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Mutual Fund Space

February 23, 2010 – 12:00 pm

While we usually discuss investing in stocks, there is another area of investment that needs better understanding.  The area I am talking about is the mutual fund space.

Most people invest in them through a 401(k), yet they do not know the ins and outs of how to pick a quality fund.  Many investors simply use performance as a decision mechanism, but that is usually very faulty and fraught with danger.  Here are some other metrics to consider when picking a quality mutual fund:

* Alpha – This is a measurement that tells an investor whether the past returns are achieved with an acceptable amount of risk.  If the alpha is above 0 than the fund is achieving their returns without inappropriate volatility.  If the alpha is negative then their historical returns were achieved using excessive risk.
* Category Ranking – Compare funds to their peers in their specific investment category.  It is unfair to put an equity fund up against a bond fund.  This is on par with comparing apples to oranges.  In addition do not compare a domestic equity fund to an international fund, or a small cap to a large cap fund.  Compare relative performance to other funds that have the same investing style (Large vs. Small, Growth vs. Value).  Once you find a few great performing funds within the category adjust the return by considering some risk metrics.
* Standard Deviation – This is the simplest of statistical measures.  It is a straight measure of volatility.   The higher the SD, the more volatile the funds price performance will be.
* Expense Ratio – This measures how much the manager charges for their service of managing the mutual fund.  Expenses vary between types of mutual funds.  A bond mutual fund should not have an expense ratio above 0.75% per year, a domestic fund should not exceed 1.5% and a foreign fund shouldn’t go above 1.75%.  If a funds expense ratio is above these levels they are probably over charging.  This does not mean you shouldn’t buy those funds, it simply means look for  quality options within that space that are cheaper.

As usual however, never buy a mutual fund that charges you a load to buy (front-end loaded) or sell (back-end loaded).  There are plenty of no load mutual funds out there with good managers and a solid track record. A load is the word the industry uses for commission.

–Steve Peasley

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