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Mutual Funds

8 Virtues of Great Funds

What to look for in a mutual fund.

Use these signposts of excellence to judge funds you own as well as those you are considering.

Lusty performance

This is job one: Making money for you. Our favorite funds have total returns (the gain in value of a fund's investments plus reinvested interest and dividends) that are better than the average for their category during most calendar years and over numerous periods, such as three, five and ten years. We're not thrilled when a fund's multiyear return is inflated by one fat year -- a problem with gold and tech funds. We're also unimpressed when a fund boasts of matching an index. Great funds beat comparable indexes.

We do like funds that limit the damage when the market falls but deliver big in good times. Take Marsico Growth (symbol MGRIX), which invests in large, expanding companies. In 2001 and 2002, when its segment of the stock market was performing terribly, Marsico Growth lost much less than most of its rivals and Standard Poor's 500-stock index. Since the stock market started to recover, Marsico has outgained the SP 500 and the large-growth-fund category, just as it did during the 1990s bull market.

Management excellence

Outstanding records don't happen by accident. They are the work of talented men, women and sometimes teams. Favor funds with good records whose managers have been at the helm five or even ten years. Or follow an established manager from a large fund firm who launches his or her own organization, so you get a proven manager even if the fund is new.

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Most great managers have well-defined investment philosophies, are committed to their jobs and exhibit an infectious enthusiasm. Plus, they don't let their funds fall apart. Once someone becomes synonymous with success, such as Bill Miller of Legg Mason Value Trust, Bill Nygren of Oakmark, Chris Davis of Selected American Shares or Will Danoff of Fidelity Contrafund, he or she occupies the same exalted perch as a renowned chef. Everyone wants to enjoy what they offer -- but they're constantly on the spot. If their establishment goes downhill, so does their reputation. So although all managers stumble from time to time, the best ones work harder to recover.

Low costs and expenses

Mutual funds charge two types of fees: a "load" for sales and marketing and an "expense ratio" for managing assets. If you choose your own funds, you should stick with no-load fund companies.

All funds come with expense ratios, and the lower, the better, because those expenses come right out of your assets. For a non-index fund that invests in U.S. stocks, 1.25% is the high side of reasonable, and anything below 1% is a good deal. Foreign stocks cost more to research, manage and trade, so in that category, you'll normally face higher expenses. But you don't have to give up too much return in fees and charges. Dodge Cox International, one of the best international funds, costs a mere 0.77%, less than half the cost of some other good international funds and below the average for stock funds of any kind. Index funds, which aren't actively managed, get a huge boost in performance thanks to their low expenses.

A svelte profile

A good track record can be an invitation to self-destruction. New money from investors piles in, until at some point the sheer size of the fund's asset base begins to chip away at its success. The manager runs out of really good ideas and resorts to not-so-good ones. Trading costs escalate when the fund builds and sells huge positions in companies. There's really no cure and only one preventative for mutual fund elephantitis: Close the fund before assets overwhelm the manager.

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It's impossible to say exactly what size is appropriate. A fund that invests in large growth companies, such as General Electric and Procter Gamble, can handle $10 billion or more. But with small companies, or in a narrow area such as health care, $1 billion can be too much to manage. If a fund's results lag its category more than one year, or cash levels build, it could be a case of bloat. Fund companies that closely align themselves with shareholders -- among them Wasatch and Bridgeway -- don't wait for those telltale signs before closing the door to new investors.


Great returns, average risk

A smooth ride is more comfortable than a rocky trip. Funds that invest in similar stocks and have similar long-term returns can have different risk profiles. The less-turbulent fund is the better choice.

A case in point: The Royce group manages funds that buy stocks of undervalued small or midsize companies. Nearly all of the Royce funds have above-average results for the past three and four years, but the funds inflicted vastly different levels of pain on their investors. The steadier Royce Premier and Total Return funds normally do as well as excitable Royce Opportunity. Yet Opportunity has twice the standard deviation of Total Return. So if Royce's expertise in small-company value funds fits your needs, you should prefer Total Return or Premier to Opportunity.

A focus on the portfolio, not the headlines

We prefer stock-fund managers who know their companies cold and focus on selecting winners, not on anticipating economic policy or reacting to news events (which can make a person a near-permanent bear).

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One clue to a manager's focus is the fund's shareholder report. It should concentrate on the stocks or industries the fund buys or sells and what's happening with those companies. Veteran stock-pickers will also tell investing stories and relate career and life experiences that make fascinating reading. Chris Davis, Bill Miller, Chuck Royce and Third Avenue Value's Martin Whitman, among others, write candid and lucid commentaries, which are posted on their Web sites. This is good public relations, but it's more than that. By taking you into their confidence, these managers are saying they want an educated, loyal partner. By contrast, a manager who finds something to blame all the time, whether it's oil prices, "uncertainty" about the dollar or fear of terrorism, isn't focused on the stocks.

The manager is your partner ... literally

If a fund's manager also invests significantly in the fund, he or she will try harder because he or she has money at stake, too.

Some funds reveal on their Web sites or in shareholder reports that the manager is also a major investor; the Davis funds are a well-known example. You can also learn this by doing some research. Go to the Securities and Exchange Commission's Web site, www.sec.gov, and click "search for company filings" and then "mutual fund prospectuses." The online prospectus has a supplement called the "statement of additional information." This includes bios of the fund's officers and managers. Further down, it tells you if they own shares of the fund and how much (within a range). You'll see that of the three managers of Skyline Special Equities, for example, two have more than $1 million in the fund and the third has between $100,000 and $500,000. If a manager or another officer, such as the fund's founder, owns or is a trustee of more than 5% of the fund, the SEC site tells you.

It's in clean hands

The fund industry has been remarkably honest since 1940, when the government first required daily pricing and quick liquidity. Still, a few years ago, the industry got mixed up in a series of scandals. Some fund bosses and insiders, and even a few managers, traded fund shares improperly for their own benefit. Others let favored clients get in and out at better prices than you could get, presumably in exchange for a lot of business.

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The scandals have faded, but their lessons remain. You can choose from thousands of funds from hundreds of sponsors, so don't accept ethical shortcuts. In 2004, we cited ten no-load fund companies as "families you can trust" -- Artisan, Brandywine, Dodge Cox, Fidelity, Harbor, Longleaf, Masters' Select, Oakmark, T. Rowe Price and Vanguard. They not only abstain from illegal acts, but they pledge reasonable fees, greater than normal disclosure and fairness. You can find other fund groups that are just as outstanding. Remember: The reputation of a mutual fund family means something.