This article is a guest post from G.E. Miller, author of the personal finance blog 20somethingfinance.com. If you like this post, head on over and subscribe to his feed.

A reader’s request:

Recently a reader, whom I shall refer to as ‘Steve’ requested that I take a look at his portfolio and tell him if his wife’s investments were good or not. Steve’s wife had quite a bit of money invested through a Wachovia ‘adviser’. Steve had the suspicion that the mutual funds chosen by his wife’s adviser were less than stellar and wanted a second opinion on them.

Now, I’m not an expert on choosing mutual funds, and what may be a good fund investment for one person may be a bad investment for another. However, there are certain standards and benchmarks that one can look at when selecting mutual funds to give you an indication of whether or not your money is in the right place. Let’s first take a look at whether or not you’re ready to pick your own investments.

Are you ready to choose your own mutual funds?

Here’s a checklist of things you’ll need to pick your own mutual funds:

• Internet access and a desire to use it to educate yourself. That’s it! With internet access you can research and compare mutual funds and open up a discount brokerage account at Zecco, Tradeking, or any other of the fine discount brokerages out there. Since you’re reading this blog post, my instincts tell me that you meet this criteria, so let’s move on.

What things should you look at when choosing mutual funds?

1. Index vs. Managed Funds: The linked post takes a look at choosing one over the other. If you have no idea on how to pick a mutual fund and don’t want to learn, then you’re probably better off going with index funds due to their generally lower expenses. If you want to take the time to educate yourself and have found an option that is better than its comparable index fund, then you might want to opt for the managed fund. Personally, I invest in index funds in my 401K due to a lack of a better option in each category I invest in, and in personal accounts I invest in managed funds. If you decide you don’t want to go with the index funds without much work, you could probably do much worse than investing half your money in the Vanguard Total Stock Market Index (VTSMX) and the Vanguard Total International Stock Index (VGTSX).
2. Diversify: It’s good to own a variety of asset classes. For instance, you may want to invest a portion of your assets in a domestic stock fund, an international stock fund, an emerging market fund, and a few different sector funds. How much you diversify and the level of risk you choose to take are a topic all of their own.
3. Expense Ratio: Expenses can really cut into your returns. There is no real reason to purchase a fund with more than a 1.2% overall expense ratio. Many index funds will have much lower fees than this. Some managed mutual funds have great returns and managers but incredibly high expense ratios. With thousands of fund options out there, you’re probably better off taking your cash elsewhere.
4. Fund Manager: Some fund managers have a reputation of great stock picking and are loyal to the fund company that they work for. These are the good ones. The bottom line is, you are not really purchasing a mutual fund by name, rather, you are purchasing the skills of that fund’s particular manager at the time that you buy that fund. If you find a fund manager who has great long-term historical performance success (five, or even better, ten years) and isn’t on the move, you probably have a good one.
5. Load vs. No-Load: Front and back-end loads are a ripoff. Loads are basically paying a fund manager a set percentage of your overall assets when you move into or out of a fund (often-times between 4-6%). When there are thousands of equally well-performing no-load funds available, why waste your money? Go with the No-Load!
6. Size of Fund: Some huge funds get too big for their own good. Many will attract performance chasing investors. The more money a fund has to invest, the less quickly they can purchase and sell investment vehicles. I tend to stay away from mutual funds that have assets exceeding $10 Billion plus. Many fund companies realize this so they create ‘sister’ funds that mirror the strategy of their kin with much less in asset value.
7. Comparison to Category Averages: If a manged fund is under-performing its category average, you’re probably better off going with their index fund counterparts and saving on the expense ratio. One of the sites you can view comparable performance on is morningstar.com.

One good resource to check for much of this data is Google Finance.

What red flags should you avoid when choosing funds?

Let’s take a look at Steve’s portfolio for red flags based on the previous criteria that we set.

• AAIPX (International Equity): underperformed its category each of the last four years, probably better off with an index fund representing its category. Additionally, this fund has changed hands three times in the last two years. When will it change hands again?
• FLMVX (Mid-Cap Value): fairly decent record compared to its category. Respectable expense ratio, but new manager as recently as May of 2006. Steve could be doing worse than this selection.
• GGOIX (Mid-Cap Growth): mixed results over the last few years, but all in all, not too bad compared to its category.
• PZFVX (Large Cap Value): abundant red flags on this one. Underperformed its index by 19% over the last year. Also has a high expense ratio at 1.3% on top of a 5% front load fee. This one is a nightmare.
• TGCNX (Large Cap Growth): new manager in 2004, every year since has underperformed its index, including one year by 12%. Has an ‘above average’ risk with a ‘low’ return. Another nightmare.

Steve could probably find a similar index fund that will get him better results in all of the asset categories that he is represented by, and all at much less expense.

What funds does your portfolio consist of right now and why did you choose these funds?

If you found this article helpful, subscribe to my RSS feed, or sign up for free email updates! You may also find the following articles of interest:

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Author: Jeremy Vohwinkle

My name is Jeremy Vohwinkle, and I’ve spent a number of years working in the finance industry providing financial advice to regular investors and those participating in employer-sponsored retirement plans.

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