Is It the Right Fund for You? Take Our 10-Minute Test
Use these rules to narrow the field.
These days, it seems that everyone has a "10-minute test" for picking stocks, including Morningstar's own Pat Dorsey in his Five Rules for Successful Stock Investing. Because there are now more than 8,000 mutual funds, the ability to figure out quickly which ones are worth detailed examination is as crucial in the fund realm as it is in the stock realm. Let's go through our 10-minute test for mutual funds to help you narrow your focus.
A caveat before we start: Many of the rules I list have exceptions. However, if you apply these shortcuts, you'll significantly increase your chances of eliminating the duds.
Examine What the Fund Owns
You should have an idea of what you want your asset allocation to be--how much money you want in stocks and bonds--before you start looking at funds. If you're looking at a stock fund, ask whether it owns lots of big, recognizable companies, which can make it suitable as a core holding. Or is it a small-cap fund that owns businesses that you haven't heard of before, making it a good candidate for a supporting player in a portfolio? Is the manager impressed with earnings growth, or is he or she more value oriented, trying to buy stable earnings or assets at a deeply discounted price? If it's a bond fund, does it hold longer-term bonds whose prices may bounce around as interest rates move, or is a shorter-term fund that will remain steadier but typically pay you less interest? Use the Morningstar Style Box for stock and bond funds to understand what a particular fund does.
Avoid High Expenses
Mutual funds are one of the few areas of life where paying more rarely gets you a better product. Fees cut into performance in a big way over the long term. For example, say you invested $4,000 a year for 30 years in each of two funds, one charging 1% a year and the other charging 2%. Assuming you earned an identical pre-expense return of 9% in both funds, at the end of the period you'd have accumulated $453,000 in the cheap fund and just $378,000 in the more expensive one. I would generally avoid any stock fund charging more than 1.25% and any intermediate-bond fund with an expense ratio above 0.75%. You may have to pay extra for more-specialized fund types, but there's rarely a good reason to pay more than 1.5% for any type of fund, no matter how exotic.
Look for Experienced Management
Another factor to consider is manager tenure. A manager who's been through a bear market or, better still, a couple of the market's routine ups and downs is more likely to stick to his or her style when the going gets tough instead of trying to time what's hot. We think sticking to a style is a strong prerequisite for long-term success in money management. Look for at least five years of experience. If a manager hasn't been running a fund that long, try to see if he's managed other funds successfully.
Avoid the Fast Traders
Although there are a handful of managers who have earned their keep by using fast-trading strategies, you can live a long and happy life without having such a fund in your portfolio. That's because quick trading doesn't exhibit the business approach to investing that we favor, whereby one tries to purchase a piece of the future profits of a business at a cheap or reasonable price. Quick traders also lose a large chunk of gains to the tax collector. Moreover, the commissions for all those trades cost shareholders money and aren't reflected in the expense ratio. If you're looking to winnow down the fund universe to a more manageable group, look for turnover ratios of 50% or less on stock funds, which implies that the fund is holding a stock for two years, on average.
Look for a Manager with Skin in the Game
One of my favorite parts of Morningstar's Stewardship Grade for funds is the manager-incentives section. I like to see how managers are compensated--specifically, if their compensation is based on longer-term performance (preferably five years) to show that their interests are aligned with those of long-term investors. For the same reason, I also like to check whether they have a significant portion of their own money in the fund. If it's a veteran manager running a core holding, I'd like to see an investment of $1 million in the fund. If we haven't graded a fund, look for these details in the statement of additional information, which you can request from the fund company or find on the company's Web site.
Check How Investors Have Used the Fund
Check out our new Investor Returns, which can give you an idea of the typical experience for investors in the fund. Is the fund so volatile that people tend to misuse it, piling in after extended strong performance only to sell their shares after a cold streak when the fund is about to rebound again?
Keep in mind that investors don't only misuse volatile funds. The Jensen Fund (JENSX), for example, exhibits minimal volatility relative to its large-growth peers. However, because it goes through periodic flat spells, it appears that investors often misuse it, based on its 10-year annualized return of 9.5% and its investor return of 5.9%. At a certain point, such discrepancies are not the fund's fault. Investors have to be responsible for their own misuse of mutual funds, and this case probably serves as an example of that.
Look at Long-Term Performance
Performance is usually the first thing that captures investors' attention, but it makes them forget about all the other important things that often result in or are the precursors to good performance. Moreover, investors often imbue short-term performance with too much meaning. Our advice regarding judging a fund's performance is that longer time periods provide the most insight into how a fund is apt to behave in the future. Five years should be the minimum, and 10 years is preferable. Keep in mind the dates of manager changes so that you attribute the correct performance to the manager who is running the fund now. The Morningstar Rating for funds is based on longer-term performance (when a fund has it), adjusted for volatility.
Beyond the 10 Minutes
Read Morningstar's fund analyses after you've completed the 10-minute test. My fellow fund analysts and I try to be sensitive to a particular fund's quirks, indicating when you should overlook things like fees (rarely) or recent performance (less rarely). Our analyses are also sensitive to what could go wrong with a fund--or at least what could put it in a slump--and conclude as firmly as possible whether we think a fund is a buy or sell.