Smart Strategies to Pick Mutual Funds

Using past performance alone often leads to a weak portfolio. Here are better ways to choose winners.

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.

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Where are you going?

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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Study the fund holdings to see if the manager adheres to his stated strategy. Some managers say one thing but then invest a different way. You may not recognize all the holdings, but you may notice positions or risks that surprise you, such as derivatives you don’t understand, ETFs (increasingly common in managed-fund portfolios these days) or emerging-markets stocks in what you thought was a domestic fund. For instance, if you hear Don Kilbride, manager of Vanguard Dividend Growth, describe his dividend growth strategy, you’ll probably understand his rather straightforward (but effective) approach to picking stocks. If you then peruse the fund holdings, you’ll see that he has executed the strategy.

Here’s one final tip. The mutual fund industry is for some reason oriented toward relative performance. That is, if a fund beats its benchmark (such as Standard & Poor’s 500-stock index) by a few points, it declares victory and the manager is well compensated -- even if the benchmark’s return was negative.

You probably want to be oriented more toward absolute returns -- ideally, up each year, and certainly in a position to build wealth over the long term. Severe losses in bear markets are devastating to the compounding of wealth. Some managers, such as Clyde McGregor, of Oakmark Equity & Income, and Steve Romick, of FPA Crescent, focus on absolute returns and aim to achieve them by, for instance, holding high cash levels or shifting some money from stocks to bonds if they spy danger in the stock market.

Fund fees

High fees are a drag on performance. That’s because you pay fund fees every year, through bull and bear markets. Fees reduce your principal, thereby interfering with the long-term compounding of your wealth. No-load fund families with reasonable fees include Dodge & Cox, Fidelity, T. Rowe Price and Vanguard.

Another way to approach fees is to consider low-cost index funds your default investment. Are you confident that the high-fee managed fund you’re considering will beat the index fund? If a manager can’t beat the index, you’re better off investing in the index fund. You’ll enjoy low expenses and be smug in the knowledge that over time most managers don’t beat their benchmarks.

When to ditch a fund

The portfolio manager changes. If the new manager has a long record running a similar fund with like performance, then you’re in good shape. But don’t wait around to see if an unproven manager can do the job.

Change in style. For example, if you bought a fund to invest in small-company stocks and now the size of the companies is growing with the fund’s assets, sell.

Asset bloat. Too much money in a fund is the enemy of great returns. Such a situation makes it hard to trade in and out of positions quickly, and it may cause a fund to own more companies than it can follow well.

Increased fees. Fees can be a serious drag on returns, particularly in bond funds. After mergers of fund families, you may find the new regime is tacking on fees.

Stock overlap. You want diversification, and sometimes you’ll discover that several funds in your portfolio invest in essentially the same securities. When that happens, sell the fund with the worst return.

Poor performance. Don’t sell a limping fund too quickly -- all funds have bad years. But when a fund’s losses compound over time, sell it and buy something better.

Contributing Writer, Kiplinger's Personal Finance