Personal Finance, Money and Investing

How to pick a mutual fund

Posted on December 5, 2007 in the Investing, Mutual Funds category

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As an investor looking to buy a mutual fund, your goal should be to buy the mutual fund that will best allow you to reach your goal. With the thousands of mutual funds available today, finding the right one can be a daunting task.

The five filters that are explained below are designed to help you to narrow down the universe of mutual funds to one or two top performers. To give you an example of how these steps work together, I have included an example, at the end of this article, of how I used the filters in conjunction with Yahoo Finance to find a quality high-yield bond mutual fund.

Performance
The bottom-line on any possible investment is ‘How has that fund performed over the past 1, 3 and 5 years?’ I want a fund that has consistently been in the top 5-10% of there group according to Lipper Analytical Services for this time period.

By using these criteria I automatically screen out those super-nova funds which have had one great quarter or year. I am not interested in a one hit wonder. I want a fund that is a perennial winner, not one that got lucky.

Most investment screens on the Internet only use data for the past year. Yahoo Finance however, allows you to screen funds using five-years of performance data.

Fund Manager
While past performance is no guarantee of future results; I am a believer that history does repeat itself in the stock market. If a fund manager has outperformed his or her peers for the last one, three and five years I believe the odds are pretty good that that person will continue to outperform their peers. However, with the rotating fund manager philosophy of some mutual fund companies, it is important to make sure that the same manager has been running for the time period you are checking. If the fund has posted terrific results over the last three years I want to invest with the fund manager who got the great results, not with someone who was lucky enough to inherit the track record.

Risk Level
While I have a high-risk tolerance, I still do not like funds that have wild price fluctuations. So I want my fund to not only outperform its peers, but to do it with less risk and price volatility than its peers. While this narrows the group of possible candidates down, it also allows me to sleep at night.

Expenses and Fees
All mutual funds have operating expenses that include the costs of managing a fund. Some mutual funds, in addition to operating expenses, charge a sales fee for the privilege of buying the fund. I am opposed to paying a sales fee for a bond fund because it much harder for a bond fund manager to greatly outperform their peers than it is for an equity fund manager.

In addition to wanting a no-load fund I also want a fund that has the lowest expense rate possible. The reason for wanting the lowest expense rate possible is that the expenses are paid from the earnings of the fund before they are distributed and are not charged directly to shareholder accounts. The result is that the higher the expenses the lower my return will be.

Minimums
This is related to expenses and fees in that making an investment in the fund must be affordable. A fund with a $10,000 minimum investment where subsequent investments must be over $1,000 is not what I am looking for. Investing consistently over time is the most successful strategy for building a portfolio. I want a fund that allows me to make smaller investments on a regular basis, that way I don’t have to rely on my intuition or luck to determine the best time to invest.

To some people this might seem like a lot of hoops to jump through just to pick a mutual fund. My answer to that is “yes it is”. However, I want my money to be managed by the best investment managers I can find and I am willing to do a little bit of research to find that person. Are you?

Example using data from Yahoo Finance

My goal was to find a high-yield bond fund that has outperformed its peers with less risk. Using the Yahoo Finance pull-down menus I entered in the following information:

Category: Bond-High Yield
Family: Any
Rank In Category: Top 10%
Tenure: I wanted a manager who had been running the fund for at least 3 years
Risk Rating: I wanted a fund whose risk level is below average
Performance Returns: Leave blank
Minimum Investment: $2500 or less
Front Load: No load
Total Expense Ratio: Under 1% o that more of the funds returns end up in my pocket instead of the fund companies
Fee: I wanted to see only no-load funds

Mutual Fund Screen Tool

Results:
In two minutes I was able to cut the 452 High Yield Bond Funds in the database down to 3. The three are Fidelity Capital & Income, Fidelity Advisor High Income Advantage I and Principal Inv High Yield II Inst. All three have 5 stars from Morningstar and all meet my “stringent” investing criteria.

If I was so inclined to invest in a high-yield bond fund which one would I choose? While it is close I would have to go with the Principal Inv High Yield II Inst (PHYTX) fund. This find has consistently been ranked in the top 12 for all junk bond funds for the last 5 years which is the kind of performance and expertise I want from my fund masnager.

As of October 31st, the Principal Inv High Yield II Inst had posted the following numbers:

RANK IN CATEGORY (BY TOTAL RETURN)

That is the sort of consistent performance that I look for from a fund manager.


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