How NOT To Pick A Mutual Fund

By Humberto Cruz
Tribune Media Services

This is how not to pick mutual funds:

Go straight to the list of top-performing funds for last year, or the last six months, or last week. Buy them without bothering to check what they invest in, how much risk they take or how much they charge in sales loads and annual expenses.

Here is how to pick them:

Look for funds with solid long-term returns and average to below-average risk for their category. Get the prospectus and annual report and see whether the fund's objectives and strategies are specific, understandable and consistent, and whether costs are reasonable.

And then make sure the fund's features are right for you: for example, tax-efficiency for long-term growth investors or low volatility for those with little tolerance for risk.

"Avoid the 'last year's winners' trap,'' warned John Markese, president of the American Association of Individual Investors, who presented a seminar on mutual fund investing at an AAII investor retreat in Boca Raton, Fla.

The seminar's workbook included a list of the top 20 and bottom 20 performers for 1998 among the no-load and low-load funds tracked by the AAII, a not-for-profit investor education group.

Of the 20 top performers, 15 scored "high'' on total risk, the highest risk category assigned by AAII. Another four scored a notch lower at "above average'' risk and only one, Fidelity Select Utilities Growth, received an average risk rating.

How about the bottom performers? Nineteen received a high risk rating and one was above-average in risk.

"The best of the best did it with what? High risk,'' Markese said. "The bottom of the list? They were high risk too, except they guessed wrong.''

Both the top and bottom performers lists were dominated by sector funds that invest in a narrow area of the market — technology mostly for the winning funds, and emerging markets, energy and Latin America for the losing funds.

Among the winners were also what Markese called "closet sector'' funds — ostensibly well diversified growth funds that "guessed right'' and loaded up on technology stocks.

Tech stocks were on a tear the decade of the ’90s but are prone to sharp and sudden swoons. Among other narrow-focus funds, emerging markets funds ran hot and cold during the ’90s, near the top of the pack some years and near the bottom at other times.

"The evidence from research is clear,'' Markese said. "Except when one sector or style gets 'hot' funds that do well in one year are no more likely to do well in subsequent years than other funds.''

When looking at longer-term performance, say five or 10 years, the pattern starts to change.

"Over longer periods of time you get more top funds that are not high risk,'' Markese said. For example, only half or 25 of the top 50 performing funds for the 10 years ended Dec. 31, 1998 were high risk, 19 were above average and six just average risk.

But even long-term rates of return can be misleading. A fund that puts up big performance numbers one year can look better than it really is for longer periods of time just on the strength of that one year.

"An average annual compounded rate of return will give you a make-believe number that's dangerous.'' Markese said. "In a stream with an average depth of half an inch you can still drown.''

For instance — this is my example, not Markese's — the non-diversified, frenetic-trading American Heritage Fund returned an average of nearly 18 percent a year from 1989 through 1993.

But that was because this highly speculative fund was up almost 97 percent in 1991. American Heritage actually lost money in two years of that five-year period, and has continued to suffer losing years in five of the past six, sandwiched between huge gain of 75 percent in 1997.

So rather than focus on the average annual compounded rate of return, investors should look at year-by-year returns, looking for funds that deliver consistent returns for their level of risk, Markese said.

"True winners will not win every year and may never show up at the top of any return performance list,'' the AAII workbook said. "However, they may provide very attractive returns over long time periods given their risk.''

For example, a fund with above-average return and below-average risk for both a three-year and five-year period "may, upon further analysis, turn out to be a very good long-term investment,'' the workbook said.

That analysis should include the fund's financial highlights in the prospectus and the fund's holdings in the annual report.

A prospectus usually shows a fund's total return by fiscal year, which often is not the same as the calendar year.

In the prospectus you will also usually find the fund's expense ratio each fiscal year, given as the ratio of net expenses to average net assets; the interest and dividend income the fund received each year, after subtracting expenses, called the net investment income; the gains or losses by the fund manager for trading securities, or net realized and unrealized gain or loss on investments, and the amount of dividend and capital gains distributions made by the fund each fiscal year.

Other interesting statistics include the fund's portfolio turnover rate — how quickly the fund manager buys and sells securities in the portfolio — and total net assets, or how big the fund is. You can track a fund's size over the years and whether money been going in or out of the fund.

All other things being equal, low expenses are better than high expenses. A low turnover rate is likely to lead to lower transaction costs, which are not included in the expense ratio but affect the fund's return. And few or no distributions show a more tax-efficient fund. Conversely, a fund that calls itself tax-efficient and makes large distributions year after year is not living up to its promise.

Another place to check whether a fund is true to its word is the annual report. This report tells you how much of the fund is invested in which securities and lists all the fund's holdings.

 If your fund invests in large-cap blue chip stocks, you will likely recognize many of the names in the portfolio. But unless you are a securities analyst or avid follower of financial news, the companies in your mid-cap or small-cap fund may be new to you.

"If you recognize a lot of these companies, they are not small to mid-cap,'' Markese said, showing his audience an annual report dated March 31, 1999 for the Nicholas II fund, which invests in small and medium-sized companies. The top three holdings (do you recognize them) were Fiserv Inc., Mutual Risk Management and Tootsie Roll Industries.

Copyright © 2000 Tribune Media Services Inc.  Reprinted with permission.

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