The Ten Biggest Mistakes Fund Investors Make

from the Wealth Management News Service

WMNS -- According to the Investment Company Institute, today, one out of every three individuals in the United States is a mutual fund shareholder, making mutual funds one of the most widely held investment options.* That's why it's more important than ever that mutual fund investors become aware of the potential pitfalls they may face when selecting funds. Here are 10 mistakes investors tend to make and how to avoid them:

BLINDED BY RETURNS

Focusing too much on a mutual fund's past performance is by far the most common mistake. While it's easy to get swept up in the latest investment trend, relying solely on past results rarely leads to success. Instead, ask yourself, "Is this a good investment right now?" Review a fund's return against the return of its stated benchmark and its peer group over the most recent three- year period. Then consider how the asset class as a whole has fared during this period. If the asset class has performed well recently, consider whether now is the right time to invest.

PAYING TOO MUCH IN EXPENSES

Costs matter. Fund expenses - the costs of running a fund, measured by its expense ratio - come directly out of the fund's income and can significantly dampen your return. Over time, a seemingly small difference in expenses can have a big effect on your nest egg.

Managers of high-cost funds have to earn higher returns in light of expenses just to outperform their low-cost peers. All else being equal, we recommend avoiding funds with high expenses.

PURCHASING A FUND OUTSIDE ITS SIZE SWEET SPOT

Every fund category has a range of assets under management where, all other factors being equal, fund managers have their best chance to compete against their peers. In general, it's best to avoid funds with really small asset bases. And, it's generally best to avoid small cap funds with large amounts of assets under management. Selecting the right-size fund is no guarantee of success, but it can enhance your prospects for a better return.

OVERPAYING FOR MARKET EXPOSURE

If you purchase an actively managed fund, you should expect your manager to outperform an index fund or ETF that attempts to mimic the category benchmark. An increasing number of actively managed funds are becoming closet indexers. If your fund's returns almost completely correlate with the benchmark, take notice. You don't want to overpay for market exposure you could get from an index fund or an ETF.

IGNORING RISK CONTROLS

Risk controls are policies such as limits on stock or sector weights. They set the playing field for a fund and ensure that the portfolio manager seeks to generate returns in a disciplined manner. Learn about what types of risk controls portfolio managers use for securities, industries or credit ratings. The more risky or volatile the investment category, the more important it is to have these controls in place.

LOVING A DRIFTER
 
A drifter is a manager who consistently invests in securities outside the category's benchmark. While many investors don't notice style drift unless their fund underperforms, investing with a drifter can cause two significant problems.

First, it can cause havoc with your asset allocation, particularly if you hold multiple funds, running a high chance of overlapping securities or industries.

Second, while a manager might be able to temporarily outperform his or her peers, it's difficult to know if the manager is demonstrating investing excellence or if he or she just got lucky with an asset allocation bet.

PUTTING TOO MUCH IN FOCUSED FUNDS

Many mutual fund investors put far too much money in volatile focused funds, such as regional or sector funds. Focused funds are subject to greater volatility than diversified funds because they fail to completely diversify security, sector or regional risk. We recommend your sector allocation not exceed the corresponding Wilshire 5000 sector weight by more than 10 percentage points.

OVERLOOKING EXCESSIVE DEMANDS ON YOUR MANAGER'S TIME

A successful fund manager could be promoted to run multiple funds or chair multiple committees, or become chief investment officer for the firm. It's important to revaluate whether the manager is going to be focused enough on your fund. Start by reviewing how many funds your manager is managing, and in what roles. The better money management firms give their best managers ample support so they can devote sufficient time to managing your money.

NOT KNOWING WHO IS MANAGING YOUR MONEY

A fund's prospectus should clearly identify who makes the investment decisions. Be wary of investing in a fund with a novice manager or a faceless team whose compensation might not be aligned with the performance of your fund.

NOT ASKING QUESTIONS WHEN A PORTFOLIO MANAGER LEAVES

If the fund's lead portfolio manager leaves, ask the following questions:
--How much of the fund's performance was driven by the brilliant insights of your manager?
--What caused the departure?
--How will the fund change under a new manager?

THE BOTTOM LINE:

With thousands of mutual funds to choose from, the selection process can be overwhelming. Being aware of these potential mistakes, should help narrow the field.

James Peterson,
vice president
Schwab Center for Investment Research
 

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