Choosing where to place your money Guides help separate gems from clunkers


March 29, 1998|By Jeff Brown | Jeff Brown,KNIGHT RIDDER/TRIBUNE

Sure it's a jungle out there in investmentland, but you can easily find your way with a good travel guide.

I'm talking, of course, about the immense and ever-expanding world of mutual funds. To use the oft-quoted statistic, there are more funds than there are stocks on the New York Stock Exchange and Nasdaq combined -- more than 11,000 funds vs. about 9,400 stocks. However, a good fund guidebook will help you pare the list to a usable size. Many guides issue new editions in the spring, based on the previous year's data. I'll assume here that you've already devised an overall strategy and identified the types of funds you need -- large-company stock funds, growth funds, bond funds, and so on. If you haven't, you're not ready to search for specific funds.

Once you've set your strategy, there may be whole categories you can ignore, making the first elimination round pretty easy. A very young investor who focuses on stocks and has a low tax bracket probably would ignore municipal-bond funds, for instance, while an older investor might want to steer clear of the volatile and risky emerging-market funds.

Within each of the categories you've chosen, look for the top performers, funds whose total returns beat those of others in their categories -- not just for the past quarter or year, but for three- and five-year periods, too. This should leave you with funds that did well because they were well-managed, not because they used risky strategies.

Good performance doesn't necessarily mean stellar returns. You might, for instance, be looking for bargains among funds in a beaten-down sector -- Asian stock funds today, for example. In that case, search for funds that aren't down as much as their peers.

To further whittle the list in each category, cross off the "load" funds that charge up-front or exit fees meant to compensate brokers. If you're making your own investment decisions, there's no point paying loads. Also cut out any funds that charge 12b-1 fees, used for marketing expenses.

Next, eliminate the funds with high expense ratios -- the fees and other charges the manager takes for running the funds. Compare each fund with others in its category, since some categories, such as small- and foreign-stock funds, tend to have higher expenses than others.

Now, remove funds that haven't had the same manager for at least three years. You want a pro with a track record. Ideally, you'll go back even farther to see how the manager did in a different type of market -- during a mediocre year for stocks such as 1994, for instance.

Then cut out funds that have high risk ratings, measured with such gauges as standard deviation and beta, which are explained in any good fund guide. That includes funds that invest portions of their assets in dangerous securities such as options and futures. Faced with two funds with similar performance and investment style, choose the one with the lower risk.

Finally, if you're investing in a taxable account, look for funds with the highest "tax efficiency," funds that leave you with more of the return after you pay annual taxes on interest, dividend and capital-gains distributions. You are taxed on distributions even if you have the money reinvested, and that chips away at your return. High tax efficiency is usually found with funds that have relatively low portfolio turnover.

Now, with all of the funds on your list of finalists, ask this question: Why buy any of the actively managed funds instead of the unmanaged index funds?

Index funds, such as those that seek to match the performance of the Standard & Poor's 500-stock index, aren't affected by changes in managers. They have low fees, low turnover and high tax efficiency. Since most actively managed funds don't perform as well as index funds, you must have a compelling reason "not" to opt for an index fund. Perhaps you've found managed funds that do outperform the indexes, or you want funds that specialize in areas for which there is no index fund.

And there you have it -- your mutual fund picks made quick and easy.

Except for one thing: Where do you get all this data?

Start with a good fund guide. Then, of course, you must read the prospectuses and other materials you can order for your list of finalists. Use newspaper fund listings to get up-to-date performance data before investing.

I find the old-fashioned, paper-based guides a lot easier to use than the online search systems. My favorites are the Morningstar 500 guide put out by the fund-tracking firm of the same name, and "The Individual Investor's Guide to Low-Load Mutual Funds" published by the American Association of Individual Investors.

The $35 Morningstar guide (1-800-735-0700) has more data on each fund, but the $24.95 AAII guide (1-800-428-2244) lists more funds and has a better primer on how to conduct a search. Both guides supply all the data needed for the fund-sorting procedure described above.

Neither guide covers all 11,000 funds, of course, but that doesn't matter. They've used various criteria to sift out funds not worth considering. Morningstar lists 500 funds, AAII more than 900. That's plenty, given the vast duplication in the fund universe.

In addition to containing the full-page discussions of individual funds, the guides have fund performance rankings by category. There are also data on each category's average risk and return, making it easy to see how any fund chalks up against its competitors.

Pub Date: 3/29/98

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