When choosing mutual funds, look past short-term returns

What’s the most prominent thing you notice about mutual fund advertisements? In most cases, it’s the fund’s return. Quite often, these returns are truly eye-popping. But if you look closer at the ads, you’ll see that many of the highest returns are for short periods of time, such as one year or three years. And a mutual fund’s short-term return is not, by itself, reason enough to buy that fund — so don’t rush to your checkbook.
Actually, a mutual fund’s short-term performance may tell you less about the fund than about what’s been happening in the financial markets. If most stocks rise significantly for a few years, the chances are pretty good that a stock-based mutual fund is going to do well, too.
But more importantly, you shouldn’t evaluate a fund on its short-term return because a mutual fund is a long-term investment. To assess a fund’s long-term performance, you’ll need to look at its annualized return — its return over a period of time other than one year. For example, a two-year return of 10 percent could be stated as an annualized rate of return of five percent. And by comparing annualized returns, you can learn a lot about a fund’s historical performance. If a fund’s annualized return for the last three years is 12 percent, but over 10 years it was just five percent, you could conclude that the results of the past three years are not representative of the fund’s long-term track record.
Apart from its annualized return, what else should you look for when considering a mutual fund? Here are a few suggestions:

*Performance against similar funds — How has the fund you’re considering performed in comparison to other funds with the same investment objective over 10- and 15-year time periods? That is, if you’re evaluating a growth-and-income fund, contrast its performance against the universe of other growth-and-income funds.
*Fund manager’s longevity — Ask your financial advisor how long a fund manager — or a management team — has been responsible for making the investment decisions. Assuming the fund has a superior 10- and 15-year track record to begin with, the longer a manager has been in place, the better.
*Expense level — Different mutual funds have different costs associated with them. All factors being equal, look for those funds with the lower expense levels. The more you pay each year in expenses and fees, the lower your overall return. However, some funds have justifiably higher expenses, and you may want to consider these funds to help diversify your mutual fund holdings.
*Investment “overlap” — Even if a fund has shown consistently good returns and has a talented, experienced manager, it still might not be right for you, particularly if it overlaps with similar funds in your portfolio. You might be better off by purchasing a different kind of mutual fund and thereby broadening your holdings. Your financial advisor can help you create a diversified mutual fund portfolio that fits your risk tolerance and investment objectives.
Finally, ask your financial advisor for a copy of the fund’s prospectus, which contains complete information about the fund, including risks, charges and expenses as well as other important information that should be carefully considered.
By doing some research and learning all you can about a mutual fund, you’ll be prepared to make smart investment decisions.