Best Mutual Funds Explained
All you need to know about mutual funds, including the risks, rewards and terms  

The Best Mutual Funds

best mutual fundsAs I said overleaf, it is very easy to become fixated on expenses when looking for the best mutual funds and in particular the expense ratio, which many investors consider to be the only yardstick on which to base their investing decisions. Whilst it is important, it should never be the only factor to consider in your choice of mutual fund.

Over recent years both investors and the industry have increasingly focused on the expense ratio as the only measure by which to select your funds - please don't - it is important and you must understand the figures, but please don't use it in isolation as some sort of guiding principle - it isn't. It is simply a number which gives you another piece of the jigsaw to use in your selection of the best funds.

The Best Mutual Funds - Definition and Explanation

Let's start with a simple definition and then we'll look at an example which I hope will make things clear.

The expense ratio is always expressed as a percentage and is the total fund assets, divided by the total operating expenses of running and managing the fund. Please note that this ratio does not include any shareholder expenses. So if a fund reports in the prospectus that the expense ratio is 1%, and it has total assets of $100,000,000, then each year the fund charges $10,000,000 for administering and managing the fund on your behalf, which naturally reduces the assets of the fund by 1% accordingly. Now the expense ratio is always reported in the prospectus for the fund so you will always know how much your prospective fund is likely to charge.

Now, how do we use this information when comparing one fund with another - let's take a look at some simple examples as shown below.

The Best Mutual Funds - Expense Ratio Examples

OK - let's look at what the figures tell us when comparing one fund with another and their respective expense ratios when looking for the best mutual funds.

Fund Expense Ratio 5 Year Average Annual Return % Total Return
(expense ratio + 5 year average )
Expense Ratio As % Of Total Return
The Wonderful Return Mutual Fund 1.35% 6.1% 7.45% 18.1%
The Almost Free Money Mutual Fund 0.72% 9.4% 10.12% 7.1%

 

As we can see from the above figures the total return in column 4 ( in other words what the fund made before deducting operating expenses ) is 7.45% in the first case, and 10.12% in the second. Now in order to arrive at the figures in the last column we divide the expense ration by the total return, so in the first case this would be 1.35/7.45 * 100 = 18.1% and in the second case is 0.72/10.12 * 100 = 7.1%. So what are these figures telling us - well in simple terms that the Wonderful Return mutual fund is charging us almost 20% of our returns in fees ( a fifth ) whilst the Almost Free Money mutual fund is only charging us 7%, a huge difference, year on year. Add to this the power of compounding and the expenses will really start to bite into your overall returns.

Now I am not saying that you should concentrate exclusively on the expense ratio and ignore all the other factors, but it does provide one way to compare one fund with another to get a feel for whether the operating expenses are reasonable or excessive. Sadly the mutual fund market has been the subject of dubious practice over the last few years and is still not entirely free from the image of sharp practice and lack of transparency, so please do your homework. Using the expense ratio should help a little in finding the best mutual funds to buy.

Now, having covered some of the basics of terminology and types of mutual fund, now let's consider the most important part of investing, deciding on our investment goals and objectives. After all, you can buy the best mutual funds in the market, but if they don't meet your financial goals, then it's rather pointless. So first we have to define what we want from our investments!

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