The sheer number of mutual funds-there are now more than 5,000 on the market-breeds considerable confusion. How to choose?
Enter an ever-growing number of publications aimed at helping investors sort among the funds. But the rankings and ratings of mutual funds can be confusing in themselves.
Consider, for example, a week’s worth of rankings by the Wall Street Journal for the world’s biggest mutual fund, Fidelity Investment’s Magellan Fund. Magellan gets a “D” grade on Tuesday, a “B” on Wednesday and an “A”on Thursday and Friday.
Same fund, three different grades.
Similarly, Twentieth Century Ultra, a growth-stock fund, gets an “A” Thursday and Friday, a “C” on Wednesday and an “E”on Tuesday.
Different time periods
The grades vary because each day’s ranking is based on a different time span: one year on Tuesdays, three years on Wednesdays, four years on Thursdays and five years on Fridays. Funds are ranked by category, then graded on a curve for each time period. An “A” grade goes to funds in the top 20 percent of each category, the “B” grade to the second 20-percent grouping and so on, down to grade “E.”
For investors, the trouble with rankings is deciding which time period to use in making a choice of funds. There’s nothing to suggest that a fund’s performance in any particular period-whether one, three, four or five years-is a good guide to its future performance.
That explains an apparent contradiction in the September issue of Kiplinger’s Personal Finance Magazine.
In a ranking of funds, Kiplinger’s on page 97 gives a “D” grade to Vanguard Index Trust 500, a fund that mimics the Standard & Poor’s 500 stock index. But on page 162, the magazine recommends Vanguard Index Trust 500 for an investor who asked what fund to choose if he wanted to invest in just one stock fund.
Was someone asleep at the magazine? Not necessarily.
In any given period, an index fund like Vanguard’s will never rank near the top of all stock funds. It will closely track the overall market, as measured by the index it mimics. It will always trail a lot of funds, and just as surely it will always beat a lot of funds.
That’s why the Vanguard 500 fund habitually ranks near the middle of the pack of stock funds in any specific period. Hence its crummy grade from Kiplinger’s and the fund’s so-so Wall Street Journal grades: “C” for the last one-, three- and four-year periods and “B” for the last five years.
The Vanguard index fund has no sales charges and extraordinarily low expenses. Because actively managed funds must pay fees to a manager and pay transaction costs for stocks the manager buys and sells, such funds have higher expenses than index funds. Since expenses are deducted from the returns received by fund shareholders, index funds are able over time to beat more than half of all stock funds.
No proven method
Why not select a fund that will beat the index and be in the top echelon? Trouble is, there is no proven way to pick stellar funds in advance. You can’t assume that the fund with an “A” grade today will turn in “A” results in the future.
Some studies, in fact, indicate that the top-performing funds in a given period are subsequently likely to turn in sub-par results.
Sadly, analysis paralysis is the response of some investors to the myriad of funds and the confusion of rankings. They don’t know how to go about choosing the best fund, so they choose none. To them, the mattress looks like a decent alternative compared with the intimidating chore of researching thousands of funds.
Hence Kiplinger’s advice on selecting the Index 500 Trust. Unlike any particular fund run by active portfolio managers, the index fund’s future results are quite predictable: It will nearly match the broad stock market’s overall results.
Many institutional investors who index part of their holdings and thousands of individuals who use index funds would rather be sure of matching the market than to gamble that they can pick a manager who will beat the market.
