What Makes a Mutual Fund an Analyst Pick?

While we Morningstar analysts each have our individual biases, more often than not, we agree about what makes a fund a good one. As such, a regular feature on Morningstar.com has been our  Fund Analyst Picks, which represent our best ideas on a category-by-category basis. (We also compile a list of funds  worth avoiding.) These funds share many of the traits of funds we own or would want to own. In fact, many of our own portfolios include funds that make it on this list.

So, what exactly are we looking for in a Fund Analyst Pick?

Consistent, Thoughtful Strategies
In our experience, successful funds tend to be driven by consistent, repeatable strategies. Nothing draws our ire more than a manager who suddenly switches strategies midstream to accommodate either the market or marketing folks. The reality is that most strategies will hit a rough patch eventually, but the key to long-term success is staying focused on the strategy and riding out those rough patches. 

Experienced, Successful Management
Although there are some notable exceptions, we rarely put a fund on our picks list unless management has years of experience. In some ways, this trait is linked to the last point about not switching strategies, because experienced, successful managers are less prone to get caught up in fads or short-term trends. They are also likely to demand more from newer analysts, deepening the quality of the bench at their firms. There are instances in which there are no experienced managers at the helm of an Analyst Pick, but in those cases we have put a lot more stock in the quality of the organization supporting the managers.

Low Expenses
This is an obvious metric but one on which we put a great deal of emphasis. Simply put, we won't buy funds that charge too much. In fact, there are several funds that come to mind for which we like the strategies and managers but just won't add the funds to the list because expenses are too high. Expenses have greater predictive value than any other data point in the fund universe. True, there will always be a handful of costly funds with great performance, but they're less likely to enjoy continued success than those with lower expenses. Realistically, returns on stocks and bonds may be fairly modest for the next decade, so every penny saved in expenses can have a meaningful impact on your bottom line 10 years from now.

Good Stewards
No evaluation of an investment manager is complete without a consideration of whether they are acting in the interests of shareholders. We like to see managers who are compensated based on long-term performance and who invest in the funds they manage, boards that are engaged and communicating with fundholders, and shareholder reports and letters that are honest, thoughtful missives. Those are signs that management cares about its main constituency, the fund's shareholders. As such, no fund with a  Stewardship Grade below C can make our list.

We're not just doing this because we want to invest with Boy Scouts. These factors can have a big impact on returns. Funds with large sums of managers' money at stake often are managed in a more tax-efficient manner, for instance.

Other Considerations
Investors will note that each category contains an assortment of picks that are often quite different from one another. That's because we recognize that different funds come with different risks and that it's rare for one fund to be suitable for everyone. We want our Analyst Picks list to be useful to a broad swath of investors, so each category tends to contain an assortment of funds. Nonetheless, we won't just include a fund to add variety to a list. It must rank among our favorites and meet all the criteria we've listed.

Due to investor demand, we also include closed funds on our list. Keeping closed funds on the list is an effective way for investors in the fund to track if we still think highly of it.

That said, we won't always have picks in each category if we're not particularly enthused by the available options. That was long the case, for example, in the Japan-stock category. Similarly, not all categories are suitable for everyone, and we aren't recommending that investors own one fund from each category. Rather, we're offering up choices in a variety of categories and leaving the decision of what may be suitable to investors themselves. In fact, outside of real estate funds, most of us here would agree, for instance, that few investors need to own a sector fund.

It's important to note that Fund Analyst Picks are entirely separate from the Morningstar Rating for funds, which is quantitatively driven. For more on the difference between these two assessments of a fund's worth, click here.

Inside the Process
Each category is assigned to an analyst who gets to know the funds inside and out. We have regular reviews in which the analyst defends his or her recommendations for picks in the category to a four-member committee consisting of Russ Kinnel, director of fund research; Karen Dolan, director of fund analysis, senior analyst Mike Breen, and senior analyst Bridget Hughes. We vet the analyst's recommendations and submit suggestions of our own, eventually deciding on the final choices with the analyst.