Demystifying Mutual Funds

Picking a mutual fund can be a confusing experience, partly because many investors don’t know what to look for. Is it important to have a well-known manager, an endorsement from a prominent publication, or a five-star rating from Morningstar? None of those things should persuade you to buy a fund--not even that last one.

Here are five questions you should ask before buying a mutual fund:

How Has It Performed?

You might say that a fund that produced returns of 22% per year for the last five years did better than a fund that returned 20% per year over the same period. Returns in isolation aren’t enough, though.

To know how your investments are really doing, you must have proper context. You must compare your funds with indexes and other funds that follow a similar strategy.

Suppose you’re considering a fund that buys stocks of well-known, rapidly growing companies. In this case, you might compare the fund with the Standard & Poor’s 500 index, which is filled with major companies.

If you own a fund that buys smaller companies, though, the S&P; 500 isn’t an appropriate measuring stick. Look instead at the Russell 2,000, which tracks smaller U.S. companies. For international funds, the most widely used index is the Morgan Stanley’s Europe, Australia and Far East, or EAFE, and the most common bond index is the Lehman Bros. aggregate bond.

You’ll often see these indexes quoted in the newspaper. They’re also available on many Web sites, including Morningstar’s (https://www.morningstar.net).

Even if your fund is beating its index, it may still be lagging other funds that follow a similar strategy. The Times features peer-group comparisons in its quarterly markets and mutual fund review and outlook sections (the next one comes out July 6) and updates the information on its Web site at http://161.35.110.226/funds.

How Risky Has It Been?

Next, you need to get a feel for how risky a fund is. Generally, the greater the return of an investment, the greater the potential for loss. Investors who take on a lot of risk expect a lot of return from their investments.

There are a number of ways to measure how volatile a fund is. You can compare a fund’s ups and downs with those of an index, for example, or with its peers.

One quick way to measure a fund’s capacity for losses is to look at its worst year. Then ask yourself whether you’d be comfortable sustaining that kind of loss.

What Does It Own?

It’s important to know what types of securities a fund owns so that you can set realistic expectations for what it can do for you.

You wouldn’t expect a bond fund to return 10% per year, but that’s not an unrealistic expectation for a stock fund.

Funds can own just stocks, just bonds, or a mix of the two. They can stick with U.S. companies or venture abroad. They can hold popular big names, such as Coca-Cola or Gillette, or focus on small companies that we’ve never heard of.

To take things one step further, research the manager’s strategy. A manager who likes high-priced companies that are growing quickly will produce different returns from a manager who favors value stocks with lower earnings but cheap valuations.

Who Runs It?

Mutual funds are only as good as the people behind them: the fund managers. They’re the ones who decide what to buy and what to sell--and when. Because the fund manager is the person most responsible for a fund’s performance, knowing who’s calling the shots and for how long is a key to smart mutual-fund picking.

Make sure that the manager who built the majority of the fund’s record is still the one in charge. Otherwise, you may be in for a surprise.

Take Oppenheimer Main Street Growth & Income. In mid-1995, manager John Wallace left the fund. He’d compiled a terrific record: The fund was the top-performing growth-and-income fund for the previous trailing three- and five-year periods. But the fund wasn’t the same after Wallace left. It went on to lag the average growth-and-income fund during the next few years. (New manager Chuck Albers came aboard in 1998 to improve things.)

Investors who bought the fund based solely on its long-term record--and who didn’t realize the manager who built that record had left--were sorely disappointed.

What Does It Cost?

Funds aren’t free--even no-load (or transaction fee) funds. You should pay for professional management, but paying enormous expenses for a fund is like giving money away. Fund fees come out of your total returns, after all.

Unfortunately, fund costs are nearly invisible. Fund companies report their expense ratios (or costs as a percentage of a fund’s assets) in their annual reports, but funds don’t bill you for expenses. Not the way a plumber would bill you for unclogging your drain.

Just as you’d scrutinize your plumbing bill before paying, though, do the same with your mutual funds.

Here are some guidelines: A 1% expense ratio is reasonable for domestic large-company funds, 1.5% for international and domestic small-company funds, and 0.8% for bond funds.

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At the Conference

The Times’ Investment Strategies Conference, to be held May 22-23 at the Los Angeles Convention Center, features panels on “Picking Mutual Funds: Fundamentals, Parts I and II” and “Evaluating Your Mutual Fund Portfolio.” For registration information, call (800) 350-3211 or visit http://161.35.110.226/isc.

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Olivia Barbee is managing editor of Morningstar FundInvestor.