Six Questions About Mutual Funds

Over the weekend, Don Steinmann at Advanced Financial Management, sent me his investment tip of the week about questions that you should ask while researching a mutual fund. It is quite instructive. Here are the questions he recommends that you ask (most answers can be found at Yahoo's finance website as long as you have the ticker symbol for the mutual fund).

1. What is the fund turnover? Turnover shows how long the fund holds onto their securities. So a 100% turnover means on average they sell all their stocks once a year. Turnover below 40% is a good number for stocks (i.e. average holding period of 2 1/2 years). After all, stocks are long term investments, so if they are keeping them just a few months (turnover of 200% or so) then there may be something wrong with their strategy.

2. What are the major holdings and do they match the 'style' of the fund? If a mutual fund is supposed to be a conservative big cap fund but owns lots of Amazon.com and Ebay, they are engaging in 'style drift'. They are drifting away from the style the fund is supposed to follow. This is a very common problem with mutual funds.

3. What are the expenses? I've talked about this many times in the past, but generally you want total annual expenses under 1.25%, including all loads and 12b-1 charges.

4. How does the fund stack up against the S&P500? Click on the 5 year chart and click the S&P500 button to compare it to the index. About 75% of stock mutual funds closely track the S&P500. And if that's all they are going to do, why not just go into a low fee index fund? Don't pay for active management that doesn't have a few original ideas. What if your fund underperforms? That might be ok, because every dog has it's day and it might be your fund's turn.

5. Who is managing the fund? Is it an individual primarily or 'team' management? This is an important question to answer because...

6. What has been the fund's performance? This is the first thing that most people look at, and sometimes the only information you get (for example) in your 401k plan at work. Yet it's number 6 on our list. And if fact it mostly matters in light of number 5. If it's a team managed fund, performance tells you very little. Different people make the decisions, and a good year's performance may just be an up market, or mere chance. But if a manager has run a fund for many years and has had good success (i.e. Peter Lynch) then maybe the performance is meaningful because you have a sharp manager. Why doesn't this matter more? Because stocks are not savings accounts with guaranteed returns. If you looked at the eye popping returns on internet mutual funds in January of 2000 you might have put all your money into them, and be broke today. Past performance is really overrated, except as an indicator of a particular manager's acumen.

There are many other things you can research, such as learning about the quality of the top holdings, Morningstar star ratings and how big is the fund (are they so large they can't get out of their own way?). But if you answer the six questions above, you'll have a pretty good sense about what your mutual fund is all about.