How to Buy…Mutual Funds

By Jonathan Burton, MarketWatch

SAN FRANCISCO (MarketWatch) — When choosing mutual funds, few aspects are within investors’ control. Future performance isn’t one of them. But expenses, risk, manager tenure and tax-efficiency are qualities that can be judged before you buy.

“Look beyond performance,” said Jim Peterson, a vice president at the Schwab Center for Investment Research. “You want to know what’s going to make a fund do well in the future and why it belongs in your portfolio.”

What to watch for:

Index funds, which track a basket of stocks, are generally low-cost options intended to provide market-like returns. Active management, in contrast, relies on a professional’s stock-picking in an effort to beat a market benchmark.

Yet an actively run stock fund is much more than an expert’s collection of chosen stocks. You’re putting money behind a manager, a fund company and a philosophy about investing, trading, taxes and risk.

“When I talk to fund managers, I ask them ‘how is your portfolio positioned today and how do you think you’re going to outperform going forward,'” Peterson added.

Answers to these questions and others can be found, easily enough, on fund-company Web sites, where it’s typical to find quarterly manager commentaries. Some managers are quite forthcoming about the reasons for their investment decisions and what they’ve learned from any mistakes.

All things being equal, such open-minded fund managers are keepers for your short list. Honest and timely messages from managers show respect for shareholders that likely extends to other important, investor-friendly attributes: low expenses, investment consistency, strong research analysis, sound corporate governance and managers’ own money on the line.

“Understand a manager’s strategy and see that their actions are consistent,” said Russ Kinnel, director of fund analysis at investment researcher Morningstar Inc.

What to watch out for:

Paying too much

“You have to care about expenses,” said Peterson. “It is the most predictable characteristic of explaining future returns of funds. It’s more reliable than past performance.”

It can’t be said enough: with funds, costs matter. Annual expenses eat into total return, year after year. With high-cost funds, you pay more and pocket less. Moreover, studies show that low-expense funds are more likely to outperform their costlier counterparts over time.

“If I have two funds investing in the same segment of the market, I want to choose the one that has lower expenses,” said David Yeske, a financial adviser in San Francisco. “Expenses will matter. They will suck away some of your returns every year.”

Taking excessive risk

No risk, no reward, as the old saying goes. Maybe you’ve found an attractive fund with a great multiyear track record. But just how attractive the fund is will be determined by how the manager generated that return. Better to invest with a manager who delivered superior gains with minimal risk.

“The biggest starry-eyed promise that investors get is performance,” said Roy Weitz, founder of the fund-watchdog Web site FundAlarm.com. “What investors really want is not just performance, but consistent performance.”

In looking for how returns were achieved, check the fund’s annualized results for unusual highs and lows. Then compare those figures with its category peers.

“It’s a way to avoid buying a hot fund, and to avoid a fund that is exceptionally risky,” Weitz added.

Morningstar’s Web site, www.morningstar.com, is a good source for in-depth research and screening tools to find solid performers. FundAlarm also ranks funds by risk level, including a rogue’s gallery of high-stakes “3-Alarm” funds.

Portfolio overlap

If one fund is good, then two or even three similar funds must be better.

Not so. Maybe you can’t be too rich or too thin, but you can be too diversified. Funds of the same stripes will likely hold many duplicate stocks. This is especially true of large-capitalization funds, where companies with the biggest market values tend to command a meaningful chunk of the portfolio’s assets.

“You think you’ve got a bunch of different investments; instead, you’ve got one big investment of the same kind,” said Ross Levin, a financial adviser in Edina, Minn.

Don’t be a fund collector. Copycat funds bloat your investment portfolio and drag down performance. At some point, the blend will produce bland, index-like results at a high cost. Plus, heavier concentration in a few stocks adds risk.

So how many funds do you need?

“No more than three in any asset class,” said Peterson, the Schwab strategist. “How many in total depends on your asset allocation. Generally, it isn’t 20 or 30; it’s more like 10 or 12.”

Recent manager changes

A fund’s performance doesn’t always speak for itself. Funds are ranked, rated and rewarded on the strength of returns over several years. But if a manager is new, those results are no longer a litmus test.

“The old track record is meaningless with the new manager,” Levin said. “If it’s a fund we’ve owned for awhile, unless we are comfortable with the manager that’s come in, we’ll sell it.”

Check Morningstar’s Web site or the fund’s prospectus to find out how long managers have been on the job and their employment history. Manager tenure isn’t as crucial when a fund is team-managed, has a deep bench of stock analysts or when a successor brings a solid showing from another fund, Levin said.

“Follow that new manager’s track record,” he added. “Where did they come from, and what did they do well or poorly in the past?”

Investment strategy ‘drift’

A burst of trading activity, venturing into new market sectors, adding larger-cap stocks, taking an aggressive stance in a volatile market — these are all telltale signs that a fund has changed its investment strategy, and not always for the better.

“You worry when a manager alters his strategy or is forced to change the way they do things,” said Morningstar’s Kinnel. “The new portfolio might not fit with what you want. It’s a sign that they’re flailing.”

Informed investors pick funds for their diversification capabilities. Like a baseball team, funds exhibit skills that are sharpest when each plays its position well. A portfolio will have a large-cap fund that follows a value investment discipline, and one with a bias toward growth stocks. There are midcap and small-cap funds covering similar growth and value styles. If these aren’t working together, the strength and quality of your portfolio is weakened.

“Any big shift I take as a red flag,” Kinnel added. “It tells you they don’t have much faith in the original strategy.”