Pick Funds the Right Way

Evaluating a fund is not hard. In fact, the process really revolves around ten simple ideas:

1 | Don't obsess over past results

Nothing is more attractive than a fund with a great record. With the market's performance so pathetic in the last couple of years, any fund that boasts double-digit returns looks like a lifesaver. But some lifesavers turn out to be waterlogged.

Past performance is a good starting point in your search for a great fund. But it's hardly the end of the quest.

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2 | Look for consistency

Any fund can get lucky -- have a great few months, or even a year. What you want are funds that are good year after year after year. That demonstrates an ability to do well under any number of conditions, not just dumb luck. Where do you find consistency? Use Fund Finder to search within a specific fund universe and style, then compare performance over each of the past five years versus other funds that employ the same investment style. Next, select performance criteria, such as minimum total return for five years and SP star ranking.

Avoid comets -- funds that have one great year and then flame out. What you want are funds that stay above average almost every year.

3 | Think long term

Don't pay too much attention to the top-performing funds of the past 12 months. Recent performance doesn't mean a lot. What does is long-term success.

Look at performance over three-, five-, or ten-year spans, more if possible. Also be sure that past performance can be attributed to the current fund manager.

4 | Know thy manager

When you invest in a fund, you're really investing in a manager or a team of managers. These are the people who decide when a stock or bond should be bought or sold for the fund. When the manager leaves, much of the skill of running the fund goes with him or her.

This is less true of some of the bigger fund firms, such as the American funds, which are run by teams of managers, and Fidelity and T. Rowe Price. All these companies have skilled teams of analysts to supplement the work of the manager. Nevertheless, even at big outfits such as Fidelity and Price, the manager is key to a fund in much the same way a quarterback is key to a football team.

So when you're considering a fund, make sure you look at how many years the manager has been on the job. If the manager has been around just two years, consider only those two years in judging the fund's record. The previous record belongs to someone else and is beside the point. Likewise, if a manager has moved around a lot, it can be useful to look at his returns from his previous jobs -- information a fund company can furnish.

To get to know a manager, read articles about him or her in Kiplinger's Personal Finance or other sources. Call the fund and order a recent annual report. Often funds will mail you articles about the manager.

5 | Beware volatility

The issue of volatility is a tale of the tortoise and the hare, except that in this context the hare sometimes wins the race. Like the hare, some funds bounce around a lot -- topping the performance charts one month only to end up in the cellar the following month.

Most investors should own both low-risk and high-risk stock funds. But a fund that has achieved superior returns relative to its volatility rank is usually worth a close look. Some studies show that such funds are more likely to continue to be good performers than are funds that achieve slightly higher returns but with greater volatility.

6 | Watch your dimes

Your chances of picking a fund that will deliver above-average results over time increase the more you can get the wind at your back. This means keeping your eye on seemingly small things, such as how much you pay in annual expenses to the fund (represented by the expense ratio). Every cent you pay in expenses is money out of your pocket.

In general, you don't want to pick a high-expense fund if there's an equally attractive fund with lower expenses. U.S. no-loads have an average expense ratio of 1.14%. International no-load funds average 1.44% per year, and bond funds 1.10%. Expenses are especially important when choosing bond or money-market funds, where returns are sometimes slender.

In addition to keeping your expenses low, you should almost always avoid funds that assess loads or sales charges. A load is a payment that goes to a financial adviser, broker or insurance agent for helping you pick a fund, or sometimes it goes directly to the sponsor of the fund. The load may be assessed when you buy the shares, or it may be taken out annually in the form of a so-called 12b-1 fee, which can amount to up to 1% per year. Our point is simply this: If you're picking a fund on your own, why pay this ransom?

7 | Compare apples to apples

In Fund Finder, we divide stock funds into nine major investing styles, from funds that invest in stocks of small, undervalued companies to funds that invest in stocks of large, fast-growing companies. Comparing a fund with another fund that doesn't practice the same investment style is a bit like measuring the speed of an SUV against the speed of a race car. If you study a fund's performance only versus others that have the same investment style (or against an appropriate benchmark index), you'll be well on your way to becoming a superior investor.

8 | Don't fall in love

The hardest thing in investing is knowing when to sell. It's almost always more difficult than buying a fund -- or a stock, for that matter. Once you've bought a particular fund, it's your fund and tough to let go of, no matter how bad things get. The temptation is to hold on until you break even, or at least until a fund bounces back. But bounces can be small and then cease. It's exceedingly hard to recognize a mistake, cash in your chips and move on.

The best way to surmount this hurdle? Look at your funds dispassionately, as you would if you were deciding what to buy. If you wouldn't buy one of the funds you own today, sell it, and replace it with something better.

Be careful when evaluating funds for sale to compare funds with their peers, as noted above. Otherwise, you can sell the wrong funds.

Every fund has a bad year. Hold on if a fund falls behind its peers for a year. But after two or especially after three years of below-average results, it's time to either find out what is holding the fund back and be satisfied with the explanation, or pull the plug.

9 | Pay the piper

When you sell a fund, you'll likely have to pay capital-gains taxes. Funds are also required to distribute taxable gains to you and other investors at least once each year. Many investment "experts," who should know better, advise investors to stay with funds that have big gains (even if their prospects aren't so hot), as well as to shop for so-called tax-efficient funds -- that is, funds that use techniques to minimize the taxes you must pay until you sell your shares.

Those are bad ideas. The fact is, you will eventually have to pay taxes on your gains in funds. The only question is whether to pay up sooner or later. The difference is peanuts, no matter how tax-efficient the fund is -- unless you can salt money away in a tax-managed index fund for 20 or 30 years.

The thing to do is find the best funds you can and pay the taxes each year on your share of their income and capital gains they produce. And don't lose sight of one important, and positive, aspect: The higher your taxes, the more money you've made.

10 | Stay away from gimmicks

Mutual funds are in business to make money. At times, that means marketing takes the lead over common sense. In the late 1990s, the market was flooded with technology and Internet sector funds. Bear markets bring a propagation of bear-market funds, gold funds and funds that claim they'll do well no matter how the market behaves. Alternative-energy funds were popular a few years ago, and funds that specialize in companies that safeguard individuals and businesses from terrorism have also been introduced.

Unless your portfolio doesn't have enough holdings in technology or health or real estate, you're probably best off avoiding sector funds. You are better off sticking to diversified funds. Such funds give managers more freedom to invest in the best stocks they can find. After all, that's what you're paying them to do.