For the average person looking to manage retirement assets, mutual funds are a superior way to invest. They are professionally managed, eliminate the job of stock picking, are easy to trade and enable a level of diversification you could never duplicate by trading individual stocks.
Pick the Best Mutual Funds for Retirement
Best of all, there are ways to evaluate mutual funds that make the job of picking the right set for your retirement even easier.
Check the Rating Services
Making the job of mutual fund selection more investor-friendly are independent mutual fund rating services, such as the Lipper Average and Morningstar Ratings. These services analyze and rank mutual funds based on common criteria, making it easier to compare one fund to another.
For example, the Lipper Leaders Rating System ranks funds based on capital preservation, expenses and consistent return over extended periods of time. Funds are rated on a scale of 1 to 5. A fund with a rating of 5 has been in the top 20 percent of all funds in its category in the past few years; a rating of 1 means it’s been in the bottom 20 percent.
It’s important to remember that high ratings represent only that a fund has been in the top fifth of all funds in its category—not that it will be a guaranteed winner in the future. Still, funds with a higher rating have shown themselves to be better performers than their peers in the industry, making the ratings quite valuable to investors.
Load, Low-Load, No-load
Mutual funds often have commissions or “loads” and that can be applied as a front load (sales charge), back load (redemption fee), or both. A front load can be as high as 9 percent of the fund’s value, while a back load will generally be less. Back loads are often reduced the longer you own a fund.
Sales or commission charges can end up costing you thousands of dollars in retirement. Taking even 1 percent away from your portfolio every time you invest money will have an impact on your nest egg’s value in retirement.
Funds come in three basic types: load, low-load, and no-load. Loaded funds can have fees on either end (front or back), and they can be quite substantial. Low loads have fees, but they’re usually on the low end of the scale—say, 1percent on the front and 1 percent on the back. No-load funds, as the name implies, impose no fees on either end, which is why they’re often the preferred type of mutual funds. Loaded funds would have to significantly outperform no-load funds to be worth putting your money at risk.
In addition to loads, mutual funds also charge fees for operation expenses. These include management fees paid to the fund’s investment manager, annual fees—also known as 12b-1 fees (marketing and distribution)—custodial fees and various administrative fees. Load fees however are not included in the expense ratios.
The job of measuring these fees and understanding a mutual fund’s cost structure is made easier by the fund’s expense ratio, which adds the various fees together and presents them as a single percentage or ratio of the fund’s value. This ratio will reduce the rate of return on your investment in a mutual fund. For example, a 1 percent expense ratio will reduce a 12 percent return to 11percent.
The expense ratio is an important consideration in comparing load funds with no-load funds since loads are a one-time fee, while the expense ratio represents an ongoing, annual charge. Over a five-year period, for example, a no-load fund with a two percent expense ratio (10 percent total over five years) will have higher fees than a load fund with a three percent front load and a one percent expense ratio (total of eight percent over the five years).
Diversification and Sectors
Diversification is one of the primary reasons an investor would choose to invest through a mutual fund. In and of itself, a mutual fund represents a diversification because it invests in the stock of many companies or even investment classes.
As an investor, you have an opportunity to use mutual funds to achieve the level of diversification you are most comfortable with. You can chose to invest the bulk of your money in index funds, which closely approximate the composition of various indices, such as the Dow Jones Industrial Average or the S&P 500, then invest smaller amounts in certain sectors which you feel are likely to outperform the general market.
Mutual funds allow you to invest specifically in certain sectors, such as energy or high tech, and to diversify holdings within each sector. In this way, you can benefit from the high performance of a sector without the risk that comes with owning only one or two stocks in the industry.
One of the primary ways you can decide if a mutual fund is right for you is by looking at the fund’s performance over the past few years. But it’s not just the performance of the fund you want to investigate. You need to look at its performance against the market as whole.
Funds with returns that are higher than the general stock market are said to “outperform the market”; those with lower returns are said to “underperform”. While there’s no guarantee that that a fund that has outperformed the market for the past 10 years will continue to do so in the future, the fact that it has does make a strong statement about the fund managers capability.
All things being equal, a fund that has outperformed the market over a long period of time is a better bet than one that has either matched it or underperformed. Because there are so many ways to measure the performance of mutual funds—both against the market and against other funds—they are typically an easier way to invest for your retirement than picking individual stocks.