Sometimes, finding a great mutual fund can be harder than finding a great stock.
Why? When selecting a fund, an investor must consider the fund manager's experience and investing style, the fund's fees and expenses, and its top stock holdings. The extra research is almost enough to make you want to avoid mutual funds altogether.
But mutual funds, if chosen properly, are an important part of any portfolio and are worth the time and effort to research. Not only do mutual funds diversify your portfolio, but a well-chosen fund also takes some of the legwork out of monitoring your investments, so you can get back to the things that really matter.
The easy way out isn't
Unfortunately, many investors take the easy way out when researching mutual funds -- they equate past performance with a good fund and end up chasing past returns.
And mutual fund marketers wouldn't want it any other way -- it's just too profitable!
According to The Economist:
The average profit margin ... was a staggering 42%. In part, this is because most fund managers do not compete on price. Instead, they persuade their clients to select their funds on the basis of past performance, even though there is little evidence to show that this is a good predictor of future success.
Why past performance is a bad gauge
See, mutual funds are required to post one-, three-, five-, and 10-year performance statistics. As a result, not much public attention is paid to year-by-year performance, yet oddly enough, those are the performance figures that matter most -- especially in uncertain markets like the one we're seeing currently.
After all, the markets have been pretty good over the past three-, five-, and 10-year periods. Honestly, a fund manager would have to be really bad not to have made any money since 2003. In fact, according to Yahoo! Finance, less than 1% of U.S. stock mutual funds have actually lost money over the past five years.
In other words, five-year returns don't mean much right now.
Even the longer 10-year measurements can be misleading. Over a 10-year period, a fund could have two years of tremendous gains, fall asleep for the other eight years, and still post positive returns.
For example, the Firsthand Technology Value (TVFQX) fund, which invests in tech names such as SanDisk (Nasdaq: SNDK), Corning (NYSE: GLW), and Seagate Technology (NYSE: STX), can market positive 10-year returns, but the road has been anything but steady.
Consider some of these "bumps" along the way:
|
Year
|
1999
|
2001
|
2002
|
2003
|
|
Fund Return
|
190%
|
(44%)
|
(56%)
|
74%
|
Source: Yahoo! Finance.
Even the most strict buy-and-hold investor would have trouble hanging on through all that turbulence.
Look for trends
Instead of selecting mutual funds by zeroing in on annualized returns, focus on how fund managers have performed on a year-by-year basis to see how consistently they performed versus the market.
Two funds that have beaten the market at least five of the past seven years are Vanguard Windsor II, which counts Pfizer (NYSE: PFE) and Verizon (NYSE: VZ) among its top holdings, and Muhlenkamp, which currently invests in names such as Caterpillar (NYSE: CAT) and BHP Billiton (NYSE: BHP).
Both funds are led by tenured managers -- James Barrow and Ron Muhlenkamp, respectively -- who have run the gantlet before and know how to handle different market landscapes. Although neither of these funds is likely to double in a given year, they're just as unlikely to lose half of their value. Since 1993, there has been only one year in which either fund lost more than 10% -- 2002, when the S&P 500 itself shed 22%. And even then, neither fund lost more than 20%.
Consistency is my middle name
Hall of Fame pitcher Tom Seaver once said about baseball, "If you dwell on statistics, you get shortsighted. If you aim for consistency, the numbers will be there at the end."
The same logic applies to finding the best mutual funds. Instead of focusing on annualized returns, look for funds led by tenured managers with consistent track records of year-by-year outperformance and who don't charge an arm and a leg for their services.
These are exactly the kind of funds that our Motley Fool Champion Funds service recommends to subscribers each month. That tack works -- on average, Champion Funds recommendations are outperforming the S&P 500 by 19 percentage points. Even more important, 84% of those picks are currently ahead of the market.
Want to see our track record? A free 30-day trial to the Champion Funds service is yours.
Fool contributor Todd Wenning consistently fails to do the dishes, much to his wife's chagrin. He does not own shares of any company or fund mentioned. Pfizer is a Motley Fool Income Investor and Inside Value pick. Vanguard Windsor II and Muhlenkamp are Champion Funds selections. The Fool's disclosure policy is more Ted Williams than Mario Mendoza.
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