How to Pick a Great Mutual Fund

By Tim OBrien on 09/09/2010 – 7:49 am PST -- Opinion

Here’s an interesting piece on how to pick a top-performing mutual fund. The summary:

A new study reinforces time-tested advice for investors shopping for mutual funds: Look first for funds with low fees, then go from there.

The study concluded that investors should make expense ratios a primary test in fund selection, because they are still the most dependable predictor of performance.

Ha! I’m sure this will get a few people reading this riled up!

In particular, someone is bound to say, “Forget about costs — you should consider performance before anything else.”

I’m assuming they mean “performance net of costs”, which is something I’m also interested in. The only problem is that performance is difficult to judge in advance, costs are not.

In fact, Morningstar, the company that rates the performance of mutual funds, even has a hard time picking funds that out-perform a simple “low cost fund” strategy:

Morningstar’s star system measures a fund’s past performance while weighing how much risk a fund took to achieve its returns. For example, a fund that produced far-better-than-average results over 10 years won’t necessarily secure a top rating if its performance was unusually volatile during that period.

Fund expenses are a slightly more important factor in predicting how well a fund will perform than the one- to five-star system that Morningstar uses to rate funds, the company said in a study it published in August.

Ha again!

As I wrote four years ago, costs matter if you want to maximize investment returns.

And for those of you interested in how I invest, I’m still putting the majority of my money into these funds.

http://www.fundreveal.com Tony DuBon

Morningstar argues that expense ratios are important to consider when selecting mutual funds. So now investors should consider Expense Ratios, the Star Rating system and the all inclusive, hard to measure “other key fundamentals… management, strategy, and stewardship.”

To add to the confusion: Morningstar’s Star Ratings are based on comparisons of risk adjusted total returns within peer groups. A 5 Star fund in a peer group might have worse performance than a 3 star fund in another peer group, if the first peer group itself has performed poorly compared to the second. Morningstar uses a proprietary and subjective risk adjustment for calculating its “risk adjusted total returns,” but also states that total returns and its star rating system do not have predictive power.

Maybe it is time to call an end to the run-around and look at the problem in a new way: Analysis based on objective facts,) focused on the elements most important to investors:
Average returns based on Net Asset Value
Risk of loss
Persistence of good performance — high returns at low risk of loss.

This approach is described in the Mutual Fund Performance Forum. The blog is available on the web site for FundReveal.com as is the mutual fund selection tool. The FundReveal tool takes all of these factors into consideration, giving investors the ability to tell at a glance where a fund rates in comparison to all other funds and to the S&P 500. Dropped. The persistence rating shows which funds are likely to outperform in the future.

Karen Dolan, director of mutual fund analysis at Morningstar Inc., said that the way [FundReveal] is measuring consistency is one of the ways that makes [FundReveal] different (“Web tool’s promise: A way to find funds that are likely to succeed,” by Davis D. Janowski, InvestmentNews, July 18, 2010).