Monday, September 9, 2013

How to Pick Mutual Funds

I decided to do a post on how to pick growth mutual funds because I just went through this exercise over the weekend and I know my sister Jen is interested.  She recently asked about how to pick similar funds for a Coverdell ESA for our nephew Max.

This post is not necessarily a post on how to pick mutual funds for a 401k, as you're limited to the funds offered through your place of work.  This is more for rollover 401k accounts, Coverdell ESA accounts, IRAs or personal accounts that you have full control over.  However, the research methods could apply to a 401k, you would just have to individually research the funds that are available to you.

The reason I went through this effort was that I recently analyzed my returns over the last 2 years of my own personal stock trading account vs our various 401k/IRA accounts and came to the realization that I'm not quite the expert stock picker I hoped I would be just yet.  My % gain over that time hasn't been as high as our other accounts.

Based on that, I decided that I'm going to take my rollover 401k that I was using for stock/option trading and take 75% of that account and put it into 5 growth mutual funds.  The remainder I will keep available for individual stock/option trading.  For the most part, 75% or more of that account has been sitting in cash over that time anyway, so I should have done that a while back. 

I decided to target 5 mutual funds to spread the $$ out into different sectors and for diversification purposes.  I wanted to share the way I did the research so that you could do the same research, plugging in the criteria that is most important to you.

To get started, go to Morningstar and use their basic mutual fund screener.  You will need to sign-up for a free account and then you can get started, it will only take a minute or two.

Once you have the basic screener up, you can pick from the different screening criteria that are important to you.  For me, I initially chose the following criteria:

Minimum initial purchase less than or equal to:3000
Load funds: No-load funds only
Expense ratio less than or equal to: 1%
For ratings and rankings I selected 4 and 5 stars
10 year rate of return greater than or equal to: 10

Then you scroll down and click on the 'Show Results' tab. 

That gave me a list of 109 mutual funds sorted in Alphabetical order.  I then grabbed the pulldown that says View: 'Snapshot' and changed that to 'Performance'. From there I clicked on the 10 year column, to sort all of the funds by highest performance over a 10 year period.  Keep in mind however, that past performance doesn't necessarily predict future performance, but that was where I started my research.

I then clicked on each mutual fund to bring up the Morningstar research page and I looked through each one and analyzed each fund based on rates of return over 3, 5 and 10 year time frames as well as comparing expense ratios, looking at the major stocks that the funds hold and looked at the % of US stocks vs non-US vs bonds, etc.

I narrowed down that list of 109, to approx 10 that I thought were the best of the bunch.  I then plugged the 5 letter symbol into my Scottrade account to see if they were available to purchase.

Several of them said they were no longer open to new investors, so that left me with about 6.  Of those, I dug a bit deeper, comparing the 10 year charts of those 6 funds with each other as well as comparing them with the chart of the S&P 500 over that same time frame.

Based on that research, I narrowed the list down to 3 funds.  One was a Natural Resource fund, one was a BioTech fund and the other was a Technology fund.  Good mix so far, but I was 2 short.

For the remaining two funds I changed the criteria a bit.  I upped the expense ratio item to less than or equal to 1.5% and changed the rate of return to greater than or equal to 10% for the 5 year time frame instead of 10 years.  In that way, I would find some funds with good rate of return over 5 years that perhaps haven't been around a full 10 years and might find some funds with expense ratios just over 1% that still have good rates of returns.

I came up with two additional funds from that research, an international fund and a mid-cap growth fund.  I decided I'm going to split the $ equally between those 5 funds with 20% going into each.  I will give the list of 5 mutual funds ONLY as an example of what I came up with as a result of my specific research this past weekend.  This is NOT an endorsement or recommendation to purchase any of these specific funds.  

FSCHX - Fidelity Select Chemicals (Natural Resources)
FBIOX - Fidelity Select Biotech (BioTech)
FSCSX - Fidelity Select Software and Comp (Technology)
POAGX - Primecap Odyssey Aggressive Growth (Mid-Cap Growth)
DODFX - Dodge and Cox International Fund (International Growth)

If you have $10,000 or more to invest, I think picking 4-5 mutual funds is a decent method of investing.  Since many funds require a minimum of $2000 or $2500 for an initial investment, that would allow you to spread your $$ evenly between 4-5 funds.  However, if you're investing say $2,000, you would be limited to 1 fund most likely.

In that case, I would suggest checking out Target Date Mutual Funds.  The way Target Date Funds work is that you pick a year that you may retire in the future and pick a fund with that date.  The longer out the date is, the more aggressive the fund is and the more stocks you would have vs bonds, etc.

For example, VTIVX is the Vanguard 2045 Target Date fund.  Vanguard has the lowest fee funds in the industry.  That is the fund I use for our Roth IRAs.  That fund invests in several other funds and they take care of all of the diversification for you.  Over time, the fund manager changes the % of stocks/bonds, etc. towards more conservative investments as you approach the target date, in this case 2045.  It is a 'set it and forget it' type of investment.  If that appeals to you, I'd recommend researching the Vanguard Target Date Funds.

The other option is ETFs.  When they talk about the stock market on the news, they usually mention how much the Dow Jones, S&P 500 and Nasdaq went up or down on any given day.  Those are indexes, which are just a basket of a certain number of specific stocks.  For example, the S&P 500 is just a basket of 500 specific stocks and the daily results are the sum or all the gains or losses of the stocks that make up that index.  If most of the stocks in the index went up more than the others went down, the index would be up or vice versa.  

When people try to determine how they did in a particular year, they usually compare their % increase or decrease to the % increase or decrease of the S&P 500.

For instance, if you made 10% on your investments in a given year that is good, however if the S&P 500 went up 20%, you would have been better off just investing in the S&P 500 rather than picking individual stocks or mutual funds.  The way you can do that is through ETFs.

If you wanted to match the performance of the S&P 500 for example, you could purchase any number of ETFs, but I'd say the most common one is the symbol SPY.  You can purchase any number of shares or $ amounts of SPY and you just pay whatever the cost is for a stock trade to buy and sell.  You can buy or sell that ETF at any time without penalty just like a stock, whereas many mutual funds require you to keep your $$ in the fund for a year or you could face a penalty if you sell before then.

There is obviously lots to consider when choosing high growth mutual funds, but I hope this post has shed some light on how you might get started!  If you have any specific questions, please let me know and I'd be glad to try and help out. 

Here are some additional resources that you might find helpful:

Dave Ramsey: How to Choose the Right Mutual Funds
Dave Ramsey's Investment Philosophy PDF


Jen said...

Great information and links! I need to make some time to dig into this. I highly recommend the target fund for the IRA's.

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