7 Secrets to Picking Great Funds

How can you be a better fund investor? Below are seven guideposts that I've found particularly valuable in more than 25 years of fund investing. No rule is perfect, of course, so you always need to keep an open mind. But if you pay attention to these seven, I think you'll find that your returns improve.

I've left out some obvious guidelines, such as to favor low-expense funds and to diversify. By the same token, some of these will surprise even veteran fund investors.

1. The best fund firms often do just one thing well. Most large fund companies offer funds that specialize in every conceivable type of stock and bond. But often firms that do everything don't do anything well. The best firms usually stick to just one brand of investing. Typically they're small firms, owned by the managers and analysts, located far from Wall Street.

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Examples are San Francisco-based Dodge & Cox and Memphis-based Longleaf Partners -- two terrific shops that focus single-mindedly on value stocks. Growth specialist Primecap, in Pasadena, Calif., is also superb. So is Champlain, a small-cap specialist in Burlingon, Vt.

2. Be wary of funds that change their names. Most funds change their name when the fund company gets a new owner. New ownership usually hurts morale at a fund in the same way that a takeover at any other company does. And poor morale often prompts good managers and analysts to find jobs elsewhere. I'd be wary, for instance, investing in the DWS funds. The Scudder funds, once a proud name, were rebranded as DWS, a division of Deutsche Bank Group.

3. Evaluate funds based on their ten-year performance. Academic studies have shown that one-year and three-year performance is virtually worthless in predicting how a fund will do. Five-year performance is only a little more helpful. But ten-year and longer performance is particularly valuable in picking funds -- so long as the original managers remain on the job.

CGM Focus (symbol CGMFX) and Third Avenue Small Cap Value (TASCX) are just two examples of funds with top-notch long-term records. Newer funds launched by veterans are also good bets. Bridgeway Aggressive Investors 2 (BRAIX) doesn't have ten years under its belt yet, but near-clone Aggressive Investors 1 (BRAGX), which is closed to new investors, was launched in 1994 -- and has produced great results since its inception.

4. Look for promising new funds. Studies show that new funds typically do better than older funds. They have fewer assets, and a manager can fill them with his or her favorite stocks. Often the best fund may be a new one run by a veteran manager who has a decade or more of experience (see For Funds, New Often Means Better).

5. Get to know a fund company's culture. The mutual fund business is incredibly profitable. Consequently, it attracts a lot of people who care first about making money for themselves -- with investors' returns running a distant second. How can you tell which firms care about investors? Look for funds with low expense ratios. Find funds in which managers have most of their own money invested. Hunt for firms where compensation for managers is based on long-term performance, not how fast assets grow. And look for candor, not hype, in a fund's semiannual reports.

If you use an adviser, the American funds are first class. They charge low expenses, compensate managers based on multi-year returns, and have a flat management structure that eschews corner offices and even titles (see What's Next for American Funds). Among no-load firms, T. Rowe Price has a similar corporate culture. Few managers ever leave either firm.

6. Avoid funds that aren't owned by fund companies. Does a Swiss bank, a Dutch insurance company or a huge brokerage or investment bank own your fund? If so, odds are it's mediocre. Highly skilled fund managers don't usually work for these companies because the companies typically treat fund management as a backwater. Talented managers prefer to work for companies that specialize in funds where their skills are more highly valued. Look in the prospectus to see who owns your fund.

Bank of America owns Columbia Management, which swallowed up a bunch of independent fund shops in recent years. A few remain good, but not many.

7. Watch funds' volatility. A fund's past returns are hardly the only number you should consider. Standard deviation -- a measure of how much a fund's returns bounce around from month to month -- is almost as important. The more volatile a fund, the more risks it takes. There's nothing wrong with investing in a chancy fund as long as its returns are commensurate with the risks (see CGM Focus, for example). But standard deviation has proven to be an excellent predictor of how a fund will hold up in a bear market. Looking at standard deviation would have provided a signal before the 2000-02 bear market of the danger lurking in funds that were filled with technology stocks.

Steven T. Goldberg (bio) is an investment adviser and freelance writer.