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Guidelines for Selecting Winning Mutual Funds

Mutual funds are a good way of achieving diversification of your investment portfolio. Most funds own fifty or more individual stocks. So if one of their stocks takes a nosedive, it doesn’t have much effect on the fund’s performance. Mutual funds also give us the benefit of professional management, most have a staff of analysts and access to information we can’t get. Even with all these advantages, many mutual funds underperform the overall market.

How do you find the best performing funds?
Dr. Paul B. Farrell offered some guidelines in a recent article I found on Quicken’s Website (www.quicken.com). Farrell is mutual funds editor of CBS MarketWatch and author of the book "Mutual Funds on the Net."

In his article titled "Are Brokers an Unnecessary Luxury" Farrell suggests seven rules to successful fund investing:

  1. Pick managers with proven track records.

  2. Diversify your portfolio with 6-11 funds.

  3. Stick with no-load funds.

  4. Pick funds with low operating expenses.

  5. Avoid funds with high turnover ratios.

  6. Screen for high return, low-risk funds.

  7. Plan your asset allocation for the long haul.

Quicken.com recently added a group of fund search tools that make finding mutual funds meeting Farrell’s criteria as easy as pushing a button.

Here’s how it works.
From Quicken’s main page, click on Investments, and then Fund Finder listed under Inside Funds. Fund Finder gives you a selection of three mutual fund search tools: Popular Searches, EasyStep and Full Search.

Searching is what you do when you pick up a financial newspaper or magazine and look through the pages and pages of mutual fund performance tables. Internet search tools speed up the process by a huge factor. There are a number of mutual fund search tools available on the Web, but Quicken’s are the easiest to use.

Click on Popular Searches and you’ll see a list of eleven pre-designed searches. Running any of these searches is easy—just click on the search name.

The first search I tried is called "Morningstar’s Best–Ranked by 5-year Performance." Morningstar is one of the premier mutual fund rating services. Morningstar grades funds by giving them a star ranking—from one star to five stars—five stars is the best. Their ranking system combines historical return and risk. A five-star fund has shown the best combination of high returns and low risk. So funds with high Morningstar rankings automatically meet Farrell’s rule calling for picking only high return, low-risk funds.

Clicking on ". . . Ranked by 5-year Performance" brings up a list of the twenty-five, 5-star funds, with the highest five-year performance. Quicken also lists the Front Load, Expense Ratio, Manager Tenure, and 5-year return for each of the listed funds.

That makes it easy to check three more of Farrell’s selection criteria.
You can determine the manager’s track record indirectly from the manager’s tenure. All funds appearing on the list have great five-year returns. So if the manager has been with the fund five years, they meet Farrell’s proven track record requirement.

Farrell says to stick with no-load funds. Loads are the commission you pay to buy a fund. In his article Farrell makes the case that after adjusting for the load, no-load funds produce better returns than load funds. If you agree, skip over funds with Front Loads other than zero.

Another of Farrell’s rules says to pick funds with low operating expenses. The expense ratio is the sum of all expenses incurred by the fund (except load fees) divided by the fund’s assets. It makes sense, every dollar a fund spends on salaries and fancy offices comes out of the money, we as shareholders, get. He gives no specific number as too high, so I suggest 1.5 percent for a maximum expense ratio.

With the push of a button and a quick perusal of the list, we’ve covered everything Farrell says to look for in a single mutual fund except portfolio turnover. You can find the turnover of a fund’s portfolio on the Morningstar site (www.morningstar.net).

With just a little more work,
you can make Quicken give you a list of funds that already meet Farrell’s rules.
Select EasyStep Search, follow the simple directions and make the following entries.

  1. Morningstar Categories: All Categories

  2. Morningstar Rating: 5 stars

  3. Total Return: beats S&P 500

  4. Front Load: none & Expense Ratio: 2 percent or less

  5. Total Net Assets: any & Manager Tenure: 5 years or more

The resulting list is just a starting point. You need to do more research before making your final decisions. We’ll cover that in future columns.
Published 02/28/99

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