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Course 201
Five Questions to Ask Before Buying a Mutual Fund


You may feel intimidated by the task of picking a mutual fund. With more than 25,000 funds to choose from, it's tempting to buy a magazine or visit a Web site that will tell you exactly which funds you should buy, or to just pick the fund that's topping the performance charts.

These aren't the best ways to find the fund that will meet your goals or suit your investment personality, however. The next section will give you a better idea of how to approach the vast marketplace for mutual funds and will introduce five questions that you need to ask and answer before buying any stock fund.

  1. How has it performed?
  2. How risky has it been?
  3. What does it own?
  4. Who runs it?
  5. What does it cost?

These questions form the foundation of Morningstar's approach to fund selection. We'll address these questions in depth in subsequent lessons, but here's a taste of what's to come.

How Has It Performed?

Many would say that a fund that produced returns of 22% per year for the past five years has a better manager than a fund that returned 20% per year over the same period. That's sometimes the case but not always. The fund that gained 20% may have beaten competing funds that follow the same investment style by six percentage points, while the 22% gainer may have lagged its competitors by a mile.

To really know how well a fund is doing, put a fund's returns into context. Compare the fund's returns to appropriate benchmarks—to indexes and to other funds that invest in the same types of securities.

How Risky Has It Been?

Of course, the very act of investing involves an element of risk. After all, you're choosing to give your money to a portfolio manager rather than socking it away under the bed or putting it into a savings account at your local bank.

Generally, the greater the return of an investment, the greater the risk—and therefore the greater potential for loss. Investors who take on a lot of risk expect a greater return from their investments, but they don't always get it. Other investors are willing to give up the potential for large gains in return for a more probable return. Consider a fund's volatility in conjunction with the returns it produces. Two funds with equal returns might not be equally attractive investments; one could be far more volatile than the other.

There are a number of ways to measure how volatile a fund is. There are four main risk measurements that appear in mutual fund shareholder reports, in the financial media, and on These include standard deviation, beta, Morningstar risk ratings, and Morningstar bear market rankings. It's also helpful to check out a fund's quarterly and annual returns in different market conditions to get a sense for its potential volatility.

What Does It Own?

To set realistic expectations for what a fund can do for you, it's important to know what kinds of securities a fund's manager buys: Stocks? Bonds? Both? These broad asset classes have different characteristics, so you shouldn't expect them to perform in a similar manner. For example, most investors wouldn't hope for a 10% gain from a bond fund, but that kind of return may not be an unrealistic expectation for certain stock funds.

Unfortunately, you can't rely on a fund's name to tell you what it owns. Fidelity Magellan FMAGX is a giant in the fund industry, but its moniker gives you very little idea of the types of securities its manager buys.

As we mentioned earlier, fund managers can buy just stocks, just bonds, or a combination of the two. They can stick with U.S. companies or venture abroad. They can hold popular big companies, such as Coca-Cola KO or Procter & Gamble PG, or focus on small companies most of us have never heard of. They can load up on high-priced companies that are growing quickly, or they can favor value stocks with lower earnings prospects but cheap prices. Finally, managers can own 20 or 200 stocks. How a manager chooses to invest your money is one of the most important factors that will drive performance.

To get a feel for how a manager invests, examine a fund's portfolio. The financial statements published by the mutual fund company always disclose this information. You can also access portfolio data, including top holdings, sector breakdowns, and the Morningstar style box (which we'll explore in later lessons) on and other Web sites.

Who Runs It?

Mutual funds are only as good as the people behind them: the fund managers who make the investment decisions. Because the fund manager is the person most responsible for a fund's performance, it's important to know who calls the shots for your mutual fund—as well as how long he or she has been doing it. Make sure that the manager who built the majority of the fund's record is still the one in charge. Otherwise, you may be in for an unpleasant surprise. We'll return to the issue of fund management later.

What Does It Cost?

As we pointed out in Lesson 107, mutual funds aren't free. You should pay for professional money management if you need it, but paying enormous expenses to invest is like giving money away. That's because every penny that you give to fund management or to brokerage commissions is a penny you take away from your own return. Further, costs are one of the few constants in investing: They'll remain pretty stable year in and year out while the returns of stocks and bonds will fluctuate. You can't control the whims of the market, but you can control how much you pay for your mutual funds.

Unfortunately, fund costs are somewhat invisible, buried in shareholder reports and taken right off the top of your fund data. Morningstar provides a detailed breakdown of a fund's costs in the Expense section of all fund reports on

Quiz 201
There is only one correct answer to each question.

1 How can you gauge how competitive a fund's returns are?
a. Look at a fund's return in isolation.
b. Compare a fund's return with those of an appropriate benchmark.
c. Compare a fund's return with its standard deviation.
2 If Fund A returns an average of 25% per year and Fund B earns 15% per year:
a. Fund A likely has a greater potential for loss.
b. Fund B likely has a greater potential for loss.
c. Fund A is the better choice for all investors.
3 What's the best way to get a feel for how a fund manager invests?
a. Look at the fund's name.
b. Check out its list of holdings and the sectors in which it invests.
c. Compare the fund's performance with a benchmark's.
4 Who decides exactly which securities a mutual fund owns?
a. You, the shareholder.
b. The mutual fund company.
c. The fund manager.
5 What's the most important thing to know about your fund manager?
a. How much their funds return each year.
b. How they manage the fund.
c. How much their salary is.
To take the quiz and win credits toward Morningstar Rewards go to
the quiz page.
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