It's your decision. The best type of fund for one person may not be the best type for another.

One type of fund that is very popular and that everyone should at least consider is the index fund. Index funds buy shares in the companies that are listed in stock market indexes such as the S&P 500 or the Nasdaq 100. Because the funds simply mimic the indexes, the funds don't have to pay managers to decide which stocks to buy and when to buy and sell them. Savings in overhead will be passed on to investors. Index funds are a particularly good choice for new investors, for those who only want to own one fund, or for those who aren't particularly interested in following stock market news and would like their investing to be uncomplicated.

There are a number of indexes you can choose from. S&P funds, which feature blue chip companies, are less risky than Nasdaq or Russell funds. The larger the number of companies in an index, the more stable the corresponding fund will be. As always, the tradeoff for stability and safety is potentially lower returns. A good choice for a conservative investor would be the S&P 500.

Many companies offer index funds, with the most well-known probably being Vanguard and Fidelity. Because funds that track the same index are essentially identical to each other, no matter which mutual fund company you buy them from, the best fund to buy will be the one that has the lowest expense ratio. You should check this before buying. You may have heard that such-and-such a company always has the lowest expenses, but companies sometimes compete with each other to offer lower expenses, so the ranking can change.

Choosing an index fund is easy. Decide which index you want your investment to track, find out which fund company has the lowest expense ratio and, bingo, you're done. If you want to buy an actively-managed fund, you'll have to consider more factors.

You may have noticed that ads for mutual funds always carry a disclaimer saying that past performance is no guarantee of future results. There's good reason for that. Here are some things that could make a fund perform differently than it has in the past:

-- Changes in the investment climate and in the economy in general will affect your fund. This can be especially dramatic with sector funds. If the price of gold is plummeting, the price of gold funds will drop, no matter how well-managed a particular fund may be. Many industries are cyclical, rising for, say, a year or two, then falling, then rising again. You should be especially careful with sector funds that specialize in industries that are considered "hot." While they may beat out almost all other funds in a particular year, the next year they may be near or at the bottom of the list. For this reason, you should never buy a fund solely on the basis of the past year's performance. Always look at long-term performance as well.

-- Fund managers make crucial decisions about which stocks to buy. A fund that has had outstanding performance over the long term under a single manager may not do as well if that manager leaves. Check to see if there have been recent management changes or if the fund manager is approaching retirement age.

With those caveats in mind, you still want to look at past performance because it's the only truly objective way to compare funds within the same categories. There are companies that rate mutual funds based on their past performance, both in terms of returns and risk. The most well-known mutual fund rating company is Morningstar, but there are others as well. Rating information, as well as other useful tools for comparing mutual funds, is readily available online at the major financial sites. The consumer financial magazines, such as Money and Individual Investor, also publish annual rankings of the mutual funds they consider the best.

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