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By Jason Stipp | 10-18-2011 11:22 AM

Kinnel's Tips for Fund Picking

Morningstar's director of fund research Russ Kinnel discusses the hallmarks of good index and actively managed mutual funds.

Jason Stipp: I'm Jason Stipp for Morningstar.

As part of Morningstar's 5 Days to Better Investing, we are checking in today with mutual fund director of research Russ Kinnel to learn a little bit about some of the hallmarks he looks for when picking a good mutual fund.

Thanks for joining me, Russ.

Russel Kinnel: Good to be here.

Stipp: So, there is a lot I want to talk to you about, but I think it's easiest to start with index funds, because these would seem to be the easiest funds to compare with one another. When you are looking at an index fund, if you want to purchase one, what are some of the hallmarks of a good one?

Kinnel: I think for starters, obviously, cost. The whole point of indexing is to have lower cost, so you want a low expense ratio, and today there are low-cost index funds in just about every category, so that's great.

In addition, you want to look for diversification, a really broad fund like a total stock market, because that way you are keeping turnover low, and you are covering a lot of ground. If you have a really niche fund that's say small value or something like that, it's going to have a higher turnover to stay within those boundaries, and that means higher trading costs, and again that gives away some of the advantage. So, low-cost, diversified, core funds.

Stipp: Does there tend to be any issues with an index fund not particularly following its index very well. How can you tell if it's really doing what it's supposed to do in tracking the performance of that benchmark?

Kinnel: Well, you can look at its yearly performance versus that benchmark. Ideally it should be something close to its benchmark's returns minus its expense ratio. Usually for broad index funds, you don't see that problem very often. For bond index funds, though, it occasionally has been a problem. So, if it's more of a niche area or a bond index, you might want to take a close look.

Stipp: OK. I want to talk a little bit about the star ratings. So, it would seem like logic would say that index funds would tend to have 3-star ratings because they are following the broad market. Is that the case first of all, and secondly, if so, then how do you think about star ratings when you are examining an [index] fund?

Kinnel: Well, I would say first off, it isn't necessarily the case, because a good index fund is going to provide superior risk-adjusted performance, and that's what the star rating is measuring. In fact, right now the three largest index funds all have 4 stars, so ... it doesn't necessarily mean they're locked-in. I do think with an index fund, you start with cost first. Star rating tells you something about its past performance, but I think cost and a broad portfolio are probably a little more important for an index fund.

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