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Screening
for Mutual Funds
Despite the recent turbulence, the last time I
looked, the overall market, as measured by the S&P 500 index was still
up slightly for the year.
But that news would be of little consolation to
holders of women’s clothing retailer Chico’s FAS, satellite radio
provider XM Satellite Radio Holdings, and homebuilder Hovnanian
Enterprises. As of last Wednesday, these stalwarts, along with more than
150 other stocks, had dropped more than 30 percent so far this year.
By contrast, only four out of more than 10,000
domestic stock mutual funds tracked by Morningstar (www.morningstar.com)
had lost even 15 percent year-to-date, and most were running ahead of
the S&P 500.
Mutual Fund Advantages
Those figures illustrate a major advantage of owning mutual funds
instead of individual stocks. Most funds hold dozens, if not hundreds of
stocks, so you get automatic diversification. One or two disasters don’t
move the needle on the entire portfolio by much.
Further, for mutual fund managers, picking stocks
is their day job and they get better access to analyst research and
market intelligence than we do.
But not all mutual funds are created equal. Here’s
a screen for pinpointing worthwhile mutual fund candidates.
Screening Finds Funds
If you’re not familiar with the terminology, screens are programs
you can use to search out funds meeting your particular selection
criteria. Yahoo (finance.yahoo.com)
and MSN Money (moneycentral.msn.com),
among other financial sites, offer free mutual fund screening programs.
I’ll use Morningstar’s free fund screener to demonstrate my selection
strategy.
Morningstar’s screener is exceptionally easy to use
and everyone with access to the Internet should be able to run the
screen.
From Morningstar’s
homepage,
select
Funds and then click on
Mutual Fund Screener.
I’ll start at the top of the screener menu and work
down, but we won’t use all of the available screening criteria.
Say No to Loads
Start by selecting “No-load funds only” from the “Load Funds”
dropdown menu. Loads are sales commissions used to compensate financial
advisors and stockbrokers who select mutual funds for their clients. The
professionals deserve to be paid for their work, but there’s no point in
paying the fee if you are selecting funds on your own. Since Morningstar
lists more than 7,000 no-load funds, ruling out load funds will still
leave you with plenty of choices.
Required First Purchase
Next, use the “Minimum Initial Purchase” menu to specify $3,000.
That means your first purchase of each fund must be at least $3,000.
Usually after you’ve made your first purchase, you can add to your
holdings in that fund in much smaller increments. Other choices range
from $500 to $10,000. Pick the amount that best suits your needs.
Star Rating
The ideal mutual fund would deliver market-beating returns with
minimal price swings, which is termed “volatility.” Most analysts equate
volatility to risk.
Morningstar’s Star rating, in essence, compares a
fund’s historical returns to its historical volatility. The ratings run
from one to five stars, where five is best. Morningstar divides funds
into categories such as technology, large value or small growth.
The funds with the highest return vs. volatility
ratio in each category earn five stars. While a five-star rating doesn’t
guarantee future performance, I’ve found that it’s a good starting
point.
Minimize Risk
Next, use the Morningstar Risk dropdown menu to specify below
average risk. Some funds achieve market-beating returns by making risky
bets. But if a fund is excessively volatile, many investors bail out
during the dips and, thus, aren’t around to enjoy the eventual returns.
Historical Returns Important
The essence of this selection strategy is to spot funds with
market beating historical returns in the hopes that they will continue
their winning ways. To isolate funds with the best historical returns,
use the three-year and five-year return menus and specify that average
annual returns must equal or exceed the S&P 500 Index returns over those
periods.
Manager Leaves: All Bets Off
Historical performance is meaningless if the fund manager
responsible for the results is no longer running the fund. Use the
Manager Tenure dropdown menu to specify a five-year minimum tenure.
Returns & Risk Count Most
Click the “Show Results” button to see the list of qualifying
funds. When I ran it, Morningstar listed 48 funds. Use the View menu at
the top to switch to the Performance view, which shows each fund’s
returns over a variety of timeframes. Click on the five-year return
heading to sort the list with the funds recording the best five-year
average annual returns at the top. If returns are more important to you
than risk, the funds with the highest five-year returns are your best
bets.
The Performance view also lists Morningstar’s risk
rating for each fund. If you are a risk averse investor, stick to funds
with “low” risk ratings.
MStar Lists Wrong Funds
One caveat, Morningstar’s screen listed some funds, labeled “Load
Waved,” that are really load funds and are available only through
financial advisors. However, some of those funds are also available in
no-load versions, albeit with higher expense ratios, and thus slightly
lower returns. You can find them by placing the fund name in
Morningstar’s quote box (then hit Enter). For instance, the Federated
Kaufmann fund turned up by the screen was labeled “load waived,” but by
following that procedure, I found the Federated Kaufmann K fund, which
is a no-load fund available through discount brokers.
The more you know about a fund, the better your
results. So consider the funds turned up by this screen as candidates
for further research, not a buy list.
published 6/11/06 |
