"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 last 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, 2005, 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: 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 is the fact that the most consistently top-performing funds had common characteristics. According to the S&P, repeat top performers had:
- Longer manager tenures at their funds. The average U.S. domestic stock fund has an average manager tenure of 4.6 years.
- Lower expense ratios relative to their peers. The average expense ratio of an actively managed U.S. fund is 1.53%.
- 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.
These Dud funds aren't necessarily underachievers. Shannon recently identified Morgan Stanley Income Builder B (INBBX) as a Dud, but with a three-year return of nearly 12%, it wasn't because of performance. Indeed, some of the fund's top holdings have been on a roll of late: JPMorgan Chase (NYSE:JPM), General Electric (NYSE:GE), Bayer (NYSE:BAY), Sprint Nextel (NYSE:S), Merrill Lynch (NYSE:MER), and the ultra-hot Schlumberger (NYSE:SLB) each make up more than 1% of the fund's assets. Of those, only GE is in the red over the past year. So why was Income Builder B given the thumbs-down? Because it violated Shannon's two cardinal rules.
Rule No. 1: Don't bend on fees
Income Builder's class B shares sport an expense ratio -- the percentage of a mutual fund that is taken from shareholders to pay expenses -- of 2.01%, according to Morningstar data. (The class A shares are cheaper; for more on class B shares, click here.)
That 2.01% might be a small sliver of your total assets, but it's a sliver that will never be put to work for you. Oh, and that's non-negotiable.
Let your money work for you. If you are investing in mutual funds, look for funds with below-industry-average expense ratios.
Rule No. 2: He who runs the fund runs your money
Of the five members of Income Builder's management team, the longest-tenured has only been in place since 2002. While the performance on this team's watch has been respectable, Shannon rarely gives a fund a second look if its management team has been in place for fewer than five years.
Put simply: It's quite possible that the juicy five- or 10-year returns quoted in fund literature were earned by a previous management team, so take 'em with a grain of salt.
Where to go and how to start
The S&P's study is a wonderful reminder that many -- too many, sadly -- mutual funds don't measure up. 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 (six of the 10 top small-cap funds, for example, are closed). In other words, these funds are already recognized for their superiority and may be difficult to jump into.
But not to fret. If you're in the market for top-notch funds with tenured, first-rate stock pickers at their steering wheel, test-drive a free 30-day trial to our Champion Funds newsletter service. You'll get instant access to every pick Shannon has ever made, every Dud he's ever exposed, and his lineup of model portfolios. 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 13.22 percentage points since inception in April 2004. Click here for more information.
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, either. JPMorgan Chase is an Income Investor recommendation. We're telling you all this because of the Fool'sdisclosure policy.
