Beware the pitfalls
NEW YORK – First-time mutual fund investors face a mind-boggling array of choices, and often have little guidance about what kind of funds to buy. That can make a neophyte vulnerable to some key investing pitfalls.
“The error most investors make is to glom on to a hot fund based on past returns,” said Christine Benz, director of fund analysis at Morningstar Inc., the investment research firm that focuses on mutual funds. “Let’s say some fund is on a list of leaders, and it’s generated an attractive return. A lot of people assume that means the fund is going to continue to deliver a high return but a lot of times, all you have is a lot of overheated stocks in the fund that don’t have much upside left.”
That mistake is the reason you’ll hear or read in mutual fund ads, “Past performance is no guarantee of future returns.”
But many investors are nonetheless drawn to boasts of, say, a 30 percent gain last year. Financial advisers say that if you are going to look at a fund’s past performance, it’s best to consider how well it did over the long term – if you can, look at the 20-year return. You want to know this wasn’t a one-shot deal.
“A lot of investors look at funds that are on a hot streak and decide they want to get a piece of it, but it’s more meaningful to look at, say, a manager’s 10-year track record. If he or she has been able to outperform peers consistently, it’s a good indication he or she has built a good investment shop,” Benz said.
Fees are another facet of fund investing that can trip people up. Fees, which can vary widely from one fund to another, are critical because the higher they are, the lower your return will be.
Fees tend to be lower at the funds that mimic major indexes such as the Standard & Poor’s 500. They’re higher at what are called actively managed funds, where managers research and select stocks from a broader universe; many are sector funds, focusing on a particular geographic regions or an industry such as biotech.
“All funds have operating expenses such as advisory fees, administrative expenses and so on. When you’re getting started, you may be better off with a broad, passively managed fund that captures the total stock market,” said Conrad Ciccotello, associate professor of finance at Georgia State University’s Robinson College of Business.
The higher costs at actively managed funds can also reduce fund returns. Active managers, who are under pressure to deliver high returns, buy and sell stocks more frequently than index funds do, and each transaction cuts into the fund’s return.
Another factor to consider in buying mutual funds is who’s touting them. Many people turn to stockbrokers who will advise you on which funds to buy and then sell them to you. Brokers make a commission on the funds they sell; it could be charged up front or when you sell, or it could be what’s known as a trailing commission, deducted from your return over the time that you own the shares.