It's settled, then. You're ready to buy into your next mutual fund. Maybe it's your first investment. Maybe it's your hundredth. From the day-trading speculator to the buy-and-hold retiree, lots of stock investors own mutual funds -- you'd be surprised at the numbers. I don't think I've ever gone without a mutual fund or two in my portfolio for any significant length of time.
Then again, that's also the problem. Everyone thinks they're mutual fund experts. They can pull up historical returns to make sure they're buying a winner. They can express interest in a particular category and narrow the selection process that way. They can review a portfolio's holdings to make sure it has the kind of stocks they can get behind as a shareowner. They can even dig into the prospectus to make sure the expense ratio is fair.
If that sounds like an exhaustive process for finding your next fund, boy, have I got some bad news for you -- all four of those steps have some serious shortcomings.
It may not seem fair. After all, you're buying into a fund because you want a professional money manager to make the tough decisions for you, right? What to buy, what to sell, when to buy, when to sell? This doesn't mean that buying mutual funds will prove to be too much of a hassle, though. It's easy, really.
Well, it's easy as long as you don't take the easy way out. Let's revisit the problem with the four wrong ways to find the right funds.
Past performance isn't everything
It's not an earth-shattering revelation that you can't simply extrapolate the past few years to arrive at likely future returns. Early into any mutual fund ad or prospectus, you'll see the boilerplate disclaimer that past performance is no guarantee of future performance. However, investors can get burned if they rely strictly on hot recent returns.
For starters, how long have the portfolio managers been with the fund? If a particular mutual fund has an impressive long-term track record, is the current management team the one that steered the fund to the greatness that attracted you in the first place?
When my second son was born, I decided to open an education IRA in his name with Stein Roe Young Investor. It was a cute concept. The managers would buy kid-friendly companies, and the quarterly reports included kid-targeted content and educational activities. The performance was smoking at first. However, the fund went through several management changes in my son's first seven years. The fund family was even acquired by a company that now charges stiff annual maintenance fees (relative to the modest initial investment), which used to be nil for Stein Roe.
The collection of great kid-geared stocks? Right now, the fund's holdings include Apollo Group
Logical fund investments like candy juggernaut Hershey
Even worse, recent performance has been pathetic. Over the past five years, the fund has returned an annualized gain of only 0.8%, badly anchoring down Young Investor's lifetime annual return of 6.1%. Perhaps that's the reason why the fund is in the process of being buried under the rug as Columbia seeks shareholder approval to roll it up into a larger fund.
In other words, a lot is baked into past performance. Just make sure that you're buying into the same management team and strategy that achieved those returns.
It's important to take a fund's performance data in perspective. You can't compare an international high-yield fund with a short-term investment-grade vehicle. You'd be wrong to pit a blue-chip value mutual fund against a high-growth micro-cap investment.
However, there are also pitfalls in narrowing your search to a specific category. In 1997, MarsicoGrowth & Income was launched. Tom Marsico was a growth-stock star with Janus when the fund family was at the top of its game in the early 1990s. Like many successful managers, he decided to capitalize on his fame at Janus and IDEX by striking out on his own. Cool. He earned it.
However, growth and income funds tend to invest in dividend-paying companies. Shareowners come to expect a little income along the way. The problem here is that Marsico's fund has never yielded an investment income distribution. Its holdings include companies that yield far less than the company's fund expenses, such as clinical lab operator Quest Diagnostics
Don't overpay for that doggie in the window
Then you have the problem of relying on a fund's report to detail its holdings. Here's where a pesky little practice called "window dressing" comes into play. A fund manager may sell his duds and load up on hot stocks just before the end of a reporting period in a poor attempt to cover up lackluster performance.
Thankfully, most managers don't resort to such tactics these days. Investors are too smart for that. If they see hot holdings and a cold track record, they will judge a fund based more on its actual returns than its list of current holdings.
The greatest expense
How much is fund ownership costing you? Management fees and other fund operating expenses come into play here, and that information is readily available. Some fund families like Vanguard and TIAA/CREF pride themselves on dirt-cheap expense ratios, but you'll often find some of the best-performing stock funds to be manager-driven vehicles with reasonable -- though certainly not the cheapest -- fees.
That's why one shouldn't limit a growth fund search to expense ratios. In fact, some funds often absorb a chunk of the management fee -- temporarily -- in order to attract new investors. So keep your eye on expenses, but do so knowing that there's often more there than meets the eye.
Four wrongs can make a right
Buying a fund is easy. Choosing the right one doesn't have to be much harder than that. Just don't fall into the trap of relying on one particular gauge without understanding its shortcomings.
Then again, if you want someone else to weed out the baddies, maybe I should introduce you to my friend Shannon Zimmerman. He cut his teeth analyzing mutual funds for Morningstar, and now he's at The Motley Fool with its Champion Funds newsletter service. Subscribers receive Shannon's top fund picks, regular commentary, and access to a lively discussion board with folks talking mutual funds around the clock. Whether you're like me -- always owning a few mutual funds alongside an active stock portfolio -- or you're exclusively a fund investor, Champion Funds may be just what you need to start buying the right funds the right way. Want one more incentive? OK, dig into a 30-day free trial that will make sure you carry out the spring cleaning that your portfolio has been begging for.
This article was originally published on Dec. 27, 2005. It has been updated.
Longtime Fool contributor Rick Munarriz thinks that funds are part of a balanced portfolio breakfast. Rick owns shares of Disney. Disney and Bed Bath & Beyond are Stock Advisor recommendations. Mattel is an Inside Value recommendation. The Fool has adisclosure policy.