Mutual Funds: Friend or Foe?

Question: How do I determine what mutual funds I should buy?

Answer: Most small individual investors purchase mutual funds, but that's a mistake. Why? Because transaction costs have fallen to the point where it's cheaper to buy stocks directly than through a mutual fund. Also, mutual fund buyers never know what stocks the fund manager is holding at the present moment.

But the biggest problem is the tax man. Uncle Sam loves mutual funds. When you purchase a share in a mutual fund, you inherit your share of all the tax liabilities of the entire fund. This is a nice way of saying that you wind up paying taxes for the investors who invested prior to you.

If you insist on buying mutual funds and want to know what type to buy, the answer is actually pretty simple. Mutual funds that have gone up the most over the last 12 months tend to outperform in the next month. After that, it's anyone's guess what is going to happen to the mutual fund.

One theory is that a good-performing mutual fund attracts assets that then are put into the fund's existing holdings. This causes a positive feedback cycle: Money comes in, stocks are purchased by fund, fund performance increases due to purchases, prices rise, more money comes in. Rinse and repeat, and you have the basic reason behind the momentum mutual fund phenomenon.

Mitch Zacks is vice president at Zacks Investment Management in Chicago and author or The Zacks Method, published by HarperCollins Business Press.