03/05/99

Picking The Best Mutual Funds

Most investors pick mutual funds based on recent fund performance, the suggestion of a friend, and/or the praise bestowed on them by a financial magazine or fund rating agency. While using these methods can lead one to selecting a quality fund, they can also lead you in the wrong direction and wondering what happened to that "great pick."

A Little Planning First - Despite the distinctive characteristics of mutual funds - performance, management philosophy, & investment objectives - your specific selections should be chosen within the context of your overall financial plan. Examining features such as past performance are not where your studies should begin. The point of departure is you; your financial priorities; your resources; your approach to investment diversification; your willingness (or lack thereof) to accept market volatility; and your time horizon for a particular investment.

Total Return /Rank in Category- Total Returns are fun to look at and brag about, but simply looking at a funds total return for the past year is not necessarily a good measure of a funds quality. For example, investors often talk about how well a specific fund did last year and how happy they are with that performance -- say a 16% return in an equity income fund. Well, in a given year that may or may not have been a good return for an equity income fund. That fund may have under-performed many or most other equity- income funds for the year. Returns should always be measured in context with how other similar "categorized" (e.g.. equity income funds, growth funds, small cap funds, etc.) funds have performed. So don't get overly excited by a funds total return until you see how it compares to other like funds over the same period.

Past Performance Indicators - As it is often said, past performance can't predict future results. But when comparing performance of funds, it is also wise to look beyond the results of one or two years. Most experts suggest that a larger "window" of 5 to 10 years gives a clearer picture of historical performance. Has your fund or the one you are considering performed well over this longer time horizon? Any fund can have one good or one bad year, but if you are investing for the long term, you want a fund that has a consistent track record. While that record doesn't guarantee future results, it gives you an indicator that may be to your advantage.

Rating Agencies - You could of course rely on a fund rating agency or the recent rankings of a financial magazine. Surely this can be an excellent way to garner information and the analysis of a publication/rating agency may lead you to a great pick. However, be a little cautious of this approach because such selections/rankings are not perfect and are often based on differing criteria. Also, you don't want to fall into the trap, of "buying the record" as Nick Murray (noted financial author) phrased so eloquently in his February 1998 article in the Dow Jones Investment Advisor. Mr. Murray stated "you can Buy the record, or you can Be the record". He pointed out that a fund that has already earned the praise of the financial press, may have its best years behind it. You want to buy low, and ride a fund to the top of the charts. Do not systematically buy-in after the great gains may have been made in a fund and it is being recognized with a top rating. Remember: try to "be the record, not buy the record."

Diversification - Another aspect to consider is how a fund fits into your portfolio. Financial Planners frequently meet with people who believe they have a very diversified selection of funds. However, on closer inspection, they are in like categorized funds and/or in funds that have similar stock holdings. In the final analysis, there isn't much diversity. You should learn a little about the investments in your mutual funds, management styles, etc. If all your funds are in the same fund family or similar categorized funds (e.g. large cap domestic growth funds) you may not have as much diversity as you think.

Turnover Ratio - Perhaps one of the most overlooked indicators of how a fund is managed is its turnover ratio. This ratio shows you how much a fund manager has traded the portfolio over a one year period. A 100% turnover ratio means that the fund manager sold everything in the portfolio it held one year earlier. Why is this important? Funds with high turnover ratios generate larger realized capital gains and a greater tax burden annually to the investor. Be aware that a fund with a high turnover ratio in an "open" investment account means more to Uncle Sam each year. (If the fund is in a retirement account, turnover ratio doesn't matter because you aren't paying taxes annually.)

Management - Who is managing your mutual funds? It is a good thing to know. You could be buying a fund with a great 10 year track record, near the top in its category, but the person who managed the fund and earned those great results just left. A new fund manager may have equally good or even better results, but you should be aware that you are trying "untested waters" unless this manager has a proven track record somewhere else. Going a step further, you may want to read up on the managers philosophy and the funds objective, stated in the prospectus, to see if they match your needs and goals.

Statistical Measures - There are several statistical measures that make an evaluation of a mutual fund even more precise and perhaps confusing. Such measures come under the headings of Standard Deviation, Beta, R-squared, Sharpe, Treynor, etc. Collectively these measures are too numerous & complex to discuss in this article. Of these measures, start with a funds standard deviation. Standard deviation provides a useful indicator of investment risk because it measures both the probability and the amount of potential gain or loss in a fund based on historical performance. Here is an example of how you do it: Take the funds 5 year standard deviation figure and double it ( two standard deviations results in 95% accuracy). Then add and subtract this number from the average annual return for the fund over five years leaving you a range between the two numbers. (With many funds, one figure is often negative.) By statistical measures you now have a 95% probability that the future returns of this fund will fall within this same range. This is a very good measure of investment risk. Sound somewhat confusing? Now you know why I am not discussing the other statistical measures in this article.

Expenses - The annual fund expenses could be eating away at your profits. Therefore, it is good to know what you are paying in expense fees. All mutual funds have an annual management fee and some have a 12b1 fee. However, don't leave a good fund just because the expense ratio is a little higher.

Summary: There are other measures of a mutual funds quality that could be considered. ( I have left the discusson of load vs no-load for another article.) The primary point in selecting funds is not to simply look at one measure, like recent total return or a great rating, and decide that is the fund for you. First, consider your needs and goals and then look at a variety of other fund measures to be sure you are making the right pick.

Please send questions or comments to dcoffin46333@wradvisors.com.