Mutual Funds
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6 traits the best funds share
Actively managed funds run the risk of being actively run into the ground. Still, the winners are not so hard to spot as you'd think.
By Timothy Middleton
Investing in index funds, complicated as it is, is a piece of cake compared with shopping for actively managed funds, or mutual funds in which managers actually pick stocks instead of simply following an index.
For one thing, there are just too many actively managed funds, roughly 5,500, according to Morningstar. For another, they're exposed to a significant risk that indexing avoids -- that the manager will stumble. Outright blunders aren't even rare: At Janus Funds and Alliance Capital, they cost investors billions in the bear market.
Still, the allure of active management is hard to resist: You can do better than the market, says Morris Armstrong, a financial adviser in New Milford, Conn. A majority of actively managed mutual funds performed better than the S&P 500 ($INX) in the three years ended Nov. 30, Morningstar reports.
And a select number of funds manage to beat the market again and again and again. They are investors Holy Grail, and theyre not nearly as hard to find.
Where to look for the best funds
Most of them share certain characteristics you can uncover with a bit of research. Their returns are above average, but their risk is below average. They're managed by people whose personal fortunes are in their funds. Their managers have lengthy track records. Their managers make fewer mistakes than average, and they hold down costs.
In a bull market, indexing seemed right, says Dennis De Stefano, an adviser in Kihei, Hawaii. But going forward, theres going to be a premium on stock selection, and active managers are going to be more and more appropriate.
Identifying funds for your portfolio begins with knowing where to look. You cant pick the 'best' four or five funds, says James Garvey, a planner with Northstar Financial Planning in Hudson, N.H. Rather, youve got to identify the type of fund you need, whether that be domestic large-cap stocks or shares in small companies in undeveloped markets. The funds must balance each other to achieve a well-diversified portfolio, Garvey says.
The core of most portfolios is a fund that invests in household names, venerated corporate giants such as Procter & Gamble (PG, news, msgs) and Johnson & Johnson (JNJ, news, msgs). But such stocks actually come in three flavors, so many people own funds specializing in growth or value stocks, plus one that blends both.
Its important to identify the kind of fund you want, because funds can only be usefully compared with others of the same type. If you want investment-size returns, you have to take investment risk. The only sensible goal an investor can have is to perform better than the market itself. If you want risk-free performance, you cant invest; you can only save.
6 traits great funds share
Once youve established the pond in which you'll fish, youve got to know how to tell a trout from a carp. The best mutual funds share these qualities:- They consistently rank in or near the top 25% of funds of their type.
- They do this with less volatility than their peers.
- The managers responsible for this performance are still at the helm.
- Those managers invest in the fund themselves.
- Their mistakes are relatively few.
- The funds expenses are low.
In taxable accounts, the best funds will be those that have those attributes, plus tax efficiency.
Of all these issues, the most difficult to plumb successfully is performance. Naive investors will look no further than Morningstar's Five Star, or top, rating. But sometimes the best funds to own can look like outright dogs.
In 1999, the performance of T. Rowe Price Mid-Cap Growth (RPMGX) was pitiful, says Matthew Olver, fund analyst for Spero-Smith Investment Advisers in Cleveland. With the Russell Mid-Cap Growth Index ($RDG.X) soaring more than 50% that year, manager Brian Berghuis delivered returns of less than 24%.
We talked to him, and he said he just couldnt understand what was going on, Olver says. It was the peak, of course, of the Internet bubble, and Berghuis told Olver he could not justify buying those kinds of stocks.
Berghuis was vindicated in the bear market, when he resumed beating his index handily -- by 20 percentage points in 2000 and again in 2001.
How to analyze performance
The way to study fund performance is to drill down into the numbers. Look at returns over long periods -- 10 years or more is ideal -- to see how the fund performed when its marketplace was booming, and when it went bust.
Curiously, unusually good performance can actually raise a red flag with a fund. Funds that dont behave like the group to which they purport to belong are not a reliable tool to implement a specific strategy, says Louis Kokernak, a planner with Haven Financial Advisors in Austin, Texas.
