to Pick the Best Mutual Funds
The last time that I checked, 7,200 of the 9,700 domestic stock mutual
funds tracked by Morningstar had racked up returns ahead of the S&P 500
so far this year. That fact, plus the advantages of automatic
diversification and having a full-time fund manager working for you make
mutual funds a good choice for many investors.
The bad news is that there are 9,700 funds out there. Here are some
ideas for picking the best funds using Morningstar, which is my favorite
source for fund data.
Start by entering your fund’s name or ticker symbol on Morningstar’s
to see the
Quote report, which has the data that you’ll need for the first five
checks. We’ll start by checking whether the fund even wants your money
and whether you have enough to meet its initial requirements.
Sometimes investors pour more money into a fund than its manager
believes that he or she can prudently put to work. In those cases, the
fund might “close to new investors” meaning that it will not accept new
share purchases from investors who do not already own fund shares.
The Status indicator specifies whether a fund is “open” or “closed” to
new investors. Don’t waste time analyzing a fund that doesn’t want your
money. Rule out funds with “closed” status.
Most mutual funds specify a minimum purchase amount for new buyers.
Morningstar lists the required minimum purchase (Min. Inv.) near the top
of the report. Rule out funds that require starting investments above
your limit. Next, we’ll determine whether the fund is charging fees that
you don’t need to pay.
Loads are sales commissions used to compensate financial advisors who
select mutual funds for 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. Morningstar’s Load indicator displays
“none” for no-load funds. Stick with no-load funds.
Now, with the preliminaries out of the way, we’ll check out the fund’s
Ideally, you’d like your funds to move steadily up in price every day.
Alas, that doesn’t happen. In practice, even if your fund scores strong
long-term returns, it does a lot of bouncing up and down along the way.
Those up and down price swings are termed “volatility,” which most
analysts equate to risk.
Morningstar’s Star rating compares a fund’s historical returns to its
historical volatility. The ratings run from one to five stars, where
five is best. In each category (e.g. value, technology, energy), the
funds with the highest ratio of return to volatility earn five stars.
While a four or five-star rating doesn’t guarantee future performance,
it’s a good starting point. Require four- or five-star ratings.
Morningstar evaluates risk based on a fund’s historical share price
volatility compared to other funds in its category. The ratings are low,
below average, average, above average, or high. If you’re a risk-averse
investor, stick with funds rated “low.” If you have a higher risk
tolerance, also accept “below average” rated funds.
Next, check Standard Deviation, which is listed in the Volatility
Measures section of the
Risk & Ratings Statistics report. Unlike
Morningstar’s risk rating, which compares a fund to its category,
standard deviation measures absolute volatility, in other words, those
nasty price swings that keeps you up nights, and incite you to bail out
just when the fund has touched bottom.
Standard deviation values, which Morningstar measures for three-, five-,
10-, and 15-year periods, run from as low as 1 to has high as 30, and
sometimes higher. The higher the standard deviation, the more volatile
the fund. Use the five-year numbers, if available. Risk-averse investors
should avoid funds with standard deviations above 10, and all investors
should rule out funds with numbers above 20.
Switch to the
Performance report to see calendar year and trailing returns.
Calendar year returns are for specific years such as 2009. Trailing
returns, updated daily, are the average annual returns for periods
ranging from one day to 10 years, if the fund has been around that long.
Morningstar also compares each fund’s returns to the S&P 500 index for
each period. That figure will be positive if the fund outperformed the
index and negative if it underperformed.
Start with the trailing three- and five-year (average annual) returns
vs. the S&P 500. Passing funds must have outperformed the S&P by at
least five percent over both periods if they’ve been around that long.
For newer funds, outperforming the S&P 500 by five percent over the past
three years is acceptable.
Also check the one-year return. Since that is a relatively short
timeframe, require only that the fund match the S&P’s return.
Finally, note the 2008 calendar year return. That was the year the S&P
500 dropped 37 percent, the worst drop in recent memory, and almost all
funds recorded big losses. The fund’s 2008 return tells you what you can
expect in a bad year. Rule out funds that recorded more than a 30
percent loss in 2008, and lower is better.
Although, I’ve described important factors to consider when evaluating
funds, I don’t have room to list everything. For more fund analysis
information, check Morningstar’s Investing Classroom (click on
Learn in the Mutual Fund section).