How to Choose Winning Funds

Editor's note: This article is adapted from Kiplinger's Mutual Funds 2007 guide. Order your copy today.

With a mind-boggling array of mutual funds to choose from, it's no wonder millions of Americans throw up their hands and surrender management of their finances to brokers, financial planners and other advisers. That's a shame because you don't have to be a rocket scientist -- or hold an MBA -- to pick funds astutely. By investing in funds on your own, you can save a substantial amount of money because you won't pay sales commissions to a broker or a percentage of your assets to an adviser to do something you can do yourself.

Although picking winners has some art to it, as well as science, it's easier if you approach fund selection rationally. Use the steps described below to pick funds like a pro.

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1. Determine your objective. What are you trying to accomplish? For example, are you looking for maximum gains, and are you willing to accept the higher risks that come with lofty aspirations? If so, you might want a fund that buys shares of small companies or one that focuses on emerging markets, such as China and India. Or do you want steady income? That probably means you want a bond fund. If so, are you willing to settle for a fairly low yield to keep your risk down? Or are you willing to take on extra risk in search of high income? If the latter, consider a fund that invests in high-yield debt, also known as junk bonds.

2. Home in on a specific category. The fund world is a big place. It contains stock funds, bond funds, money-market funds and hybrids, which may own stocks, bonds, Treasury bills and sometimes even commodities. And there are a myriad of choices within each broad category. Some stock funds, for example, invest in big companies; others invest in small or medium-size companies. Funds that invest in rapidly growing companies with high-priced stocks are different from those that care less about a company's growth prospects and more about buying its stock at a bargain price.

There are similar divisions among bond funds, which typically are grouped by quality, maturity and types of bonds (municipal, corporate and mortgage, for example). See our list of our 25 favorite stock and bond funds.

3. Watch your costs. Fund fees can be confusing. To make matters as simple as possible, it's best to divide costs into two broad areas: fees you pay every year, and charges -- such as commissions -- that you incur when you buy or sell a fund. Most commissions go to the broker, financial planner or insurance agent who is advising you.

Annual fees, which are expressed in a figure known as the expense ratio, include management fees and legal, accounting and printing costs. They can also include ongoing commissions, which are called 12b-1 fees.

Here's a simple rule: If you invest on your own, buy no-load funds. A no-load fund does not charge a commission when you buy or sell, and it is not allowed to levy an annual 12b-1 fee greater than 0.25%. Among families that focus on no-load funds are Fidelity, Vanguard, T. Rowe Price, Dodge & Cox, Baron, CGM, Royce and Marsico.

Why get hung up on fees when plenty of funds with high fees have delivered good returns? We'll answer that question with another question: Why start investing with two strikes against you? If you pay a commission, you start the performance derby in the hole to the tune of the charge. And annual fees lower a fund's total return, whether it performs well or not. Because future performance is unknowable, it's best to avoid commissions and to invest in funds with below-average fees. (The average annual expense ratio for diversified U.S. stock funds is 1.44%; diversified foreign funds, 1.55%; domestic taxable bond funds, 1.09%; and national municipal bond funds, 1.02%.)

Vanguard, in particular, is known for its rock-bottom fees. Vanguard 500 Index fund, for example, sports an annual expense ratio of just 0.18%, meaning the fund extracts $1.80 per year in fees for every $1,000 you invest.

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4. Study past performance. If past performance doesn't necessarily predict future results, why bother looking at a fund's record? The answer is that long-term results show a fund is well-managed. The longer the term the better—at least ten years, if possible.

Be sure to compare a fund's results with those of similar funds. Pick up a copy of our Mutual Funds 2007 guide and take a look at the decile rankings in our tables. They show how a fund has performed relative to its peers in each of the past five calendar years. Look for funds with decile rankings of 1 (best) to 5 (average) in each of the past five years. Funds that produce average to above-average results year in and year out generally generate superior long-term results as well.

By focusing on the decile rankings rather than returns, you're less likely to fall into the trap of buying a bunch of funds that have performed well just because they all focused on a hot area of the market—large-company growth funds in the late 1990s, for example.

Dodge & Cox International is a fund with a terrific five-year return. And it achieved that by blowing away its competition—diversified overseas funds—in each of the past five years. But you don't need to see three, four or (in rare cases) five decile ranks of 1 to find good long-term performers. Consider Selected American Shares, a fund that has regularly delivered above-average returns compared with other large-company funds and, as a result, has a superior long-term record.

