"Money is better than poverty, if only for financial reasons."
-- Woody Allen
My investment philosophy is largely fueled by fear -- fear of losing money, that is. I want to build wealth, sure, but more than anything, I don't want to lose. I'm not alone: Every Sunday, I hear NFL coaches mouthing platitudes to that effect, and studies have shown that investors are much more affected by a 100% loser than a 100% winner.
So I took great interest in a study that Standard & Poor's released over the summer. The S&P's Mutual Fund Performance Persistence Scorecard (link opens a PDF file) measured the consistency of top-performing mutual funds over three and five consecutive years. As of May 31, only 10.7% of large-cap funds, 9.2% of mid-cap funds, and 11.5% of small-cap funds maintained a top-quartile ranking for three consecutive years. Which is to say that only one in every 10 top-performing funds in a given year stays in the top 25% for the next two.
Gulp.
And it gets worse before it gets better: According to the S&P study, the odds of a superior fund remaining superior are even worse for longer periods of time.
DNA of a winner
With more mutual funds than publicly traded stocks available for your hard-earned investment dollars, this is actually not all that surprising. Even less surprising, the most consistent top-performing funds had common characteristics. According to the S&P, recurring top performers had:
1. Longer manager tenures at their funds. The average U.S. domestic stock fund has an average manager tenure of 4.6 years.
2. Lower expense ratios relative to their peers. The average expense ratio of U.S. funds is 1.53%.
3. A protected downside: According to the S&P, "While winners did better in the bull market rebound, the consistent winners also minimized or avoided losses during the bear market." Winners, in short, stuck to their strategic guns in good times and bad.
That's a solid three-step start for finding market-beating mutual funds. And it just happens to be exactly what Fool fund-finder Shannon Zimmerman never shuts up about. (I mean that in a good way.)
Shannon's two biggest pet peeves about mutual funds are unproven track records and high fees. Every month, while he recommends a fund to subscribers of his Motley Fool Champion Funds service that has all the makings of a winner (he calls them "Champs," incidentally), he also singles out one "Dud" fund.
Shannon recently identified GAM American Focus (GNAAX) as a Dud, but it's not merely because of the fund's performance. (It has closed since being tapped for dreaded Dud-hood, by the way. Coincidence?) Although some of its top 10 holdings have been down in 2005 -- Merck (NYSE:MRK), Verizon (NYSE:VZ), Pfizer (NYSE:PFE), and UPS (NYSE:UPS), to name a few -- other holdings have done just fine lately: Johnson & Johnson (NYSE:JNJ), Coca-Cola (NYSE:KO), and Citigroup (NYSE:C). So why was GAM American Focus given the thumbs-down? For starters, its performance has swung wider than that of its benchmark, and its beta indicates that it should have outperformed the S&P. But it's even more troubling that the fund violated Shannon's two cardinal rules.
Rule No. 1: Don't bend on fees
GAM American Focus' expense ratio -- the percentage of a mutual fund that is taken out of the pockets of shareholders to pay the fund company -- is 1.78%, slightly higher than the fund average. Even worse, however, is the 5.5% front-load fee that the fund skims off your assets.
Now, that load may seem like a small sliver of your total assets, but it's a sliver that will never be put to work for you. Instead, it'll line the pocket of the middleman who steered you into the fund. Oh, and that's non-negotiable.
Let your money work for you. If you are investing in mutual funds, look for funds with an expense ratio of less than 1%, and don't go for load funds.
Rule No. 2: He who runs the fund runs your money
GAM American Focus' manager has been in place for just under five years, and his tenure has coincided with a period of underperformance. Even when a manager gets off to a good start, Shannon only rarely gives a fund a second look if its management team has been in place for fewer than five years.
You know all those three- and five-year track records promoted in fund literature? It is quite possible that those returns were earned by previous managers, so take 'em with a grain of salt.
Also, does the manager stick to his strategic guns? If the fund's skipper has the courage of his convictions in good times and -- more importantly -- in bad, then you've automatically improved the chances of protecting your downside. I've previously written about John Montgomery, the strict quantitative manager at Bridgeway Funds. Montgomery is an exemplary fund manager -- he has a proven track record and is ethical to the core. Montgomery's outstanding returns since inception on Ultra-Small Company have been fueled by his strategy of finding undervalued small-cap companies. According to Ultra-Small Company's past two annual reports, SFBC and VentivHealth were two of the top 10 holdings in both 2004 and 2005 (and, according to the fund's Sept. 30 report, both remain among the fund's primary holdings). Pull up a two-year performance chart of these phenomenal but volatile small caps, and you'll see why it's important that the fund manager stick with what he does best.
Lastly, Montgomery stands more assured of his strategy than many of his customers. Witness this explicit warning from an annual report: "I have a much higher tolerance for risk than most investors, and find myself sleeping just as well in a bear or bull market, partly because I have a clear, long-term view of the stock market and my own investments."
Where to go and how to start
The S&P's study is a wonderful reminder that many mutual funds -- too many, sadly -- don't make the cut. It also highlights several of the consistent top performers. But if you're looking to the study for great fund picks, be warned that several of the funds it highlights are closed (including six of the 10 top small-cap funds). In other words, these funds are already recognized for their superiority and may be difficult to jump into.
Don't fret, though. If you're in the market for top-notch funds with tenured, savvy stock-pickers like John Montgomery at their steering wheels, you're in luck. Shannon is offering a 30-day free trial to his newsletter service, which allows you to access every pick he's ever made, every Dud he's ever exposed, and every all-star fund manager he's ever interviewed (Montgomery included). It also gives you unfettered access to the Fool's superb message boards. The Champion Funds portfolio is beating "the market" (as measured by the S&P 500 for stock funds and iShares Lehman Aggregate Bond Fund for fixed-income funds) by 7.57 percentage points since its inception in April 2004. Of the 34 funds in the portfolio, 32 are in the black since Shannon picked 'em. And unlike many mutual funds, Champion Funds won't cost you a dime up front. You can try it free for 30 days.
This article was originally published on Oct. 27, 2005. It has been updated.
Brian Richards does not own a dog. He does not own shares of any stock or fund mentioned in this article. If he did, he'd have to tell you about it, because of the Fool's disclosure policy . Pfizer and Coca-Cola are Motley Fool Inside Value recommendations. Merck is a Motley Fool Income Investor recommendation.
