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Many people think of mutual funds as inherently safe or balanced investments, but this assumption can lead people into trouble. Many mutual funds provide greater diversification than is possible through investing on one’s own. However, individuals still need to conduct a significant amount of due diligence before buying mutual funds.

No guarantees exist that funds will put investors first, maintain stability in the long run, should or offer significant returns. Individuals must ask questions of each mutual fund they are considering to make an informed decision about which option will serve them best in the future.

Below are some of the most important questions to consider when looking into a mutual fund.

  1. Who is the fund manager?

stock purchaseBefore investing in a mutual fund, individuals should have a sense of who exactly the fund manager is, including both past experience and overall track record. In the most basic sense, individuals are entrusting the manager with their money when they invest in a fund, since that person has ultimate say in where the money goes.

Typically, individuals should look for fund managers with significant experience. At least five years of experience is recommended. However, managers may have presided over investment vehicles other than mutual funds, and this experience is also important to consider.

A manager’s recent track record is the most important, and individuals can compare a manager’s performance to that of other managers working in similar investment categories. In an ideal world, the manager has performed in the top quartile during both up and down markets.

  1. Where does the fund rank among its peers?

While more than 16,000 mutual funds exist, you should never forget that researchers like Morningstar and similar organizations work diligently to rank them. A quick way of investigating a mutual fund is to see how it stacks up against its peers.

While a good track record does not guarantee a stellar performance in the future, a high ranking can inform your ultimate decision. Potential investors should pay close attention to exactly how the ranking is calculated. This includes what bearing shareholder expenses, investment companies, and fund managers have on the rating.

  1. What are the costs associated with the fund?

news stocksThe price of investing in a mutual fund is not always obvious. This means that individuals need to investigate the various costs associated with a particular fund before investing.

Often, mutual funds have sales charges, also called loads, of up to 5 percent of the total purchase price. This additional charge is meant to cover stockbroker commission.

Many people choose to avoid mutual funds that charge loads so that more of their money goes directly into a particular investment. One way of looking at it is that investing $1,000 in a fund with a 5-percent load means that 5.26 percent needs to be earned on the invested $950 simply to break even.

Another cost associated with investing in mutual funds is the operating expense ratio (OER). This covers the expenses of operating the fund.

While all funds charge this expense, the amount of the charge can vary significantly. The level of OER depends largely on the type of investments that the fund makes. For example, investing in global companies typically requires additional legwork and may cost investors more money.

  1. How has the fund performed against a benchmark?

Today, it is possible to purchase index funds that track the performance of a particular index. Because of that, individuals may want to make sure that the mutual fund they choose has actually matched or outperformed that index, whether it is the Russell Small Cap Index, the Standard & Poor’s, or another.

Individuals should look at the performance of a mutual fund over an entire market cycle rather than at a single point in time. A market cycle includes an up and down market cycle. By investing in a mutual fund that consistently outperforms the index, investors are said to “add alpha” to a portfolio.

Consistency is also important. If a given mutual fund performs erratically over the course of a cycle, that fact should be cause for concern. Gentle shifts in performance are acceptable, but large peaks and valleys, especially ones that do not align with the index being tracked, should be alarming.

  1. What are the tax implications?

When individuals invest in mutual funds outside of their retirement plans, the subsequent tax burden can be significant. Funds make capital gains distributions to shareholders at least once each year if there is net profit. All shareholders need to pay capital gains tax on these earnings.

Funds with a high turnover rate, meaning that they trade quite frequently, will have high capital gains distributions and, therefore, higher tax liability for shareholders. Individuals who want lower amounts of tax liability may want to consider stock funds with a turnover rate of about 35 percent, which is significantly below the average of about 53 percent.

Individuals may also want to pay attention to when annual capital gains distributions are made and wait to buy into the fund after this date to save on taxes. Some mutual funds under the equity linked saving scheme (ELSS) may actually have tax benefits and allow investors to deduct investments and save on their taxes owed.