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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.


Stipp: So, I want to turn and talk about active funds. These seem to be more difficult to assess just because of the fact that if an active manager is really taking certain bets that are different than the market, you're going to see periods of outperformance, and you're going to see periods where the fund doesn't keep up with its benchmark or with its category peers. When you're examining an active manager's record, how do you read through that to see if he really is adding value?

Kinnel: Well, for starters I want to look at their record versus their benchmark and peers over that manager's tenure. So, if they started eight years and three months ago, start the period at eight years and three months ago--you can do that with our charts--and go forward and see how did they do against their category peers and their index, and if they outperformed, then maybe you are onto to something.

Next step, go look at calendar-year returns to see, one, what's the worst that happened to get an idea if it's a risk level you can tolerate, and two, go and look at how did they do year-to-year. Did they do well in value years, growth years? How close are they to the index? Is it a really extreme fund that is widely variant from the index, or is it one that is a little more predictable, so you have a better feel for what you're getting in that fund.

Stipp: I know that we have seen, for example, that some funds can do well over time, but investors don't always use them very well. What's the issue with that? Why is it that we have seen some funds that have great performance but the investor returns, or investors' experience in those funds, just hasn't been as good as those funds' stated returns?

Kinnel: I think with the higher-risk funds, you have the problem of funds can have good long-term returns, but year-to-year they might have terrible returns, and in order to get those long-term returns, you have to tolerate those risks. And I think sometimes people don't really realize what they are getting into when they buy a fund. They may not realize that while its 10-year numbers are great, it actually can take some big risks, and so you really need to understand the risks, and you also need to set your time period right. If you're buying a focused-stock fund, you need to hold it for 10 years or more. If that's not aligned with your goals--if you want to spend it, say, in five years--then you shouldn't be in a focused-stock fund.

Stipp: Another thing that we've been talking about is examining the manager's record over past time periods and different timeframes, annual returns, which can certainly give you a good sense of how the fund has done in the past, but if you want to know can this keep up, will this manager be able to continue to do it in the future, what the fund's prospects might be going forward, what do you look at to get clues about that?

Kinnel: Well, the record is obviously helpful. Fees are very helpful. Even with actively managed funds, the best ones tend to have low cost and therefore have less ground to make up on an index fund. I also look for consistency--consistency of management and strategy. That is, the management should be there for a long time. You shouldn't have many managers or analyst turnover. The way they invest should be consistent, and that doesn't mean necessarily they are always in the same part of the style box, but that they are consistently following their explained strategy.

Stipp: You mentioned fees in there, so we do know that actively managed funds tend to have higher fees, and I know fees are one of those more pertinent indicators of a fund's future prospects--lower fees being better--but given that you probably will pay a bit more for active funds, how do you know how much is too much to pay for one of these offerings?

Kinnel: Well, I think it really depends on a case-by-case basis, but I think ideally you want a fund that's below average or low, and we spell that out on each fund's data page. Low fee funds or below-average-fee funds are much more likely to outperform. High-cost funds are very unlikely to outperform, and so you really tilt the scales in your favor when you go for low cost. So, if you want a rule of thumb, I would say maybe something like a 1% or 1.25% or under for a stock fund, maybe 70 or 80 basis points or lower for a bond fund

Stipp: So, we've been talking about individual securities so far, but what about the fund company? What do you want to look for? What hallmarks of investor friendliness will tell you that this company probably has your best interest at heart?

Kinnel: So I think you want a really good steward, a fund company that, when push comes to shove, they do the right thing for investors, and that means being open with their shareholder communication, keeping fees low, not launching crazy funds, trendy, gimmicky funds, and obviously, not getting in trouble with the SEC.

Stipp: So, I know also one of the things that you folks look at is managers that invest in their own funds. What can that tell you? Does it have any sort of predictive ability that you've been able to see?

Kinnel: There does appear to be some predictive ability. It just makes sense that managers are the best informed investors about their funds, and it's no accident that the fund managers who invest more in their funds tend to do better. They also tend to invest in lower-cost funds, and you'll see that some managers for all the talk they put out there, they might not invest in their fund. Maybe they think it's gimmicky; maybe they think the fees are too high. And that's a pretty telling sign.

Stipp: So, if the manager has skin in the game, it's a good sign that it probably could be a good bet for you if you like the other hallmarks of success on that fund?

Kinnel: That's right. They're aligning their interests with you. If they're not invested, then their interest might not be aligned with yours.

Stipp: All right, Russ. Thanks so much for the tips on picking an index or an actively managed fund and for being here today.

Kinnel: You're welcome.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.