How to pick mutual funds

In-depth mutual fund information is widely available, either from the funds themselves or third-party ratings companies like Morningstar. Here are some things to look out for:

Opt for funds with low expenses

Fund expenses directly reduce your returns, so you'll increase your odds of success by avoiding funds with bloated expense ratios; that's the annual cost, divided by your investment.

Look for consistency of style

For a fund to fit into a diversified portfolio, it's important that the manager stick to a particular investing style. If you bought a fund because you want your portfolio to include, say, small value stocks, then you don't want a fund manager jumping into large growth issues.

Consider risk

Returns may vary, but funds that are risky tend to stay risky. So be sure to check out the route the fund took to rack up past gains and decide whether you would be comfortable with such a ride. Here are some risk measures to consider.

Beta measures how much a fund's value jumps around in relation to changes in the value of the S&P 500 index, which by definition has a beta of 1.0. A stock fund with a beta of 1.20 is 20% more volatile than the S&P -- that is, for every move in the S&P, the fund will move 20% more in either direction, up or down.

Standard deviation tells you how much a fund fluctuates from its own average returns. A standard deviation of 10 means the fund's monthly returns usually fall within 10 percentage points of their average. The higher the standard deviation, the more volatile the fund.

Worst quarter is a very straightforward measure of risk: It merely shows the fund's worst quarterly return on record, giving you a feel of what to brace yourself for.

Check out past performance

When examining a fund's performance, you should look at its long-term record (at least three years and preferably five years) versus that of its peers, as well as how it has fared over shorter stretches.

Compare those results to category averages -- you can't really fault a small-cap fund manager for a lousy year if all small-cap funds did poorly. But it's a lot harder to be forgiving if a fund does much worse than all its peers, especially if it does so over a sustained period.

Seek low taxes

You can't forget about taxes just because you don't have any intention of selling your fund shares. As a fund owner, you also own all the stocks in the fund's portfolio. If the fund manager sells a stock for a huge capital gain, you'll have to report that gain on your tax return.

Steer clear of asset bloat

This is more of an issue with small-cap funds than with large-cap funds. The latter buy big stocks with a lot of shares outstanding, so the manager shouldn't have too much of a problem buying more GE and IBM when investors pour money into the fund.

But since small-cap funds are buying stocks with very few shares outstanding, an extra billion or two in total assets can tie the manager's hands.

To put the additional money to work, the small-cap fund manager may have to drop his standards or accumulate overly large positions in individual stocks, which might limit the manager's liquidity when trading.

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