Last week, I wrote about the importance of a fund's price tag, and why that figure is high on the critical list of criteria I use when selecting funds for the Motley Fool Champion Funds newsletter service. Simply put, because the expense ratio represents the percentage of your investment that the fund company takes back each year to cover costs and make a profit, the lower that figure, the better.
Indeed, a smaller price tag provides a built-in competitive advantage, which is why with mutual funds, you generally get what you don't pay for.
As important as it is, though, a cheap price tag is hardly enough for a fund to make my grade. There are a good many other vital signs I need to see before a contender can join the ranks of our Champs, and a smart and sensible stock-picking strategy ranks high among them.
One of the main reasons so many investors choose mutual funds for their retirement savings, after all, is that the diversification they provide can help keep a lid on volatility. Trouble is, investing with a fickle fund manager, or one who approaches his job like a Las Vegas high roller, defeats that worthy purpose. With that in mind, it certainly pays for you to spend quality time examining a manager's strategy before, um, rolling the dice with his fund.
But what's the best way to conduct that kind of research? An excellent question. Prospectuses aren't generally written in plain English, and even on those rare occasions when they are, they tend to be very broad documents. Indeed, if I had a nickel for every fund whose strategy is described as "capital appreciation," I'd be a nickel magnate. So it's really a darn shame that the only proper response to that empty statement is: Well, duh.
Eagle fund scouts
Prospective investors should nonetheless read a fund's prospectus cover to cover before whipping out their checkbooks. But if they really want to earn their due diligence merit badges, they'll go beyond that level of scrutiny.
For instance, I'd strongly encourage you to give the fund's most recent annual or semiannual report a close read. The quality of these will vary from shop to shop, but in addition to portfolio holdings and such crucial factoids as expense ratios and turnover rates, the best of the bunch include candid communication with shareholders -- a letter or summary commentary about what worked for the fund, what didn't, and what the manager has to say for himself in light of the fund's showing.
These days, many fund companies make these documents available on their websites, and a very select few even provide an archive of older reports. This is a terrific and, to my way of thinking, very shareholder-friendly practice: Historical reports make it relatively easy for dyed-in-the-wool fund sleuths to compare what a manager has said over the years with what he's actually done.
If, for instance, a fund's chief stock picker talks about his penchant for buttoned-down mid-cap stocks trading at steep discounts to their peers, seeing the likes of eBay
To be sure, there may be compelling reasons for these kinds of strategic shifts, but if there are, you should expect to read all about 'em in the manager's communications with his shareholders.
Beyond that, you should generally be skeptical of funds with a history of packing a ton of assets into a small number of holdings or into just a few favored sectors. Managers of these kinds of funds frequently talk about investing in just their "best ideas," but their strategies, alas, often lead to excessive volatility -- not excess returns.
The Foolish bottom line
Before investing in any mutual fund, make sure that you're comfortable with its strategy and make sure, as well, that the manager has a history of being candid about the strengths and weaknesses of his strategy. A value-oriented fund probably isn't going to go gangbusters when investors are going gaga over growth stocks, for instance. And funds with concentrated portfolios are far more likely to give you a bumpier ride than more diversified fare. Facts is just facts, after all.
Make no mistake: There are fine funds out there whose managers use eclectic strategies and run concentrated portfolios. Indeed, I'm always on the lookout for these rare breeds, and I've recommended a few to Champion Funds subscribers already.
Still, these picks are exceptions to the rule and not the norm. That's precisely what makes 'em Champs, after all, and if you'd like to take a gander at the kind of fund that fits that profile, a risk-free test-drive of our newsletter is just a click of the mouse away.
Shannon Zimmerman runs point on the Fool's Champion Funds newsletter service, and at the time of publication didn't own any of the securities mentioned above. Merck is a Motley Fool Income Investor recommendation. eBay is a Motley Fool Stock Advisor recommendation. You can check out the Fool's strict disclosure policy by clicking righthere.