Mutual funds can play an important role in any investment portfolio. But with so many different types of mutual funds available to investors, it can be difficult to sort them out.
There are, however, a number of ways to analyze and compare the thousands of funds, narrowing the universe of potential selections and simplifying the process of picking ones that align with an investor's needs and goals.
How to evaluate a mutual fund
With so many options available, it can be helpful to start the selection process by considering the following when deciding how to compare mutual funds:
A mutual fund’s net asset value, or NAV, represents the value of the fund’s assets minus any liabilities, expressed on a per-share basis. The NAV of a mutual fund doesn’t change throughout the day the way the price of a share of stock does. Instead, mutual fund NAVs are updated at the end of each trading day once U.S. markets have closed. This set number is used as the basis for buying or selling of shares.
Although the price of a mutual fund doesn’t give investors a snapshot of its value in real-time, this number can be a good starting point when evaluating potential investments and their past performance. It also tells investors how many shares they can afford to buy.
Understanding how an investment has performed in the past can give investors an idea of how it might perform in the future. Of course, past performance doesn’t guarantee future results, and fund performance is impossible to predict. Still, investors can use this information to make market comparisons and identify potential trends.
Investors often look at a mutual fund’s performance over a longer period of time, such as the past five or 10 years. They can compare that performance to other market benchmark indexes, such as the S&P 500 or Dow Jones Industrial Average. This comparison can tell an investor whether the mutual fund has a history of outperforming the market in either the short- or long-term, and help inform their investment choices.
Every investment involves risk, but some investments and even specific industries may represent more risk to investors than others. Since a mutual fund is a pooled collection of investments, the composition of a fund’s underlying assets is an important factor in its evaluation.
Mutual funds can be made up of stocks, bonds, cash, and other securities. But there are many different types of mutual funds to compare, each with its own makeup.
For instance, equity mutual funds may focus on growth companies, which are expected to outperform the market in the years to come, or value companies, which are believed to be underpriced relative to their true intrinsic value. Meanwhile, bond funds primarily invest in bonds and other debt instruments, which usually are less volatile but offer more modest returns.
Depending on what an investor expects in terms of mutual fund performance and how long they plan to invest, different funds may be a better choice than others. Money market mutual funds, for example, are often used to park cash that will be used for something else in the near future.
Every mutual fund is required to provide investors with a legal document called a fund prospectus, which gives investors a summary of the fund’s strategy, fees, management, taxes, and more. Investors looking to analyze a mutual fund can review the prospectus before purchasing shares.
Even investors with the highest returning mutual funds can see that various charges and expenses have an impact on the value of their holdings. That’s why it’s important to know how much management will cost before investing in funds.
One of the biggest costs is the expense ratio. This fee is expressed as a percentage and represents how much the investment professionals running the fund charge for the assets they oversee. Investors are responsible for paying this fee each year that they own shares of the fund. These fees are automatically withdrawn from investors’ holdings in the fund.
Some mutual funds carry others fees, known as loads. These are essentially a sales commission charged to the investors, which may be levied upon the purchase or sale of the fund’s shares (though in some cases, they can be recurring charges).
What are some factors to consider when comparing two similar mutual funds?
After narrowing down a list of potential mutual funds, investors may be wondering how to choose between two very similar investments.
First, investors can look at how the mutual fund is managed and how it has performed over time. If it has consistently outperformed index funds or benchmark indices, it may be an indication that future performance could follow the same trend.
Investors may also look into the investments involved when comparing funds, and consider whether those meet their short- and long-term investment goals. Imagine a fund primarily composed of growth-stock companies which can be highly volatile and not offer dividends—that may not be ideal for a risk-averse investor seeking passive income.
Most investors aim to accomplish two things: increase the value of their assets and not lose money. Analyzing each fund’s fees and expenses carefully before investing is an important part of this process. Even if two mutual funds perform identically over a 10-year period, the fund with the higher expense ratio will result in reduced net returns compared to the fund with lower fees.
What are some alternatives to mutual funds?
In some cases, investing in a mutual fund may not be the right choice. For investors looking for alternatives, there are two close options to consider:
Exchange-traded funds (ETFs) are professionally managed and pooled investments, just like mutual funds. But unlike mutual funds, which may have minimum purchase requirements, ETFs can be purchased for the cost of a single share. They may also come with a lower tax burden for investors.
Also unlike mutual funds, ETFs can be purchased on stock exchanges at any time during the trading day. This flexibility gives investors the opportunity to take advantage of price dips or spikes when buying or selling shares. By comparison, mutual funds can only be traded once a day, after the exchanges close. ETF don’t come with load fees that some mutual funds charge, though a broker may impose a commission when investors buy and sell.
Index funds are pooled investments designed to track the performance of an index that might be made up of stocks, bonds, commodities, currencies and more. Index funds can be structured either as mutual funds or ETFs, and are almost always passively managed. This is in contrast to active management, in which an investment professional selects certain assets with the goal of outperforming the market. Passive management can mean lower fees and more stable returns. But because an index fund follows an index and is not constantly buying or selling securities, its performance is at the mercy of that benchmark index.
The bottom line
There are many different types of mutual funds available to investors today, each with its own investment strategy, purchase requirement, fee structure, and underlying assets. Deciding which mutual fund is right for an investor’s portfolio can be a daunting decision.But the process of picking a fund that best suits an investor's needs and goals can be simplified by using analytical tools to compare and contrast the thousands of funds available.