How to pick a good mutual fund: watch the costs

Mutual funds have suffered a serious blow when the public learned about serious machinations in the industry. The public has heard a number of times that the majority of the funds underperform the average return of the stock market. However, the funds are still there. Moreover, you will probably need to invest in them if you have a 401(k) plan since these plans only let you invest in mutual funds.

The good news is nobody forces you to invest in poor performers. Then there is the question: how do you figure out who is the best and who is the worst?

Of course, there is no universal recipe to pinpoint the fund that is going to beat the rest of the crowd in this very year. But there is information out there that will help you make a decision:

First, study the fund’s own prospectus. On of the first most important issues to look into is the how much the fund is going to charge you in various fees. The reason why actively managed funds underperform the market as a rule is the fees they charge that eat into the profit. The costs can be split into:

Transaction and Fund Expenses that include:
- Sales charge, or so-called “load”, for buying into the fund. You can avoid this fee by opting for a no-load, that is, the fund that does not charge you for walking through the door. As a lion’s share of the “load” likely goes into your broker’s pocket, beware of brokers that steer you exclusively towards loaded funds to chip some cash off you instead of looking for the best solution.
- Sales charge to reinvest distributions often waived by low-expense no-load funds.
- Back-end load, also called a redemption fee, or deferred sales charge: what the fund charges you for selling its shares. Although this fee can run up to 4-5%, once again, a no-load can only have a 1% charge they hit you with if you keep your shares les than six months. True, most funds will reduce the fees if you are with them for a longer time period.
- Exchange fee you pay for moving money from one fund to another. Some families will skip this fee if you move your money within the family.
Operating expenses computed as a percentage of the fund’s average net assets comprising:
- Management fee: what the fund managers get for their work and expertise
- Marketing or 12b-1 fee: the Securities and Exchange Commission allows the fund to charge you up to 1% of their average net assets for the marketing materials the fund uses to attract customers
- Other administrative costs including the maintenance of shareholder records, dispatch of financial reports, filing documents with the SEC, and paying for the service department.

Even after you studied all the fees carefully and made your choice, you need to be on the alert: funds can change their fee structure and levels, and it never hurts to check once in a while whether a “fee creep” has happened.