5 Ways to Vet a Fund
Here's how to identify the most important information
It's easy to overdose on data when choosing funds. Numbers can be interesting, but only a few really help you make good selections. Unfortunately, many investors have a hard time figuring out which stats to use and, all too often, make the mistake of leaning too heavily on a fund's returns over the past year. My new book, Fund Spy (Wiley, $24.95), is designed to help you identify the most important information. Here are some things you should look at:
Expense ratio. This one's simple: You improve your odds of success by investing in funds with low fees. Over a ten-year span, stock funds whose annual expense ratios are among the lowest 20% in their categories are 40% more likely to outpace those in the second-cheapest quintile. And the least-expensive funds are more than twice as likely to outperform those with expenses in the highest 20% of their categories.
Stewardship. Some funds watch out for shareholder interests, and others treat investors as if they were second-class citizens. For instance, some sponsors will keep a fund open to new clients even though existing shareholders would be better served if the fund closed. Over a lengthy holding period, a fund company will have many opportunities to choose between maximizing profits and protecting shareholders. I want the good guys on my side. Steer clear of funds with Morningstar stewardship grades of D or F.
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Risk. Most investors are better off avoiding high-risk funds. That's because it's tough to stay put when a highly volatile fund gets whacked, even though holding steady might be the right course of action. Morningstar's risk rating gives you a quick assessment of how dangerous a fund could be.
The bear market that ended (I hope) on March 9 also provides a very real measure of funds' risks. Check how a fund fared in 2008, during which the stock market tumbled 37%. In fact, before you buy a fund, look back over at least ten years' worth of returns to see how it fared in different climates. This should enable you to set realistic expectations and prepare you better for potential losses. But you should also ponder how you handled losses during the bear market. If you couldn't stand the pain in certain funds and unloaded them, then look for more-conservative investments.
Manager stake. In 2005, regulators started requiring managers to disclose how much of their own money they had invested in their funds. But that information is buried in the mountains of paperwork that funds must file, and few investors have the time, patience and inclination to ferret it out. Fortunately, we've loaded the data into our computers at Morningstar.
It makes sense to follow the lead of insiders. After all, who knows a fund better? It turns out that fund managers are all over the place when it comes to putting their money where yours is. Most don't have a dime in their funds, yet hundreds have more than $1 million invested. Consider a fund only if at least one of its managers has $500,000 or more invested in it. (The rule does not apply to money-market funds, but it does to just about every other category.)
To see how your fund rates on the criteria described above, take the Spy Selector test.
Management quality. The final step -- identifying good managers who employ sound strategies -- is the subjective part of the process. You can learn a lot from fund shareholder reports, and from reports at Morningstar.com, Kiplinger's and other sources. In Fund Spy, I identify the great fund com-panies and the also-rans. I also describe 20 great funds that pass my tests. Among them are Harbor Bond, T. Rowe Price Small-Cap Value and Dodge & Cox International Stock, all members of the Kiplinger 25.
Columnist Russel Kinnel is director of mutual fund research for Morningstar and editor of its monthly FundInvestor newsletter.
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