Sunday, December 18, 2005

5 screening criteria for mutual funds

When one starts to screen mutual funds for investing, the following 5 must be set before any additional criterion is applied to the screen.

  1. Set front load = 0. Yes, this should be the first selection criterion. There is no need to throw your mutual fund investment in a hole to begin with outrageous 5% or more front loads. This should remove all class A shares from your result set.
  2. Set deferred Sales Charge = 0. When your pie grows, keep it entirely. Do not give up part of it in the sales charges when you sell. This takes care of the class B shares from the result set.
  3. Say no to 12b-1 fees. 12b-1 fees include the charges of marketing and selling the mutual fund. There is no need to pay the marketing fees for the fund family. If the fund is good, people will find it. If you believe in efficient market theory then you have to believe that no good fund goes unnoticed. The new assets will surely flood the better performing fund. Removing 12b-1 fee funds from the selection should remove all class C shares from the result set.
  4. Keep expense ratio less than 1.25%. Although industry average expense ratio of the mutual funds is around 1.46%, I suggest you keep it less than 1.25%.
  5. Find funds with lower turnover. The mutual funds with higher churn rates have higher capital gains taxes that must be paid to government in taxes each year. This reduces the overall return of the fund.

After applying these 5 criterions, go ahead and add others as you may. This should be a good standard starting point. There is no magic formula out there for finding great mutual funds. We don’t know right now which mutual funds will perform better from here in out. But, I believe these screening criterias will remove some definite bottom feeders from your list.

All disclaimers apply.


Anonymous said...

aw, forget that. just stick to vanguard!

Dave said...

I don't exactly agree with this. There are some great funds out there which do very well that have high MERs. You can't just blindly reject funds because of a high MER.

Anonymous said...

Dave, What does MER stands for? Google suggests Mars Exploration Rover. That has nothing to do with mutual funds.

Uncle Foobar said...

MER = probably stands for Managed Expense Ratio, or what you pay for the privledge of being rooked.

I've bought some class-A mutual funds that never bothered to charge the upfront fee; YMMV.

Note: the cap gains are pretty irrelevant if you're investing in a retiring IRA or whatever...i think.


The Unknown Professor said...

I'd agree with "anonymous". If you believe in market efficiency (and I do), then paying for professional management doesn't make sense. An index fund (like Vanguard's) can give market returns with a less than 0.20% expense ratio.

However, if you want to go with an actively managed fund, you've made some excellent suggestions.

thc said...

Some of the best funds have sales charges and 12b-1 fees, small cap and international funds will often have higher expense ratios than 1.25%, and with a 15% capital gains tax rate, I'm not all that concerned with turnover. Other than that, it's a good list.

Loi Tran said...

Morningstar has good information on Mutual Funds.

Anonymous said...

If you use Vanguard be sure you get the preferential treatment Admiral shares are given.
(100M each fund min.!)Otherwise you are in trouble.

Investing Intelligently said...

The company my advisor works for, Clearsight, doesn't charge the up-front sales charge. So I can buy any mutual fund and it is essentially no load. This is also true with other companies as well I'm sure. So they buy front-load funds and charge a 0% load to the investor.

I don't agree with unknown professor. Market efficiency is most prevalent in large caps (I think). Professional management can be better than passive indexing in many cases. Check out ABC Funds performance versus the benchmarks.

Anonymous said...

The question of Active V Passive Management is roughly akin to the question of religion. there is plenty of evidence on every side and no one willknow for sure in this life.