Choosing good mutual funds

This topic is under continual discussion in the financial planning community. Mutual funds are baskets of stocks, bonds and cash that are invested for some objective (this objective is stated in the prospectus).

Some funds are passively managed. These are called index funds. For example, the S & P 500 funds seek to mimic the performance of the S&P 500 (Large US Companies). These funds buy a basket of stocks in the S&P and rebalance rarely to continually mimic their stated objective. For allocation purposes, these are "pure plays." And, because these funds don't buy and sell investments much, they will not throw off as much capital gain or loss as a fund where the manager buys and sells a lot of investments inside the fund, (referred to as the turnover rate). These funds should have lower internal management fees than actively managed funds.

Active managers seek to out perform their indexes by good investment selection. In actively managed funds, not every individual investment in the fund may fit the stated objective. For example, in the poor performing years of 2001 and 2002, many actively managed mutual funds with all kinds of objectives had enormous amounts in cash to protect the fund from losing too much money. When you buy a fund with active management, you buy expertise as well as objective.

At Wealth by Design, LLC we usually recommend index funds for US large cap stocks and in broad based bond funds. In these areas of the market where information is widely available, we don't feel it's generally worth it to pay extra for active management.

Small cap and International funds require a lot more research to avoid buying poor performing investments. We think it's worth paying a manager here.

As we review mutual funds, we look at the following:

• Management fee. If two funds are otherwise very much the same and one has a lower fee, we choose that one. Management fees range from .50 to 2.50%. The drag on return of a higher fee takes its toll over the long run.

• Manager performance and tenure. If we buy a great manager, you will come out ahead. We look at how long that manager has been doing his job, and how she or he has performed in good and bad markets. Steady performing managers who beat the market are worth paying for.

• Load. We do not choose load funds as a rule. Load funds usually have an A, B or C after their name. A load is a sales charge for buying and or selling the fund. Some load funds are great performers, but usually there are great no load alternatives to load funds.

• Social responsibility. If this is a concern for you, we build you a socially responsible portfolio without sacrificing allocation.

Barbara Bachelder, CFP® for Wealth by Design, LLC