The Best Way to Evaluate Mutual Fund Choices

Considering the size of the mutual fund industry, the idea of evaluating all of its choices might seem overwhelming. The worldwide mutual fund industry oversaw approximately $23 trillion in assets in 2011, nearly half of it in U.S. mutual funds, according to a 2012 Investment Company Institute Fact Book. Luckily, investors have ways to help find the funds that are best aligned to their risk and return expectations. Chief among them are mutual fund prospectuses, which are regulatory documents that report financial and management details.

Prospectus

The detailed information that an investor needs to evaluate a mutual fund is included in the fund's prospectus. In the United States, mutual funds are required by law to register with the U.S. Securities and Exchange Commission. On the SEC website, investors can access prospectuses for all of the mutual funds that a particular investment firm offers. Sometimes, mutual funds include an entire series of funds in one regulatory filing.

Fund Type

One of the first things to observe about a mutual fund is the type of financial securities that it purchases. Most funds contain stocks, bonds, or a combination of the two. Stock funds experience more volatility because stock prices can be erratic. Bond funds are likely be more stable but they won't produce the highest returns. By knowing the securities inside of a mutual fund, an investor can determine whether the fund manager adheres to the investment strategy outlined in the prospectus. It is not uncommon for fund managers to stray from a fund's design to try to get higher returns.

Performance

When evaluating a mutual fund, it's helpful to learn about past investment performance to form a reasonable expectation for profits. To get the truest sense of how a mutual fund performs, an investor should view returns over the past five to 10 years, according to a 2010 Kiplinger article. A shorter time frame could display an abnormal return that was a short-term blip and wouldn't accurately represent the fund's past performance.

Management Style

Active fund managers hand-pick the stocks or bonds that go into a fund. Active management promises investors returns that exceed what is earned in the broader stock market, but it charges higher fees for that performance. In a passive fund, investment performance is linked to a broader market index, and the makeup of the fund does not change often. Passive-fund managers charge lower fees because they are less involved with the management of the fund. In the first 11 months of 2012, investors seeking lower fees and less risk withdrew nearly $120 billion from actively managed funds, according to a 2013 article in "The Wall Street Journal."

Talent

It is not unusual for the success of a mutual fund to be linked to the management talent who make the investment decisions. The prospectus should list the names of the people who run each mutual fund. The fund's website might tell you more about the management team's tenure with the firm. Any disruption or changes to a management team is especially of concern to investors in actively managed funds. That's because their fund's performance is directly linked to the talent and abilities of those investment professionals, according to a 2011 U.S. News and World Report Article.