3 Ways Some Mutual Funds Can Trick You

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The mutual fund industry continues to grow. There is more than $15.8 billion invested in nearly 8,000 funds, according to industry tracker Investment Company Institute, making it just as challenging to find the right fund to buy as for stock investors to nail down specific equities.

Mutual funds offer a great way to achieve a diversified portfolio in a single investment. Most funds are open and honest, but there are some practices that investors should watch out for. Let's go over a few potential warning flags.

1. Window-Dressing Is a Drag

One of the more nefarious industry practices -- and thankfully one that doesn't happen often these days -- is window-dressing. Money managers would shake up their portfolios at the end of a reporting period, replacing market losers with some of the biggest winners over the past year.

Window-dressing, therefore, merely makes the "window" look better. It conveys the illusion that a fund manager has invested in all of the right stocks, when in reality it's a matter of just trying to make the list of portfolio holdings at the end of the year look good.

Today's investors are smarter than that. The Internet offers easy access to performance reports and third-party rating agencies and ranked lists. Year-end stock holdings don't hold a lot of weight when a fund can be easily pitted against the competition.

2. Fund Families Bury the Black Sheep

Mutual funds that consistently lose to the market don't stick around. Mutual fund families tend to close investments that aren't performing well, and that usually means merging those assets into a more successful fund.

In theory, investors shouldn't mind. Their underperforming funds are being upgraded. However, the new funds may not have the same objectives as the old fund. More important, someone trying to judge a mutual fund operator based on the performance of its available funds will only be seeing the more successful ones that are still active.

3. Relative Performance Isn't Always Relative

Different categories of funds stack up their performance against different benchmarks. That makes sense: It's not fair to compare a short-term bond fund or an emerging-markets equity fund to the S&P 500.

However, some funds aren't true matches to their benchmarks. Some income funds invest in blue chips, but others may invest in riskier fare. International funds will naturally vary based on their allocations into different countries and types of stocks within those countries.

This may not be a deliberate trick. It's just as easy for a fund to underperform a benchmark than it is to exceed it. However, it certainly makes it easier for a fund to promote itself by marketing the outperformance against a benchmark that isn't an appropriate fit. As a potential fund investor, it's important to assess a fund's actual performance and the risks it took to make it happen, and that's where third-party sources such as Morningstar and annual Kiplinger's rankings can come in handy. Be a smart fund investor from the beginning, and everything else comes easy.

Motley Fool contributor Rick Munarriz has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. Check out our free report on one great stock to buy for 2015 and beyond.
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