New to Mutual Funds? Here’s a Guide to Choosing the Right One

If you're thinking about investing in mutual funds in Singapore, follow these guidelines to help you choose the right one.

Choosing a mutual fund is challenging, because of one unique quality in this industry: most mutual funds will underperform. It’s always a challenge picking the ones that will stay ahead over the long term.

For the total beginner, here are some of the key questions to ask:

What is the Goal of Your Investment?

There are thousands of mutual funds available on the market, and not all of them cater to the same goals.

For example, a pure equities fund may hold only stocks as assets, thus making the fund useful as a long term, retirement-oriented asset. Another fund may hold a large number of properties or bonds, and be focused on generating immediate income (this is useful for people such as retirees).

Before you even start to choose a fund, you should have a clear idea of what you’re investing for. Some examples include:

• Investing to send your children abroad to study in 5-10 years
• Investing to ensure you will be ready to purchase your first home by age 35
• Investing to ensure you will have an income of at least S$2,500 a month by the time you retire at age 65
• Investing to make enough money for a car or life ambition (e.g. climbing Mount Everest) within the next five years

Depending on your purpose, different funds will have varying degrees of suitability. If you are investing over a short term (say five years, to buy a house), you might find an equity fund too volatile; stock prices can change dramatically over a short period. If you are investing over the long term, say 30 years, then a fund that holds primarily fixed income assets may have returns that are too low.

Note that almost all mutual funds are aimed at an investment horizon (the amount of time you will stay invested) of at least five years.

Are There Load Fees?

Funds sometimes require “loading”, which refers to the way you pay for the fund. Besides the regular fees (see below), a fund may require load fees. They are either front-loading (you need to make an upfront payment), or backloading (you need to pay a lump sum toward the end of the investment horizon).

It is always preferable to pick a fund with no loading, or at least with very low loads. Here’s why:

Say you invest in a fund, with an initial sum of S$20,000. There is three per cent front- loading (S$600). Due to the load, your initial investment is now (S$20,000 - S$600) = S$19,400.

Now if you invest the full S$20,000, at returns of around three per cent per annum, for 10 years, you would have around S$26,878. But if you pay the loading and invest S$19,400 over the same time and rate of return, you would only end with up with around S$26,072. That’s a difference S$876, and you can expect this gap to grow the more you invest, so be sure to avoid loading where possible.

(Note: most mutual funds that are sold to lay investors should not require loading.)

Look for the Total Expense Ratio

The Total Expense Ratio (TER) includes the management fees, the distribution costs, and all the other charges needed to run the fund. This may have a different name, but if you ask for the TER the salesperson will have to point it out to you.

The lower the the TER, the higher your returns. For example, if the fund provides a total return of five per cent, but the TER is three per cent, you are only really getting a return of the remaining two per cent.

You should always look at the fund’s performance with relation to its TER. Between a fund that provides returns of 5% and has a TER of 3% and a fund that has returns of 3.5% but a TER of just 1%, the latter is actually better.

Measure the Performance with Regards to the Benchmark Index

Mutual funds have a benchmark index, against which they measure their performance.

For example, a mutual fund may use the Straits Times Index (ST Index) as its benchmark. If this is the case, the returns should be close to the ST Index. If the ST Index has returns of 2.7%, the fund should deliver returns of around 2.5% or 2.9%.

A fund is said to have beaten the market if its returns are above the benchmark index. If the fund has returns below the benchmark index, it is said to have underperformed. Note that this is also true for negatives. If the benchmark index has returns of negative 4%, and the fund delivers returns of negative 3.8%, it has still beaten the market (it lost less than the market).

Note that, as a norm, most mutual funds do not consistently beat their benchmark index.

Look at the 10-15 Year Performance

When comparing mutual funds, ignore histories of just one or two years. It is impossible to gauge the quality of a fund (or fund manager) based on such a short time frame. It’s akin to judging the academic results of a student by looking at just one or two of the exams they’ve taken.

Look at results over 10 or 15 years, and have the salesperson explain them to you. If the fund has not been around for that long, you might want to step back and look for something else.

Note that there is a common saying that past performance is not an indication of future success. However, it is also a common saying that you should not invest in something with no proven track record. As with many things in finance, both guidelines are contradictory. We will move on the side of caution and suggest you do look at past performance.

Check the Rules for Cashing Out

Not all mutual funds allow you to quickly cash out, should you need your money back. Some funds impose steep fees on pulling out before a certain length of time (e.g. five years), and some funds vary the number of units you can sell on a first come, first served basis. For example, the first 100 people who want to sell can sell all their units, the second batch of 100 people can sell only half their units, and so on.

Funds impose these rules because, when times are bad, there may be a rush of people who want to sell and “escape” a bad investment. This could sink the fund before it has a chance to recover.

You should be clear on these rules before you buy. In particular, do not commit to a fund that will lock down your money for long periods, if there is a chance you may need the cash if you have no emergency savings.

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