The most famous example is Legg Mason Value (LMVTX). A stellar performer in the 1990s, it sank 7.1% in 2000, when the average large-cap value fund advanced 8.2%. The reason: Despite its name, its not a value fund, but tilts strongly in the growth direction.
Sometimes, performance is hurt by genuine mistakes, but that still doesnt mean the fund is bad. In 2002, Pimco High-Yield Bond (PHDAX) spent part of the year in a bad slump, uncharacteristically falling behind its average competitor.
We asked the managers why, recalls Penny Marlin, an adviser with Lubitz Financial Group in Miami, and they had very good reasons. With the junk market in the dumps, the fund sought to move up in credit quality by buying higher-rated issues.
They bought telecom bonds, and they were too early on that and were hit hard, Marlin says. But thats a legitimate reason and no excuse for ignoring what's otherwise one of the best funds in the group.
Discovering the managers mindset is impossible if a fund doesnt disclose who the manager is, and in the 1990s, when many star managers opened their own funds, some fund complexes began describing its workers as a management team.
This is a copout, says C. Bradley Bond, a planner in Murrysville, Pa. You need to look at the actual manager. If you cant, you have no idea about the management's stability.
Management is everything in active investing. The very best managers have lengthy records and, says Michael Helffrich, a planner with PFP Advisors in Minneapolis, substantial ownership of the fund.
Helffrich cites the tiny Longleaf Partners family of funds as an example of managers who eat their own cooking. Southeastern Asset Management, sponsor of Longleaf funds, puts all of its pension contributions into its three funds, and employees and their families are forbidden to own equity investments apart from the funds.
Employees are the funds' largest shareholders, and they have done well. All of the value-tilted Longleaf funds did poorly during the Internet bubble, but returned to their segment-leading performance when it burst.
My survey of more than a dozen financial advisers revealed that most of them prefer small fund companies to big ones, in part because owner-managers do the best job. If the manager owns the fund company, they are not 'hired guns' and won't leave because of a disappointing bonus, says John Henry Low, president of Knickerbocker Advisors in Pine Plains, N.Y.
Watch expenses
Expenses were all but forgotten in the bull market, but their importance has been demonstrated vividly in the last three years. Every dollar retained by the management company is a buck investors dont receive.
The equity-fund average is 1.5%, or $1.50 in expenses for every $100 invested. But some kinds of funds are cheaper to operate, like those investing in Fortune 500 companies.
Blankinship & Foster Family Wealth Advisers in Del Mar, Calif., spurns funds with expense ratios greater than 1.1% for large-cap stock funds, 1.3% for mid-cap funds, 1.5% for small caps, 1.4% for foreign-stock funds, 0.6% for bond funds, 1.25% for real estate funds and 1.5% for technology funds.
As for loads: If youre reading this, dont pay them. Loads are paychecks for brokers who sell mutual funds. Since youre selecting your own funds, why should you pay a load?
Compare holdings
Once youve winnowed your choices down to a few funds, check their portfolios against the holdings of your other mutual funds to avoid unwanted concentrations, says George Middleton, a planner with Limoges Investment Management in Vancouver, Wash. (No relation to this author.)
Examine the portfolio for other insights, as well. A roster of roughly two dozen names indicates a riskier approach than one with scores of holdings. Thats not necessarily bad, but you need to be prepared for a bumpier ride.
Be sure to read the funds prospectuses closely. Daniel Roe, a principal of Budros & Ruhlin in Columbus, Ohio, also reads all of a funds annual management letters to shareholders. What they said about the market in past years may give you far more insight about their strategies than what they are saying today, now that we know if they were right or not, he says.
And by the way: You might want to examine the funds you already own through this lens. Some that look like stinkers, because theyre down, might actually be just as good as you thought they were when you bought them.
At the time of publication, Timothy Middleton owned the following securities mentioned in this article: T. Rowe Price Mid-Cap Growth Fund.
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