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How
to Pick the Best Mutual Funds
In a recent
column, I described how to search
for worthwhile mutual fund candidates using Morningstar’s
free mutual fund screening program. At the end, I cautioned that
the funds turned up by the screen were candidates for further research,
not a buy list.
Today, I’ll follow up with some suggestions about
how to research mutual fund candidates. You could apply the analysis to
funds turned up by my screen, as well as to funds that you’ve uncovered
in other ways.
Screening Requirements
In my screening column, I suggested looking for no-load funds
rated five stars by Morningstar, with Morningstar “low” or “below
average” risk ratings, and with three- and five-year historical returns
at least as good as the S&P 500 index. I also advised stipulating that
the same manager had to be running the fund for at least five years.
Finally, I suggested specifying that passing funds should have minimum
initial purchase requirements consistent with your specific needs.
Today, I’ll assume that the funds you are
researching meet those requirements, with the possible exception of the
five-year historical return and five-year manager tenure. Specifying
five-year returns and manager tenure disqualifies newer funds. While
funds with five-year track records are desirable, I’ll leave it up to
you whether you want to allow funds with only a three-year history.
Morningstar is the only site I know of with all of
the data needed to do the analysis I’m going to describe. Start by
entering your fund’s name or ticker symbol on Morningstar’s homepage
(www.morningstar.com)
to see the
Snapshot report for the fund.
If Not From Screen
If the fund didn’t come from my screen: confirm that your fund is
rated five stars by checking the Morningstar Rating in the Key Stats
section. Also, in the Key Stats section, confirm that the fund is no
load by looking for the word “none” under both “Front-load %” and
“Deferred Load %” in the Key Stats. The required minimum initial
investment is also listed in under Key Stats. Use the Morningstar Rating
report to confirm that the fund’s Morningstar Risk rating is either
“low” or “below average,” and the Management report to confirm the
manager’s tenure.
Check Returns
For all funds, whether from my screen or not, switch to the Total
Returns report to see the fund’s calendar year and trailing returns.
Calendar year returns are returns for specific years such as 2004 or
2005. By contrast, trailing returns are the average annual returns for
periods ranging from one to 10 years, if the fund has been around that
long. The trailing returns are computed through the previous market day,
and thus, are more current than the calendar year returns.
Morningstar also compares the fund’s performance to
the S&P 500 index for each period. That figure will be positive if the
fund outperformed the index during the period and negative if it
underperformed.
The most important figures are the fund’s trailing
3- and 5-year returns vs. the S&P 500. Look for funds that outperformed
the S&P by at least 5%, ideally over both the
three- and five-year periods. If you decide to waive the five-year
check, require at least 8% outperformance vs.
the S&P 500 over the past three years.
Also check the fund’s one-year returns vs. the S&P
index. Since, one-year is a relatively short timeframe for evaluating
fund performance, require only that the fund match the S&P’s return.
Ignore year-to-date and the shorter timeframe’s listed by Morningstar.
Finally, in the return section, note the 2002
calendar year returns. That was the year the S&P 500 dropped 22 percent,
making it the worst year in recent memory. By noting a fund’s 2002
calendar year’s results, you can see how it performs during a bad year.
Absolute Risk Measure
Next, we’ll consider risk, using Standard Deviation, which you
can find in Morningstar’s Risk Measures report. Unlike Morningstar’s
risk rating, which compares a fund’s volatility only to other funds in
its same category (e.g. small-value, banks, tech stocks, etc.), standard
deviation measures historical price volatility on an absolute basis.
It’s the price volatility that keeps shareholders awake nights and
incites them to sell just when a fund has touched bottom.
Standard deviation values run from as low as 1 to
has high as 30, and sometimes higher. The higher the number, the more
volatile the fund. Your maximum acceptable standard deviation depends on
your risk tolerance. Risk averse investors should avoid funds with
standard deviations above 10, and all investors should rule out funds
with values above 20.
Another Risk Check
Our final risk measure is price/earnings ratio. You may be
familiar with the price/earnings ratio of a stock, which is its recent
share price divided by one-year’s per share earnings. A mutual fund’s
price/earnings ratio is the based on the average P/E of its individual
stocks. Morningstar does some extra data manipulation that results in
lower P/Es than you’d get by simply averaging a fund’s individual stock
P/Es (typically 60 percent to 75 percent of the simple average).
Research has found that low P/E mutual funds are
less risky and produce better returns than high P/E funds. Using
Morningstar’s numbers, risk averse investors should avoid funds with
P/Es above 15 and all investors should avoid funds with P/Es above 22.
I’ve described the most important factors to
consider when evaluating funds, but I don’t have room to list
everything. For more fund analysis information, check Morningstar’s
Investing Classroom (click on Learn near bottom of
home page).
published 6/25/06 |
