Buyer beware: Your mutual fund checklist

For better or for worse, mutual funds are just about the only way for the average investor to get a broad stake in the market. A basket of professionally managed stocks can open up a world of opportunity and moderate the risk from a few single stocks. A poorly managed fund can drain your savings, and the only one making money will be the mutual fund company.

There’s a fine line between the two. Once you factor in fees, the average mutual fund underperforms its benchmark index. Investors who don’t like those odds can often purchase the index itself for a fraction of the cost through exchange traded funds, or ETFs.

But you can be on the winning side of the mutual fund game by measuring any of the thousands of funds available on the market against four factors.

Performance

If you look at the small print on mutual fund advertisements you should see a line that says something like: “Past performance is not indicative of future returns.” Securities regulators force them to do that, but while it may seem obvious most investors have a natural tendency to latch on to yesterday’s winners.

When looking at past returns look at the big picture and see how it has performed over a matter of years or even decades.

Compare the returns with mutual funds in the same asset class, such as Canadian equity and the benchmark index, such as the TSX Composite. If the fund consistently beats both, you may have a winner even if the fund has lost money over the short term.

Independent websites like Morningstar Canada provide handy comparisons.

Management

Good mutual fund managers employ strategies that could take time to come to fruition. Value investors, for example, will buy stocks that have declined through no fault of their own during a broad market drop. The price is sometimes low in relation to its earning potential and it could be just a matter of time until it catches up.

Securities regulators do not require mutual fund companies to provide a great deal of information about their management style but the company website is a good place to start. Read the fund’s prospectus, or objective.

Also, look at the track record of the mutual fund company itself as well as the individual fund manager. Mutual fund companies will often sponsor a fund but hire outside managers to look after it on a day-to-day basis. Look at the performance of other funds under their management.

Fees

You need to pay big bucks for good management, right? Well, not always. Annual fees, or management expense ratios (MERs), are based on a percentage of the amount invested but just a fraction of that goes to the manager. The rest goes toward administrative costs, marketing and paying that guy who sold you the fund.

A typical fee for a Canadian equity fund is 2.5 per cent. More elaborate funds like international equity or small caps, have higher management costs and therefore higher fees.

In addition, some funds charge flat fees - called loads - when they are bought or sold to compensate that guy who sold you the fund. Again, avoid them.

Is it right for you?

Billionaire investor Warren Buffett once said he never invests in something he doesn’t understand. It’s a good rule. Since you’re paying an advisor, get him to explain exactly what the fund holds and how it is managed.

There’s also a rule imposed by regulators for mutual fund salespeople called “know your client”. That means the mutual fund must be consistent with the investor’s risk tolerance and long term investment goals.