The Financial Industry Regulatory Authority has a Fund Analyzer that tracks over 18,000 mutual funds and related investments like exchange-traded funds. GIven the options, choosing a fund to invest in can be overwhelming. The first step in evaluating mutual funds, though, is to figure out what you want. That way, you can weigh similar funds against each other and start to make sense of the options.
One of the most powerful evaluation tools for a mutual fund is its record -- how it's performed in the past. By itself, the metric might not mean a lot, but when you compare it to its benchmark -- a particular index -- you can see just how good the fund is. When a mutual fund does better than a comparable market index, like comparing a small-cap fund to the Russell 2000, it's a good sign. When it has a history of outperforming competing funds, it's an even better sign.
Some say investing is about trading risk for profit. If it is, it makes sense to compare a given investment's risk level to its profit. The Sharpe ratio does this. To calculate the Sharpe ratio for a particular fund, subtract the return of a riskless investment -- three-month Treasury bills are a popular choice -- from the fund's annual return. Divide that amount by its volatility, which should be available from the fund's issuer. For instance, if a fund with a 15 percent volatility returns 10 percent per year, and three-month treasuries pay 1 percent, you'd divide 9 by 15 to find a Sharpe ratio of 0.6. You can then compare that fund's Sharpe ratio to those of other funds to see which one has the highest ratio. The higher the number, the better your return is relative to your risk.
You can also use information from third parties to break down your mutual fund choices. Your broker may be recommending funds to you based on their sales charges, so an unbiased third party can be helpful. Companies like Morningstar, Lipper and Zacks all have mutual fund ratings that typically express a fund's relative performance in a simple number of stars or other similar rating. Some media sources also publish mutual fund rankings you can use to identify funds that are worthy of a closer look.
One of the most powerful evaluation tools available to you is a comparison site. These sites let you select a small group of funds and look at their characteristics right next to each other. You can see how each fund compares to others on metrics like expense ratios, returns and Morningstar ratings and decide which one looks best to you.
- Comstock/Comstock/Getty Images