12 Questions to Ask Before Investing in a Fund

As a kid, many of us played 20 Questions, a guessing game where the leader thinks of a person, place or thing and players had up to 20 questions in which to figure it out.

I never saw a game go the distance, the moral of which is important: Sufficient questioning clarifies matters.

That’s the idea behind the “profile prospectus,” a short, easy-to-read version of the no-one-reads-this-mess mutual fund prospectus. The profile was tested last year by eight fund groups and is expected to gain regulatory approval this year.

Unless the SEC changes its proposed rules, the profile document will be limited to 11 standard questions, supposedly the critical stuff an investor should know before buying. The questions involve function--the mechanics of buying, selling and working with the fund--and intent--what the fund expects to buy and whom it is supposed to be appropriate for.

But those aren’t the questions to ask before buying a fund.

“Some of the most important things you need to know about a fund have nothing to do with what you are buying and everything to do with you,” said Don Phillips, president of Morningstar Inc., the Chicago-based rating service.

“In fact, the questions about yourself are the ones you can answer with the most degree of certainty, so getting those answers first is probably the biggest factor in being satisfied with the fund you buy.”

With that in mind, I made a list of essential questions to ask before buying a fund. Finding answers means scouring your own inner workings every bit as much as the innards of a fund.

My list has 12 questions--it does the SEC one better.

1. What do I want to achieve with this money, and what types of funds meet that goal?

There are myriad reasons to invest--education, retirement, a house and so on-- but they boil down to a few essentials.

Generally, personal investment objectives are safety, current income and long-term growth, or a balance thereof. By isolating the investment purpose of the money--say you need short-term growth in order to buy a house in a few years, or you want regular income in order to support you in retirement next month--you can start searching for funds that will meet your goals.

“A lot of people make investments where the objective of the fund does not meet their own objective for their money,” said Michelle A. Smith, managing director of the Kansas City-based Mutual Fund Education Alliance. “They buy the fund before they decide what the money is for, and wind up with something too risky or volatile, or too conservative. They may still reach their goals, but they are relying on luck.”

2. What is my time horizon for this investment?

Time is a big factor in determining the risks you can take and the appropriate assets to buy. Typically, a longer time frame makes you more aggressive. You know better than anyone else-- professional fund managers notwithstanding--when a tuition payment is due, when the car will need to be replaced and when you plan to retire. The time needed to meet those goals, therefore, goes a long way in determining how you allocate assets.

3. How much risk can I live with?

This is the toughest question of all, because the typical response is, “Risk is fine, so long as I don’t lose money.”

It doesn’t work that way.

Picture yourself in the fund during the ugly periods. If funds you are considering weren’t around for downturns, use the average performance of the asset group during market doldrums.

Consider 1990, when the Lipper small company growth fund index was off nearly 14%. When weighing a small-cap fund, imagine your investment of, say, $10,000 and think about how you’ll feel if it’s worth just $8,600 a year from now. If that feeling makes you ill--regardless of the fund’s upside potential--you need less risk.

4. Does this investment diversify my portfolio and fit my asset-allocation plan? Diversification--buying different kinds of assets and thereby reducing the overall risk of your investment portfolio--is the investment world’s free lunch. If a new investment does not diversify the portfolio, consider adding the money to an existing selection; if that seems too risky or concentrated, then it’s obvious that you need to change your asset allocation.

5. What are my alternatives?

Smart investors always consider what else is out there. If you could be satisfied with a very low-risk return of 5%, chances are your money belongs in Treasury bills. Just because the world seems obsessed with funds is no reason for you to be. Always examine your options; it’s the best way to feel comfortable with whatever you invest in.

6. Do I have a special criterion for selecting a fund?

Social investors, for example, want funds invested in companies that adhere to particular social, moral or ethical standards. No-load investors do not want to pay sales fees (and may opt against any funds charging annual marketing fees). Other low-cost investors want funds with below-average expense ratios. Be honest about personal agendas. If you want to follow an investment theme, consider only funds that fit in.

7. Do I understand the data I’m looking at?

Morningstar gives a risk-reward rating of up to five stars. Mutual Funds magazine grades funds on its own five-star scale, as do several books. Some newsletters make forecasts involving expected returns; others forecast by giving each fund a letter grade. The vagaries of each system make it possible for poor choices--based on your personal criteria--to earn high grades.

Funds themselves contribute to this confusion. Some measure performance against the stock market but offer no indication of how the fund did relative to its peers.

To be a confident investor, you must be comfortable with the data used to make your decision. This may require a bit of background reading to make sure your assumptions are correct, but overestimating your knowledge can lead to costly mistakes.

8. What is the fund’s performance potential?

Most people make past performance the big factor in choosing a fund, but they mistakenly examine performance only in lump-sum terms, so that a fund with one big year can look good even after returns start to fade.

Look at performance to see if the fund gives a smooth ride or a roller coaster version--and decide what you can live with. “You want consistently superior performance, above-average but not topping the charts,” says Kurt Brouwer of Brouwer & Janachowski, a San Francisco advisory firm. “That requires a strategy you can look at and understand, that stands the test of time--and not just the current year.”

9. What am I willing to pay to get that performance?

This is less about sales charges than expenses. When the market is up 35% in a year, a 2.5% expense ratio doesn’t look bad. But in the future, when the market earns just 5%, half of your profits will go straight to the fund.

Costs matter, from fees to expense ratios. You may choose to ignore them in good times, but don’t be caught unaware.

10. Who manages the fund and how long have they been there?

Performance is a direct reflection of choices made by the fund manager. Your investment “hires” a manager; make sure it’s the one who raised the value of the fund.

Says Gerald Perritt, editor of the Mutual Fund Letter, a Chicago-based newsletter: “If the manager doesn’t have a proven record--either with the fund or managing the same assets elsewhere--it will be hard to justify buying the fund.”

11. Can I live by the rules of this fund?

This actually involves several questions, from whether you can afford the fund’s minimum initial investment to whether you like how the fund handles transactions.

You may be used to a fund group with a 24-hour phone service center and electronic transfer privileges, but some funds work business hours and require signature guarantees--a letter authenticating your John Hancock--before you can sell. To avoid frustration, know the details of buying and selling shares, as well any transaction fees.

12. What are the big positive and negative selling points to this fund?

This is the last question because answering it forces you to review the entire process and focus on why you are adding this particular investment to your portfolio. If the upside doesn’t obliterate the negatives, it’s probably time to scrap the fund and start the process over again.

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What the SEC Thinks Are Key Questions

Here are the 11 questions that mutual funds would have to answer on the Securities and Exchange Commission’s proposed profile prospectus:

1. What is the fund’s goal?

2. What is the fund’s investment strategy?

3. What are the significant risks?

4. Is the fund appropriate for me?

5. What are the fund’s expenses?

6. How has the fund performed?

7. Who is the fund’s investment manager?

8. How do I buy shares?

9. How do I sell shares?

10. How are the distributions made?

11. What other services are available?

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Charles A. Jaffe is mutual funds columnist at the Boston Globe. He can be reached by e-mail at jaffe@globe.com or at the Boston Globe, Box 2378, Boston, MA 02107-2378.