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Read This Before You Buy a Mutual Fund

I have had a decent number of questions sent my way about mutual funds so I felt I should do a follow-up to my prior article, How to Choose Mutual Funds.

The typical mutual fund turns over its portfolio at least once a year and owns on average 160 stocks. There are two things that lead to mediocrity when it comes to investing: too much trading and owning too many stocks. Many mutual funds are guilty of both.

I have seen many mutual funds which claim that they employ a careful fundamental approach in choosing stocks. Yet their turnover ratio is 200% to 300% or more. This basically means that the fund buys and sells entire portfolios of hundreds of stocks 3 or 4 times a year! All this churning means that securities analysis on Wall Street is going the way of the dodo.

Owning hundreds of stocks means that the fund managers often know little about what they actually own. In such vast portfolios, no individual stock matters much and makes little difference to the overall performance of the fund. So many fund managers don't even bother to look at the individual stocks they own in detail.

A new book by Louis Lowenstein called 'The Investor's Dilemma' hammers these points home along with some other ones. In his book, Mr. Lowerstein emphasizes that most fund companies have little interest in how well investors actually do in their funds.

Mr. Lowenstein says that fund companies are instead interested in growing the amount of assets they manage. This is how they earn their money. He goes on to give examples of mutual fund chief investment officers who have very little of their own money in the funds they manage. Instead, these executives have their money invested directly into the fund management companies themselves.

There are some exceptions, of course. There actually are good mutual funds. Despite his calling money management a "soulless business", Mr. Lowenstein does list some of his favorite mutual funds in his book.

How can an investor find a good mutual fund? An investor can use any reputable source of information on mutual funds including the following: Yahoo Finance, Morningstar, or any online broker such as E-Trade or Schwab.

What information should an investor look for when he or she is trying to choose a fund? Here are my tips:

1) Look for a small portfolio. I emphasized this point in my earlier article on How to Choose Mutual Funds. The fund should have about 50 stocks maximum. This way you know that the fund managers have actually researched the companies in the portfolio and have confidence in them. An example of such a fund with a fabulous long-term track record is the CGM Focus Fund which is run by the brilliant money manager Ken Heibner.

2) Look at the turnover ratio. This tells you how much mindless churning of the fund portfolio is going on. This data will appear with the performance data. This number should be as low as possible. Any number over 100% is a huge red flag! An example would be a fund with a turnover ratio of 25%. This would imply an average holding period for the fund's portfolio of stocks of four years, which is ok.

3) One last point - do not buy a fund that is too large in size. Some very well-known funds have well over $100 billion in assets. Trying to steer these funds would be like trying to steer an oil tanker in your swimming pool. At the most, a fund should have no more than $25 billion in assets and ideally much less. A smaller fund can more easily buy any type of stocks and not be forced into only buying large companies like Intel or Citibank.

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