With more than 32 million pages on Google referring to Mutual Funds and more than 19,000 Funds available to invest (according to the Center of Research in Securities Prices) it looks very difficult to decide which funds use to achieve your financial goal. With that in mind, here are the 5 questions to ask when investing in mutual funds as well as the reasoning behind them.

What class (share) is the broker/advisor recommending? A same fund can come in different classes, and the main difference between them is how you pay for them (please note that none of the following fees include the trading costs inside the funds). Usually, share classes are:

  • A Shares: The investor pays an upfront fee (usually most of it is used to pay the broker a commission). That fee can be as high as 8.50%, but the average is around 4.5%. That is, if you invest $10,000 the fee is $450 to enter this fund. Generally, as the invested amount increases there are break points at which the fee decreases. Besides the upfront fee there are also management fees, which are charged as a percentage (about 1.4% on average) of the assets held. Management fees are costs for staying in the fund and there’s no reduction in them regardless the size of the account.
  • B Shares: These shares are often sold as “no load”. This class doesn’t have an upfront fee; instead, the fund charges a higher management fee than A shares -between 0.5% and 0.7%-, so the actual fee could be over 2%. In addition, the fund charges a back-end fee if the investor decides to leave the fund before a set period of time (usually between 5-7 years). The back end charges and the higher (than A shares) management fee are used to compensate the broker that sells these funds..
  • C Shares: Like the B share, this class allows all the money of the investor to go to work right away. An important difference is that the back-end fee is generally much lower in C shares (usually 1% and its usually only for a year). The management fee is comparable to that of the B shares.
  • There is; however, another alternative: true no-load funds. By using these funds, the advisor is not compensated by the fund company; instead, the advisor charges a fee directly to the investor. In my opinion, this is the most transparent alternative because it eliminates conflicts of interest from the advisor based on compensation. Please note that some “no-load” fund families have fees for: purchases, redemption, exchanges, and account fee.

For an informative review on Mutual Fund fees, please review this SEC page; and remember to read the prospectus before investing in any mutual fund, because it discloses all the costs that the SEC mandates.

Why are you recommending this fund? If you get answers as “It has a great performance history” or “This fund has terrific managers” avoid investing in those funds. Why? Because academia (like Bryan Caplan, Associate Professor at George Mason University) has shown that there is no correlation between past and future performance (if you want to go deeper on this, please consult literature on mean reversion). Besides, other studies (like this from S&P) have shown that between 70 and 90% of fund managers underperform their respective indexes and it’s impossible to know in advance which funds are among the ones that will outperform the indexes. Finally, not all asset classes can be “hot” all the time. That is why so many investors lost tremendous amounts of money in the late 90’s: they were chasing funds with great short term past performance and were guided to believe that past performance meant future performance as well.

How often and how do you rebalance the portfolio? This is one of the most important premises in asset management. In short, it means that you “sell a portion of your winners to buy more of your losers”; that is, to keep the discipline of your original portfolio design and it helps to control risk as well. For example, if the US stock portion of your portfolio is supposed to be 13% and it is now 18% because of market conditions  it is the advisor job to bring it back to 13% with as little expense as possible.

How are you going to measure the risk in my portfolio?     Most advisors claim that controlling risk for their clients is very important; however, it is uncommon that the advisor shows the actual, measurable level of risk that the investor will face if he/she follows their recommendations.

This question applies if you have a taxable account: How do you intend to tax manage this portfolio and minimize taxes on gains -or even losses? If there is no clear answer, or worse, a blank stare avoid working with that advisor. Taxes could become a massive expense to investors. In fact, as recently reported in Bloomberg: “the tax bill will arrive even if the fund had terrible annual returns”;  so the investor will not only suffer from the losses in his/her investments, but also will have to pay taxes on top of that”.

If you would like me to personally answer all your questions about mutual funds or investing in general, please go to THIS page.