Finding Profitable Funds

Questions abound when it comes to mutual fund investing. Fool contributor Tim Beyers recently put together a few of the toughest for an interview withMotley Fool Champion Fundschief analyst Shannon Zimmerman.

Tim: I recently wrote that I wouldn't invest in biotech because I didn't understand it. A reader responded that maybe I ought to consider a biotech sector fund to get some exposure to the industry. That sounds like a decent idea. Is it?

Shannon: By and large, I would say no. One of the main reasons people invest in mutual funds is that they've had it with the volatility of individual stocks. And to the extent they invest in a mutual fund that targets a narrow segment of the market, they're just courting volatility again.

That said, there are exceptions. For example, I think there are good health-care sector funds. Vanguard Health Care, for instance, is a good fund because it's cheap, has a great manager, and invests in a wide swath of the health-care industry. Right now, the fund's portfolio includes "usual suspect" big-pharma names such as Pfizer (NYSE: PFE  ) , Schering-Plough (NYSE: SGP  ) , and Merck (NYSE: MRK  ) . But it also holds CVS (NYSE: CVS  ) , a rapidly expanding drugstore chain; Cardinal Health (NYSE: CAH  ) , which is mainly a medical-goods distributor; and biotech companies such as Amgen (Nasdaq: AMGN  ) and Gilead Sciences (Nasdaq: GILD  ) .

That's a good mix, I think, and health-care funds can work because they target a diversified industry, one that's broad enough to give fund investors the broad diversification they want -- and need. I'd argue that it's also possible to find quality real estate sector funds, mainly because real estate is an asset class unto itself. We just highlighted an excellent real estate pick in Champion Funds, in fact.

Tim: You've written a few times that there's no single easy way to judge a fund. If that's so, then what tells you whether a certain fund is likely to be a profitable bet?

Shannon: Investors should always evaluate a fund based on several core criteria. First would be the experience and track record of the manager who is currently in charge. Sure, some folks would be inclined to make decisions on a star rating like Morningstar's. But that's purely based on past performance and may have nothing to do with the current management team and its track record.

Another consideration is the price tag. A typical stock fund might run with a price tag of roughly 1.5% -- a fee, by the way, that is shaved off your investment each and every year. That's not cheap, so savvy investors would do well to look for funds that are below that figure, preferably much below it. It's just simple common sense, after all. The higher the price tag, the higher the hurdle for the fund when tracking against benchmarks and cheaper competitors.

A third point would be strategy. Investors should ask: How does a manager go about picking stocks? Does he make big bets on certain industries, or does he give you a broadly diversified portfolio? I also tend to favor managers who have bottom-up strategies, those who are familiar with the fundamentals of the companies they invest in. These guys like to get in and kick the tires, and they're different -- radically different -- from those who make top-down calls -- you know, managers who look for "hot" industries or market segments and then load up on stocks in those areas. That's almost always a bad way to go.

Finally, investors should know the ethical reputation of the fund company they're dealing with. The main question to consider here is whether the manager "eats his own cooking" by investing in the fund alongside you. For my money, few details are more telling than that one.

Tim: You've mentioned this before. Aren't the feds going to start requiring this?

Shannon: Not exactly. Fund managers won't be required to eat their own cooking, but they will be required to disclose how much they voluntarily consume.

Tim: Stop it, you're making me hungry.

Shannon: No, seriously. During the second half of 2005, investors should be able to open their fund prospectuses or annual reports and see just how large an interest management owns. It probably won't be too different from what's disclosed in most stock proxy statements, and that will make the job of evaluating funds infinitely easier. As you might imagine, I couldn't be happier about it.

Tim: Let's talk about measurement for a second. I've heard so-called experts say over and over that it isn't fair to benchmark most funds against the S&P 500. Is that true?

Shannon: There are two main points to bear in mind here. First, we benchmark all the Champion stock funds against the S&P 500 because, at the end of the day, an S&P 500 index fund is always a viable option for investors -- at least for those investors who don't mind sinking most of their money into large-cap stocks and lagging the broader market each year by about the amount of their fund's annual expenses.

Second, when it comes time for me to make recommendations for the newsletter, I don't just look at a fund's returns vs. the S&P. I also consider how the fund stacks up against its relevant benchmark -- you know, the one that provides the best proxy for the manager's investment style. For example, it's best to measure foreign stock funds against the MSCI EAFE, an index that tracks the vast array of international stocks in the same way the S&P tracks the domestic market.

The bottom line is you want to make apples-to-apples comparisons so that you can differentiate between those managers who are legitimately good stock pickers and others who just happen to be at the right place at the right time.

Tim: You know that here at the Fool we preach the gospel of undervalued stocks. How can you tell if a fund is undervalued?

Shannon: Technically, there really is no way to value a fund like you would a stock. You can't use net asset value (NAV) -- the price of a share of a fund -- in the same way that you can use stock prices. NAV just equals all the fund's assets (including the cash it holds) divided by its shares and lowered to account for the impact of expenses. That doesn't give you a basis for valuation. Also, there's no supply-demand dynamic with shares of mutual funds as there is with stocks. If a fund is accepting new money, there will always be shares available.

That said, valuation-conscious investors can and should look at the valuation metrics of a fund's portfolio. A lot of fund firms are putting this data on their websites. So, for example, you could take a look at how a stock fund's composite holdings stack up on a price-to-earnings or price-to-cash flow basis vs. the S&P 500. Doing so might reveal a richly valued basket of stocks and could indicate that's a fund's current portfolio -- or perhaps even its manager's investing style -- has little room left to grow.

Tim: I have to ask: I wrote recently that the fund scandal appears to be winding down. What do you think? Have I gone mad?

Shannon: You sure you want me to answer that? No, seriously, you're not totally off, but that question has to be answered on a company-by-company basis. It's been a year since the fund scandal broke, so I do think it's now possible to begin separating the funds that have taken the right steps from those that haven't. That's good news for investors.

Tim: OK, then, smarty pants. Let's name names.

Shannon: Well, I don't want to out-and-out endorse any of the fund shops that were implicated in the scandal because it's absolutely still a case of seeing how they'll behave over time. That said, I think that Alliance, Janus, and PBHG have made meaningful strides. Heads have rolled at those shops and huge fines have been paid. Each of them has agreed to a fee reduction program to boot, so any fund investor -- particularly a cheapskate like me -- has just got to love that.

One other point on the scandal: If any of this happens again, the SEC and, no doubt, shareholders are likely to come out with both guns blazing. If so, it will probably result in the equivalent of the death penalty for many of the fund companies involved.

Care to read up on Shannon's recent insights on funds and fund investing?

Fool contributorTim Beyersstill occasionally flirts with funds, but his first financial love remains stocks. He owns no shares in any companies mentioned, and you can view his Fool profilehere. The Motley Fool has adisclosure policy.


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