10 steps in selecting a fund

Your Funds

Your Money

May 23, 2004|By CHARLES JAFFE

LILLIAN, of Metairie, La., sent me a 10-year-old clipping last week, a copy of a column I wrote on how I pick mutual funds.

Her attached note was very simple: "After everything that has happened, do you still pick funds this way?"

"Everything that has happened," of course, are the improper trading troubles that have caused the fund industry's biggest scandal ever.

Since I first described my personal methodology for picking a fund in 1994, I have made some marginal changes to my investment philosophy, but the fund scandals are reflected in only one small way.

Investors' long-term happiness with a fund is often traced to what they thought when they first bought it, which is why it's crucial to develop a personal selection system.

With that in mind -- in the hope that it will help you develop your own methodology -- and at Lillian's request, here is how my system works today.

Step 1: Determine why I want or need a new fund.

Investing is not my hobby. It's a means to a better future. That means I avoid impulse buys, super-hot funds and moves that don't fit a bigger strategy.

Fund selection starts with deciding what this money must accomplish, whether it's diversification, growth, stability, income or something else; focusing on the reason to pick a new fund helps properly set my expectations.

Step 2: Find funds that meet my needs.

Cut to the asset class first, then look for funds that meet basic needs and desires.

I avoid wasting time on funds I can't afford to buy into, that do not offer automatic investment plans, that require signature guarantees for redemptions and more. I avoid funds with sales charges, not because load funds are bad but because they're not for someone who does significant personal research and doesn't pay an adviser for help.

I dislike funds with above-average costs and prefer funds where the manager has been around for at least 10 years.

Step 3: Learn the story of the fund and its manager.

I'm looking for something that can be the basis for trust and confidence, whether it is the manager's expertise or the common-sense simplicity of indexing.

In searching for a compelling reason to buy a fund, I spend a lot of time on a fund's newsletters and reports. You can learn a lot about a manager's style and discipline by reading what the firm sends shareholders and prospective investors. If there's no good reason to buy a fund in its own paperwork, there's probably no reason to buy the fund either.

This is also where I now factor scandals into play. If a firm has done anything in the past that frightens me for the future, I'm looking elsewhere.

I want to finish this step able to articulate what I know about a fund well enough to justify its place in my portfolio. I want to explain that position to, say, my mother, because I may someday have to justify my pick in order to stick it out when the market gets tricky.

Step 4: Compare the fund I favor with its peers, then check returns.

By picking a fund more for its asset class than for raw performance, comparing a fund with the competition is crucial. People who review returns first are more likely to chase hot numbers, which leads to unbalanced portfolios filled with yesterday's winners.

My initial cut is for funds in the top 25 percent of their peer group over the past five years. I'm also looking for consistency, meaning I will sacrifice some upside potential for a fund that promises a ride that is smooth enough to allow me to make reasonable plans for the future.

Step 5: Choose the finalists, read the prospectuses and reports.

I look at holdings to make sure they are consistent with a manager's discipline, and I examine what the fund is allowed to invest in, which is key to how the portfolio could change in the future.

If the holdings, a Morningstar, Value Line or Lipper Leaders report doesn't sit right with me, I move on.

Step 6: Check under the hood.

This is where the short list gets weeded to my pick. 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 current holdings. Expense ratios are a key tiebreaker.

Step 7: Pick my winner, jot down my thinking and write the check.

I start my file on any new fund with a detailed list of the factors that led to my decision, a move which makes it much easier years later to answer the question "Would I buy it again today?"

If I'm not nervously excited by the potential of my pick, something is wrong. Without that rush, I would refine my search process and start again.

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