FUNDS


Smart Strategies to Pick Mutual Funds

This article appears in Mutual Funds 2010. Buy this special issue.

Selecting a mutual fund can be daunting. You have thousands of funds from which to choose, and many more are born every month. Most fund sponsors aren’t shy about hawking their wares with tempting advertisements that tout great one- or two-year results. Don’t fall for those statistics. Funds with hot short-term records rarely repeat their stellar performance.

We’ll explore better ways of identifying great funds. But before we do, we recommend that you do two things: Figure out your investment objectives and determine how you’ll allocate your assets. Without doing that, picking funds is like figuring out a route without knowing your destination.

Where are you going?

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It’s surprising how many people never sit down and think clearly about what it is they’re trying to achieve with their investments. Take a page from financial planners, who help clients write an investment policy statement before making any purchases. This identifies the objectives you’re investing for (retirement, college tuition, a house down payment) and matches the investments to the goals.

Your asset allocation is, simply, which types of investments you choose to put your money in, and in what proportions. Do not skimp on this stage. Studies show that 90% or more of your returns will be determined by your asset allocation. In other words, selecting types of investments -- such as bonds, international stocks, small-company stocks -- is more important than buying particular funds that invest in them. When international stocks boom, for example, all international-stock funds tend to do well, regardless of who is managing them.

Different types of assets also come with different risk and reward levels. Generally speaking, the higher the risk, or volatility, the greater the expected return. The lower the risk, the lower the expected return. So most kinds of bond funds should have relatively low risk and return, and funds holding emerging-markets stocks should have much higher risk and return.

To build a great portfolio, you need to focus on three things: the expected return of the different assets, their expected volatility and how correlated the assets are. Correlation is a measure of how closely the assets’ performance is linked. When one goes up, does the other go down? Or do they move in lock step?

If you load your portfolio with assets that don’t move in lock step, the total value of your portfolio won’t be as volatile. Foreign bonds might be going up, for example, while commodities are going down. The overall stability will help you sleep well at night, and it will keep big losses from causing you to panic and sell at the bottom of a market. We saw that kind of panic selling -- to the tune of tens of billions of dollars -- in February and March of 2009, at the bottom of the bear market.

So when you purchase each fund, consider what that fund’s diversifying effect will likely be on your overall portfolio. For instance, say you’ve purchased a fine small-company U.S. stock fund. Then you identify a second and maybe a third such fund. Small-company funds have great returns over time, but they’re volatile. So by loading up on so many similar funds you’re doing little to decrease your portfolio’s overall volatility. It may be better to add a different asset with low correlation to small-cap stocks, such as commodities.

Proper asset allocation can have amazing benefits. For example, you can add a high-risk, high-return asset to your portfolio and actually decrease its volatility. Commodities, such as metals, grains and lumber, are a good example of this. They can have big swings in price, but because they don’t correlate closely with stocks, a portfolio with both commodities and stocks will be less volatile than one with stocks or commodities alone.

Don’t be afraid of different types of assets. Many investors stick with funds that invest solely in U.S. stocks and bonds, but that does little to dampen volatility. For example, like commodities, foreign currencies tend to react to different economic events than do U.S. stocks and bonds, so foreign-currency funds can dampen a portfolio’s ups and downs.

Finally, subject you and your portfolio to a stress test. The markets have behaved in recent months, but what if we endure another major bear market? These are par for the course, so think of how your portfolio is likely to perform during such periods and how you’d react to that performance. Then adjust your risk accordingly. Before the 2008 crash, many investors let their portfolios swing too far to stocks and wished they had more bonds and Treasury securities.

Researching funds

Now that you’ve thought clearly about your long-term investment goals and understand asset allocation, it’s time to move on to the task of picking the right funds. Remember, investing is important work for your family’s future, so apply at least as much rigor to researching funds as you would to shopping for a car, house or college for the kids.

An excellent place to begin the search is by using Kiplinger’s Fund Finder tool. It will provide you with valuable information on fund returns over several time periods, how funds rank compared with similar funds, investment style, volatility, expense ratios and much more. Let’s examine the importance of some of these categories.

Past performance. This can be significant, but there are some caveats. To start with, the longer the performance period, the better. Again, short-term performance rarely repeats, so consider five- and ten-year returns first. Also, the performance of an actively managed fund is often only as good as the manager who is running it. So match the returns to the tenure of the manager in charge (more on managers later).

Another key point is that types of investments often have a great run for two or three years. So if emerging-markets funds, for example, have shot the lights out for two years, don’t jump into one and expect it to continue the streak. It’s best to pick a well-diversified portfolio and ignore the ups and downs of the individual components.

Volatility. High volatility can be a scary thing, but keep it in context. The longer your time horizon, the more you can cope with volatility and sock away savings in such jumpy investments as stocks. For instance, small-company stocks are a volatile asset class, but over long time periods they tend to generate excellent returns. And recall that combining asset classes with high volatility but low correlations will tamp down overall portfolio risk.

Know your manager. You may never meet your fund manager, but you can (and should) get to know him quite well -- by doing your homework. Here are some tips:

The Internet is a wonderful tool for conducting research. Start with the fund’s Web site and study the manager carefully. Read about the manager in the fund prospectus and annual report, and pay close attention to quarterly letters written by the manager, as well as to webcasts and interviews. Often when you can see a manager talking, you pick up on her traits. Does the manager admit mistakes, respect investors, sound too greedy or know what she’s talking about? And check to see if the manager is personally invested in the fund, which is a big plus.

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