The Keys to Picking Winning Funds

It's easy to overdose on data when choosing funds. Numbers can be interesting, but only a few really help you make good selections. Unfortunately, many investors have a hard time figuring out which stats to use and, all too often, make the mistake of leaning too heavily on a fund's returns over the past year. Instead, here are some things that you should look a closer look at:

Expense ratio
This one's simple: You improve your odds of success by investing in funds with low fees. Over a 10-year span, stock funds whose annual expense ratios are among the cheapest 20% in their categories are 1.4 times more likely to outperform and survive those in the second-cheapest quintile. And the least-expensive funds are 2.5 times as likely to outperform and survive those with expenses in the highest 20% of their categories.

Stewardship
Some funds watch out for shareholder interests, and others treat investors as if they were second-class citizens. For instance, some sponsors will keep a fund open to new clients even though existing shareholders would be better served if the fund closed. Over a lengthy holding period, a fund company will have many opportunities to choose between maximizing profits and protecting shareholders. I want the good guys on my side. Steer clear of funds with Morningstar Stewardship Grades of D or F.

Risk
Most investors are better off avoiding high-risk funds. That's because it's tough to stay put when a highly volatile fund gets whacked, even though holding steady might be the right course of action. The Morningstar Risk rating gives you a quick assessment of how dangerous a fund could be.

The bear market that ended (I hope) on March 9 also provides a very real measure of funds' risks. Check how a fund fared in 2008, when the stock market tumbled 37%. In fact, before you buy a fund, look back over at least 10 years' worth of returns to see how it fared in different climates. This should enable you to set realistic expectations and prepare you better for potential losses. But you should also ponder how you handled losses during the bear market. If you couldn't stand the pain in certain funds and unloaded them, then look for more-conservative investments.

Manager Stake
In 2005, regulators started requiring managers to disclose how much of their own money they had invested in their funds. But that information is buried in the mountains of paperwork that funds must file, and few investors have the time, patience, and inclination to ferret it out. Fortunately, we've loaded the data into our computers at Morningstar.

It makes sense to follow the lead of insiders. After all, who knows a fund better? It turns out that fund managers are all over the place when it comes to putting their money where yours is. Most don't have a dime in their funds, yet hundreds have more than $1 million invested. Consider a fund only if at least one of its managers has $500,000 or more invested in it.

To see how your fund rates on the criteria described above, take the Spy Selector test.

Management Quality
The final step--identifying good managers who employ sound strategies--is the subjective part of the process. You can learn a lot from fund shareholder reports and from reports at Morningstar.com. In Fund Spy, I identify the great fund companies and the also-rans. I also describe 20 great funds that pass my tests. Among them are  Harbor Bond (HABDX),  T. Rowe Price Small-Cap Value (PRSVX), and  Dodge & Cox International Stock (DODFX).

For more tips on identifying the most important information and picking the best funds, see my new book, Fund Spy: Morningstar's Inside Secrets to Selecting Mutual Funds that Outperform.

From Kiplinger's Personal Finance magazine, August 2009.

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