The Best Mutual Funds – Part 2

mutual-funds-IIWhen is comes to finding the best mutual funds, there are a lot of moving parts and features to consider.  Some of these things are much more important than others.  So if you’re trying to find the best mutual funds, here are some more things you need to know about:

12b-1 Fees

These are another kind of internal fee that some funds will charge you. You’ll never see these fees show up on a monthly or annual statement.  In fact, the only way you’ll know if you’re paying them is to look in the fund prospectus.  Most loaded funds have 12b-1 fees, and a few no-load funds do too. These are basically an annual trailing commission that goes to the broker who sold you the fund. It’s supposed to be his or her incentive to continue to take care of your account. It’s generally .25% per year, so it’s not going to break you. But when you add that on to an up front commission of 5.75%, and an expense ratio of 1.50% or 2.5%, and it starts to become very difficult to keep up with the market. If you’re looking for the best mutual funds, try to avoid 12b-1 fees.  The more you pay in fees, the less your returns will be.

No-Load Funds

No load funds are funds that have no commission for the investor to pay at all. So every $1 that you invest goes right into the fund. Some famous no-load mutual fund companies are Fidelity Investments, Vanguard, and the Dimensional Funds. The only way a no-load mutual fund makes money is from the internal expense ratios. But that doesn’t mean that their expense ratios are higher. In fact, quite the opposite can be true. No-load funds are in our opinion are some of the best mutual funds available today.

Most full-cost brokers (ie. Merrill Lynch, Edward Jones, bank guys, etc.) won’t ever educate you about the way fund companies charge fees and make money. They will usually tell you that the best mutual funds are their own, which are generally loaded with fees and commissions. Knowing this can save you thousands of dollars and make a huge difference in the size of your account years from now.

ACTIVELY Managed Funds

Actively managed mutual funds have fund managers who are actively buying and selling securities inside the fund in attempt to outperform the market. Many people think that actively managed funds are the best mutual funds. Keep in mind that each time a trade is placed, the fund has to pay a commission. These commissions are in addition to the funds expense ratio and 12b-1 fees, and are only reported in the annual report. Morningstar says that these trading commissions can run as high as 1% – 2% of the funds assets per year if the manager is a very active trader. You can get a feel for how much trading is going on by looking at the funds turnover rate, which is also reported by Morningstar. If a fund has a turnover ratio of 50%, that means the manager is selling and then buying again 50% of the funds assets each year. Many stock funds commonly have turnover ratios of over 100% per year.

Also, when a stock inside a fund is sold by the manager, any capital gains that are realized from that sale will be passed on to you as the shareholder. So even though you didn’t do anything, you could be paying taxes on your investment at the end of the year. Funds will estimate the amount of capital gains that they plan to pay out at the end of each year. It’s important to look at those estimates (usually published in November) and see if you should sell your shares before they pay it to you. This way you can avoid taking that gain and getting taxed on it. Yet, some of the best mutual funds are still actively managed.

PASSIVELY Managed Funds

A Passively managed fund, usually called an index fund, is a portfolio of stocks or bonds that replicate a major market index. The S&P 500 or the Lehman Brothers Aggregate Bond Index are two major indexes that most people have heard of. There are a lot of people who now agree that the best mutual funds are passively managed. Passively managed funds are very low cost funds to own because there are not a lot of analysts doing research on what stocks to buy and sell. These kinds of funds generally don’t do much trading of the stock or bonds they own, so this keeps the trading commissions and taxes low. Expense ratios of passively managed funds are usually in the 0.08% – 0.5% range, much lower than actively managed funds. These are an excellent choice for an investor who is satisfied to match the performance of the index.  And for most investors, index mutual funds will perform better than actively managed funds in the long run.

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