5. Consider risk. Don't view risk as a four-letter word. There's nothing wrong with investing in risky funds. You'll need to assume some risk to achieve healthy gains. What's important is that you understand a fund's risk and can handle -- both financially and emotionally -- any potential losses.

The tables in our Mutual Fund 2007 guide present two figures that provide insight about a fund's level of risk. The first is the volatility ranking, which measures the swings in a fund's returns. Volatility is great when funds are rising in value, but volatile funds tend to suffer the most in inhospitable markets or when their managers simply make bad decisions. Our volatility rankings compare like funds -- stock funds are compared against all stock funds, bond funds against all bond funds.

Our tables also show bear-market results -- how funds performed during the last major market drops. In the case of stock funds, that covers the calamitous bear market from March 2000 through October 2002. For bond funds, it covers the milder bear market that ran from Sept. 30, 1998, through Dec. 31, 1999. Every bear market is different, and there are no guarantees that funds that took the biggest hits during the last bear market -- large-company growth funds during the 2000-02 downturn, for instance -- will do so during the next big decline. But if you're trying to avoid overly risky funds, beware of those that suffered huge drops during previous bear markets.

For example, Fidelity Select Technology, with a volatility ranking of 10 and a devastating 84% decline during the last bear market, is not for risk-averse investors. But Merger fund, with a volatility ranking of 1 and a gain of 4% during the last downturn, might be just fine.

FUND ALPHABET SOUP

Deciphering the different fees and commissions charge by load funds

If you have the time and inclination, always pick funds on your own to avoid extra costs. But if you buy shares through an adviser -- a broker, planner or insurance agent -- you'll probably have to purchase a particular share "class." Here's a guide:

Class A shares usually carry a sales charge up front. This is called a front-end load, in fund lingo. If you invest $1,000 in the Class A shares of a fund with a 5% load, you're actually investing $950 and paying $50 in commission. Class A shares typically have lower 12b-1 fees -- which are subtracted from fund assets to cover the cost of marketing and distribution, including commissions -- than other share classes.

Class B shares don't carry front-end loads, but you'll pay a sales charge if you sell your shares within a certain period. This back-end load diminishes year by year, and with most funds it disappears within six years. Even so, Class B shares may be more expensive than A shares, because B shares sometimes have higher 12b-1 fees. And to complicate matters even more, most Class B shares convert to A shares after a certain number of years.

Class C shares generally don't have a front-end load, and the back-end load is typically lower than with Class B shares and imposed for a shorter time. C shares carry higher management costs, including higher 12b-1 fees. They may appear to be the least-expensive option compared with A and B shares, but only in the short run. Over longer periods, this share class is frequently the most costly.

6. Size up the fund. With funds, bigger can be better -- but it can also be a hindrance to good results in the future. Expenses at bigger funds are often significantly lower than those of smaller funds. That's a plus. But if a fund grows too big, it can become too unwieldy to manage effectively. In particular, the mere act of buying or selling stocks in vast quantities can move their prices in an unfavorable direction.

There are no firm rules about what constitutes asset bloat. Much depends on the kinds of stocks a fund owns. In general, be wary of a fund that invests in large companies if its assets exceed $30 billion, particularly if the fund trades a lot. A fund that focuses on smaller companies could be bloated if its assets top $3 billion. Fidelity Low-Priced Stock, which holds mostly small and midsize companies, is closed to new investors, but existing shareholders should worry about its $37-billion asset base. Among funds that are still taking cash, one that should be on anyone's bloat list is Columbia Acorn, which also invests primarily in small and midsize companies and tops $19 billion in assets.

7. Know who's at the helm. For the most part, a fund's record is only as good as the manager who compiled it. Since managers are always coming and going, find out how long the manager of a fund you're considering has been at the helm. An impressive ten-year record may not be particularly meaningful if the current manager has been in charge only since 2005. Manager turnover may not be as meaningful in big shops, such as Fidelity and T. Rowe Price. But in one- or two-person operations, manager changes can be crucial.

Useful resources

Compare the expenses of up to three mutual funds, exchange-traded funds or share classes of the same mutual fund at www.nasd.com. Click on "Investor Information," then "Tools and Calculators."

Check up on your fund. Have your mutual funds been naughty or nice? Go to FundAlarm.com to see you if own any bad apples. Fund skeptic Roy Weitz, a finance manager for a Los Angeles nonprofit firm, looks for warning signs that fund managers and sponsors are treating their investors poorly.