Picking Mutual Funds to Outperform the Market

With over 6,000 mutual funds available, it may be tempting to pick funds from a popular star or index rating system. Savvy investors, however, balance multiple factors in their selection process. Ratings represent only the historical performance of funds and cannot predict the future. Performance consistency, management skill, and expense limitations are among the many factors that influence a fund's prospects. Each must be carefully evaluated to improve your chances of finding a fund to outperform the market.

Create a plan
Define your financial goals. Are you saving for retirement? Putting money aside for a home? Funding a child's college education? Your answer will have significant implications on your choice of mutual funds. More time gives you flexibility to use an aggressive approach. Immediate needs call for safety and capital preservation. Take careful consideration of your tolerance for risk. If the market dips, at what point would you lose sleep? Is it a 5% drop? 10% drop? An asset allocation plan will balance your portfolio and maximize return for your level of acceptable risk.

Dismiss recent results
Past performance is no indicator of future results. No truer words could ever be spoken and they are included in every mutual fund advertisement. But it's extremely difficult to ignore these numbers which the fund companies conveniently place in big bold letters - immediately above the fine print warning us. Nothing is more attractive than a fund with a great record, especially given the dismal performance in the market.

Past performance can provide a good starting point, but nothing more. In fact, past performance predicts losers better than the winners. A 1998 study from fund-tracking firm Morningstar, demonstrated the top fund performers rarely hold their spot on the charts. The study also concludes bottom performers rarely did anything but continue to sink. Never assume the past will repeat itself, yet, ignore a fund's historical record at your own peril. Avoid the perennial losers.

Seek consistency
Evaluate a mutual fund's performance beyond just the recent year. Any fund can get lucky, but it's the rare firm that prove themselves year after year. Examining a fund's long term performance can answer the question of consistency. If the performance was good, was it repeatable due to skill - or merely a spike due to dumb luck?

Watch for a solid record of returns, rather than funds showing spurts of great years followed by fits of lousy ones. Compare the fund's returns to a relevant benchmark index, (large-cap vs. S&P 500, small-cap to the Russell Index, etc.) Solid funds should not only consistently beat the benchmarks, they should also beat their peers.

Seek good managers
Always review the experience and performance of the fund's managers. When you buy a mutual fund, you are actually investing in the experience, skill, and savvy that the manager brings to the table. When the manager leaves, the fund performance generally goes with him. How many years has the manager been leading the fund? The longer (if generating strong results), the better. And keep an eye out for the gurus. The industry's better managers are well-respected, high-regarded, and often quoted in the press. You'll find multiple articles and even manager profiles published in the popular financial magazines and newspapers.

Think cheap
Check out the fund's cost of ownership. While you can not predict a fund's performance, you can control the ongoing expenses. Since expenses impact your ability to grow investments over time, select a fund with low costs. Check the expense ratio, sales fees, trading costs, and 12b-1 fees charged to cover the marketing, distribution and sales. Everything counts against your bottom line - keep it small as possible. When possible, choose funds with expenses less than their category average.

Taxes are often overlooked and can substantially reduce your after-tax gain unless investing within a tax-deferred, retirement account. Avoid funds with large distributions (capital gain payments) by searching for funds with low turnover. Since buying and selling stock incurs transaction costs, lower turnover translates to lower expenses and lower capital gains' taxes. Fund managers who seek to boost returns through repeatedly buying and selling securities are no friend of yours.

Putting it all together
Picking mutual funds is a challenging task. You will need to spend time learning, researching, investigating, analyzing, and comparing. The key is to develop your own methodology using some of the components listed here along with your own judgment and decision capabilities. Review your investment plan and fund selection criteria at least once a year. Make sure the plan still matches your goals and the funds match your expectations.

It's your money. It's your future. Take your time. Get it right.

Tim Olson

Mr. Olson is the editor of The Asset Advisor, a financial investment service providing proven strategies for no-load mutual fund investors. He brings 26 years of education and experience from Stanford University, Ernst & Young financial consulting, personal wealth management, and venture capital investing.