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Evaluating Mutual Funds

Each mutual fund has a specific investment objective that it tries to achieve. The first step in choosing a new fund for your investment portfolio is to figure out which type of fund you want to add, based on an objective that's compatible with your goals. There are tens of thousands of mutual funds out there, so start by using an investment screener to narrow down your choices. One word of caution: there's no guarantee that a fund will achieve its goals or keep its investment objective.

Next, investigate a number of funds with that objective to find the one that you think will work best for you. Essentially, you're trying to compare apples to apples. Looking at funds next to each other generally includes looking at these aspects of each fund:

  • Return: the gain or loss in the value of the fund to show the fund's performance over time
  • After-tax return: the gain or loss after subtracting the income and capital gains taxes that are due
  • Cost: the expense ratio, which includes operating and other expenses, and the sales charge (if any) for buying the fund
  • Management: the reputation of the manager and their tenure with the fund
  • Net asset value (NAV): the change in share price, which shows whether (and by how much) shares in the fund have gained or lost value
  • Yield: income per share that the fund paid over the past 12 months as a percentage of the current NAV

Measuring Return

Some things to consider when you're evaluating a fund's return are the statistics reported by different funds compared with the performance of funds with similar objectives. And, as always, if a fund has done well in the past, that's not a guarantee that it will continue into the future. Here are some statistics you'll find.

Total return is the dollar amount a fund has increased or decreased in value when all of the fund's distributions (that is, dividends and capital gains paid out to the fund investors) have been reinvested. Many investors consider total return the most accurate measure of performance.

Percent return is a fund's total return divided by an initial investment of $10,000. This helps set a standard so you can compare the performance of funds with different total returns.

Annual percent return provides performance results over periods of time, such as 1 year, 5 years, and 10 years.

However, the return your fund reports won't necessarily be the return you get if you're invested in the fund. How can that be? Well, the timing of your investment affects your result, along with whether or not your distributions were reinvested.

Word to the wise

As you look closely at return, you should keep a few things in mind that may not be immediately obvious.

A fund's long-term return matters. Strong returns in one or two years, combined with several years of not-so-great returns, might mean that the fund is riskier than you thought. Or, it could mean that the investment style the fund used that produced such unbalanced results in the past could do so again.

If your investment earnings are taxable, be sure to check each fund's prospectus for its pretax and after-tax return. Some funds are more tax-efficient than others (like funds with lower turnover and capital gains distributions). If you invest in the more tax-efficient variety, you keep more of your return than you would with an otherwise comparable (but less tax-efficient) fund.

Another thing: the returns that a fund reports are not adjusted for inflation. To find what's known as real return, subtract the current inflation rate from the reported rate of return. For example, if a fund's return is 8%, and inflation is currently 3%, the real return is 5%.

Using Benchmarks

A benchmark helps you to figure out how well (or how poorly) a particular fund is performing. You can judge a fund's performance (compared to the segment of the market that it belongs to) by comparing its total percent return to its benchmark. In the prospectus, each fund will indicate the index (or indexes) it uses as a benchmark for the fund. For example, a large-company stock fund may be compared with the S&P 500 Index for the same period. A small-cap fund may use the Russell 2000 Index as a benchmark.

There are also narrowly-focused benchmarks for specialized funds. Companies that evaluate mutual funds provide a range of fund indexes that track specific fund categories. How well an index performs, however, isn't necessarily how the fund will perform, because you can't invest in the index directly. An index does not by itself include any fees, expenses, or sales charges, but a mutual fund will.

Risk vs. Return

Each fund has a specific risk profile, which describes the level of risk you take by investing in the fund. When you assess fund performance, consider the effects of risk on potential return. For example, certain funds (including those described as capital appreciation or sector funds) will probably be more volatile than other funds. That's because the fund manager is more likely to take certain risks to meet the fund's objective. In any case, it is possible to lose part or all of your investment.

Increased volatility means the value of your fund holdings could rise or fall dramatically at any time. In contrast, capital preservation funds are likely less volatile than other funds because their managers need to take fewer risks. The flip side is that they also generally provide more modest returns.