Thoughts on selecting a fund that may bring you happiness

Your Funds

Dollars & Sense

October 21, 2001|By CHARLES JAFFE

IN PICKING a new fund for the Roth IRA this year, I realized that the way I pick funds has changed again.

It's no big deal, just a further refinement of a process that changes as I learn more.

I first described my personal methodology for picking a fund shortly after I began writing this column in 1994. The changes over time have been on the margins, not at the core of my investment philosophy.

But investors' long-term happiness with a fund often traces back to what they were thinking when they first bought it, so finding a comfortable method for choosing funds is smart.

There is no perfect way to do it. All systems have flaws.

A personal selection system doesn't guarantee success, either, but it should lead you to funds that make you happy in the end. With that in mind, here are the steps I go through before buying a new fund. Don't necessarily follow my path, but consider it as you develop and refine your own.

Determine why I want or need a new fund.

Investing is both a means to a better future and a hobby. I don't confuse the two. That means no impulse buying, no hot funds, and no moves that don't fit a bigger strategy. Fund selection starts with deciding what this money must accomplish. That lets me properly set my goals and expectations.

Find funds that meet my needs.

I can quickly pare the field by sticking to funds that seem right for me. First, I cut to the specific asset class I am interested in. Next come my basic needs, from the size of minimum initial investments to check-writing features and more.

I don't waste time with funds that I can't afford to buy in to, that do not offer automatic-investment plans and telephone-redemption features, or that charge sales loads. (Load funds aren't bad, they're just not for someone like me, who does significant personal research and doesn't need to pay an adviser for help.) One change in my methodology over time: I consider only those funds with below-average expenses in their asset class.

Learn the story of the fund and its manager.

Buying a fund is a leap of faith. I need something to base my beliefs on, be it the style and expertise of an investment genius or the common-sense simplicity of indexing.

Look for a compelling reason to buy a fund. In many cases, you may find what you're looking for in the fund's newsletters and reports; you can learn a lot about a manager's style and discipline by reading what the firm sends to shareholders and prospective investors. If you can't find a good reason to buy a particular fund in its own paperwork, you may be looking at a fund that's more hype than substance.

If you can't explain to your mother what you know about a fund and convince her that it's a good choice, you may not have the conviction to stay put in tough market cycles.

Compare the fund with its peers, then check returns.

Since I pick a fund more for its asset class than its raw performance, how the fund compares with the competition is key. (Most investors review return numbers above all else, which leads to chasing hot numbers and building unbalanced portfolios.) My initial cut is for funds in the top 25 percent of their peer group over the last five years.

My performance review has less to do with raw returns than consistency and volatility. I take the fund's worst quarter and forecast it over a year to tell me what might happen if things get scary. I won't buy a fund where that volatility frightens me, and I will sacrifice some upside potential for a fund that promises a smooth, in-line-with-the-asset-class ride.

Choose the finalists; call for prospectuses and reports.

I want to make sure a fund's holdings are consistent with the manager's discipline, and check out what the fund is allowed to invest in, which is a key to how the portfolio could change in the future. If the list of holdings makes me nervous - or if I find anything in a prospectus, a Morningstar report, or other data that doesn't sit right with me - I move on.

Check under the hood.

This is where I weed my short list, and this step has become longer as I refine my process. I look at a fund's turnover (the lower the better in my book), tax-efficiency (unless the fund is in an IRA), and overlap with my existing holdings (if the fund is a match for something I already own, I'm likely to just add to the existing account). Expense ratios are a key tiebreaker.

Pick the winner, jot down my reasons, and write the check.

I start my file on a fund with a detailed list of factors that led me to my decision. That'll help me later, should I consider selling or want to review my thinking on the "Would I buy it again?" question.

I'm always nervously excited by the potential of my pick; if I'm not, something is wrong. If that rush is missing when you sign a fund's paperwork, refine your process and start again.

Chuck Jaffe is mutual funds columnist at The Boston Globe. He can be reached by e-mail at jaffe@globe.com or at The Boston Globe, Box 2378, Boston, Mass. 02107-2378.

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