6 Tips for Picking Top Funds

The sad truth is that roughly two-thirds of all actively managed mutual funds fail to beat their benchmarks. Most investors are better off sticking with funds that simply try to mimic an index; their typically low costs give them a big edge over most actively managed funds. If you want to invest in actively run funds, you need to devote time to picking good ones. Start by following my six rules for successful fund picking:

1. Ignore short-term results. Returns over a quarter, a year or even two years are meaningless noise. Almost all funds go through hot and cold spells. Investing in a mutual fund after it has been hot for a short time can be a recipe for disaster. Selling a good fund after a couple of bad years is usually folly, too. “You can’t judge an investor from what they’ve done over six months or a year,” says Warren Buffett. He plans to make public returns from Berkshire’s newly hired money manager, Todd Combs, just every five years.

2. Adjust for risk. Don’t look just at a fund’s long-term returns; look also at its volatility. You can do this by studying various measures of a fund’s risk-adjusted returns. For example, at Morningstar.com, you can check a fund’s alpha, its Sharpe ratio and its Morningstar rating (for all of these numbers, the higher, the better; to learn more about the terms, plug them into your favorite search engine). But these measures make little sense in a vacuum. Use them to compare funds you’re considering.

The Morningstar star system has a lot of critics. But most of the barbs are based on ancient history—before 2002, when Morningstar began to separate funds by category in assigning star rankings. A recent Morningstar study found that domestic stock funds that earned five stars in 2005 beat their index 55% of the time over the next five years.

3. Focus on expenses. Morningstar has found that costs are the best predictor of a fund’s future performance. For example, on average, a domestic stock fund with an expense ratio in the lowest 20% among such funds outpaced its benchmark index 59% of the time over the five-year period that ended in 2010.

What’s more, combining low fees with five-star rankings worked better than either measure in isolation. Five-star domestic stock funds with expense ratios in the bottom 20% of their category beat their index 66% of the time. Foreign stock funds with both attributes beat their benchmark 53% of the time; taxable bond funds, 79%; and municipal bond funds, 71%.

In addition, a fund’s expense ratio often tells you what kind of company you’re investing with. Are you entrusting your money to a financial-services firm that’s eager to peddle you whatever is in vogue? Or are you buying from a company that views you as a long-term client? Companies in the second category, such as Dodge & Cox, T. Rowe Price and Vanguard, tend to charge less.

4. Check out the manager’s tenure. The longer, the better. Moreover, a manager’s departure calls into question the relevance of a fund’s record. This is particularly true when a manager at a small fund firm departs.

By the same token, when a superior manager leaves a fund and joins a new firm, you should consider following him or her. I’d certainly put Jeffrey Gundlach in that category. Not only is he a brilliant thinker, but after he and TCW parted ways in a bitter dispute, he seems to have taken most of TCW’s best bond analysts and put them to work at his new fund, DoubleLine Total Return (symbol DBL TX), a superb choice for investing in mortgage securities (and a member of the Kiplinger 25).

5. Watch for bloat. If you are considering a small-company fund, be aware that a surge in assets under management can hurt performance because it becomes more difficult to buy and sell securities efficiently. Also, make sure your fund hasn’t made its record in smallcapitalization stocks only to morph into a different sort of fund after assets surged and its manager could no longer invest efficiently in small companies.

6. The numbers don’t tell you everything. Get to know the managers of the funds you like. Read their missives to shareholders and media reports about them. Tune into their webinars and podcasts. Look for clear-thinking managers who have a passion for investing and a disciplined investing methodology.

July 22, 2011

—Steven T. Goldberg