As the chief analyst for Motley Fool Champion Funds (a free trial is yours for the taking), I am constantly sifting the universe of mutual funds in search of those few that meet my strict criteria. It's true that I'm a Fool for funds, but I'm also a fund snob. When roughly 75% of the suckers lose out to the S&P 500 over the long haul, and when your job is to steer folks toward those poised to beat that benchmark, you have to be selective -- or, as a few of my so-called friends like to say, cranky.
Call me cranky
I just don't think fund investors should have to pay -- sometimes a lot -- for the "privilege" of underperforming. After all, a low-cost index fund -- such as Vanguard 500 Index
With that goal in mind, I highlight below two of the primary areas that I focus on while ferreting out mutual fund Champs from the pack of mangy mongrels: performance and managerial tenure.
Past performance, as they say, is no guarantee of future returns. Picking a mutual fund on the basis of how it's done in the past would be tantamount to driving down the freeway while staring into the rearview mirror. Good luck to you, road warrior, but don't mind me while I hotfoot it to another lane. A fund's star-studded track record, after all, may very well belong to a different management team or to an exceedingly risky strategy.
On the other hand, a fund's past performance can shed light on its future prospects if that track record belongs to a manager who's still at the controls. Therefore, when I go shopping for mutual funds, I'm really shopping for a manager, and it's his or her track record that I'm most interested in gauging. Typically, my "gauging" takes the form of an interrogation -- the mutual fund equivalent of the third degree.
[Cue blinding klieg light into the eyes of unsuspecting fund manager.]
So tell me, pal, has your fund beaten the S&P 500 during your time at the helm? And just how well has it fared relative to its official benchmark? What about tax efficiency? Do you do everything humanly possible to retain as much of the fund's pretax gains as possible? And just how well has your charge stacked up relative to other funds that pursue a similar strategy or, for that matter, the same segment of the market? What about volatility? Has your fund soared in bull markets but sunk during bears (or vice versa)?
OK, fun as that would be, I don't really have a klieg light. Alas, annual reports, SEC filings, and prospectuses contain much of the evidence I need to do my work. Using those dry-as-dust documents to answer my questions -- and filtering the answers through my own (entirely civil) conversations with money managers and my own experience -- I'm able to make judicious use of a fund's historical performance.
All of which leads to a second critical factor in my assessment: managerial tenure. To be a Champ, a fund must have an experienced manager at the controls, a seasoned stock (or bond) picker who has lived through enough market cycles to understand how to execute his strategy in various environments.
I'm definitely not looking for a manager who changes his stripes to suit Mr. Market's moods. If a small-cap manager suddenly starts buying Starbucks
Instead, I want to invest with someone who has the courage of his convictions, someone who understands that, even when the market isn't shining on his style, there are still compelling opportunities to be found -- maybe even on the cheap.
That said, I don't have a hard-and-fast rule about how long a manager needs to be at the helm of a particular fund to make the grade. If Bill Miller -- of Legg Mason Value TrustFund (LMVTX) fame -- jumps ship or opts to add a new Legg Mason charge to his resume, you'd better believe I'll give it close scrutiny. That guy is good. (Sure wish Value Trust cost less, though.)
The bottom line
There's nothing magical or intrinsically worthwhile about a mutual fund in itself. A fund is only as good as the folks picking the investments. As I go about the business of digging up the industry's very best each month in Champion Funds, it's the managers' permanent records I study most closely.
For those of you who are feeling especially ambitious, here's a little homework: Next time a commercial touts a mutual fund's past performance, see if you can spot -- in the voice-over or fine print -- any reference to the folks responsible for that fine showing. But be forewarned: You might need a klieg light to find it.
This article was originally published on April 13, 2004. It has been updated.
Shannon Zimmerman, lead analyst for Motley Fool Champion Funds , is thinking of becoming a bit more selective when it comes to choosing his friends. He owns shares of Vanguard Total Stock Market, and he'd like you to know that The Motley Fool has a disclosure policy .