The numbers in the ads always look great.
Over the last year, you read, the XYZ fund has grown at an average annual rate of more than 35 percent. Over the last five years, it is up more than 20 percent, surpassing the Standard and Poor’s 500 stock index.
As you reach for the phone, you notice the small print: “Past performance is no guarantee of future results.”
You pause, cradling the receiver, suddenly wondering: Is that just a legal disclaimer, or are there other important factors?
“Performance is the last thing you should look at because there is no persistence in it,” argues Charles Trzcinka, a finance professor at New York University’s Stern School of Business. “The fact that funds talk about performance above all else is a disservice because performance is overrated.”
If performance data are not the criteria of choice, what should investors look at, once they’ve weighed their goals and settled on the kind of fund to buy? And where should they look for that information?
Experts suggest that they evaluate the size of various funds and their expenses, the funds’ managers, the risks they take and how actively they trade. And they should take care, yes, to compare the fund’s performance with an appropriate benchmark index.
The information that investors need is available in annual reports and fund prospectuses and from services like Lipper Analytical Services and Morningstar Inc., the fund tracking company in Chicago.
“When investors get to fund selection, they should be looking at portfolios, annual reports and interim reports and see which ones communicate with them,” said A. Michael Lipper, president of the firm that bears his name.
Morningstar has created a star rating system as a quick measure of mutual funds within categories like growth, small capitalization and so forth. In its evaluations the risk score is subtracted from the return score. The difference is then plotted to determine a rating for various periods. Funds in the top 10 percent of their investment category receive a five-star rating, the company’s highest.
Given that formula, some five-star funds are riskier than others. “All five-star funds aren’t equal–a fact conveniently ignored by fund companies that tout high ratings without providing information on the risk component of the score,” Laura Lallos, a senior analyst at Morningstar, wrote in the newsletter Morningstar Mutual Funds.
Analysts at Morningstar and elsewhere spend much time quantifying each fund’s risk level, in part by measuring a fund’s excess return–the return above three-month Treasury bills, which are seen as the safest investment–against the excess return of a benchmark index.
One caution: In advertising performance, funds may not always use the same benchmark index that analysts would use. It makes little sense, for example, to measure an aggressive-growth fund loaded with small-cap stocks against the S&P 500; a more appropriate benchmark would be the Russell 2000 index, which measures the performance of small-company issues.
To be sure, determining what is appropriate is tricky. “An inappropriate index is a little like pornography,” said Robert Plaze, an associate director in the division of investment management at the Securities and Exchange Commission. “You know it when you see it.”
Both the National Association of Securities Dealers and the SEC have regulations regarding the use of appropriate indexes in ads and annual reports, but comparisons that the experts consider imperfect may still be permissible.
Because high costs cut into performance, they are often seen as a crucial factor in selecting a fund.
As a rule, equity funds that are actively managed–ones that trade shares frequently, in other words–have higher costs than bond funds: Of the 2,664 diversified domestic stock funds it tracks, Morningstar said the average annual expense ratio was just more than 1.4, or $14 for each $1,000 invested. The comparable number for 1,859 taxable bond funds was just more than $11 for every $1,000.
Given the expense factor, it is perhaps not surprising that many investors have been turning from actively managed funds to index funds. On average, Morningstar said, expenses on index funds were $6.50 for each $1,000 invested, thanks to the low turnover inherent in funds that simply mirror their benchmarks.
“To get a higher return, you either have to take more risk or lower costs,” said Brian Mattes, a spokesman for the Vanguard Group. “In the long run, index funds beat actively managed funds by about 1.70 percentage points, and that is strictly because the costs are lower.”
Before selecting an actively managed fund, make sure the people who are placing the bets have been around awhile and are not likely to move on, the experts say.
“If you have a new portfolio manager, past performance goes out the window,” said Lewis Altfest, president of L.J. Altfest & Co., a financial planning and investment advisory firm in New York. “And you want to look at the fund management company as a whole.”
Investors should take note, for example, if a fund company has recently been sold or made an acquisition. Such events could lead to a shakeup of managers.
Trzcinka has no problem with active managers, but says investors should beware of those that are too active.
For one thing, high turnover of holdings means more brokerage commissions are being paid, driving up a fund’s costs. And more important, for investors who own shares in a regular account as opposed to a tax-deferred retirement account, if capital gains are realized, shareholders will have to pay taxes on them each year.
“Look at the reports and make sure the fund has relatively low turnover in its portfolio,” Trzcinka said. “Make sure they are buying stuff and hanging on to it. Anything above 30 percent is a high turnover rate. An index fund, by contrast, has 5 percent turnover.”
And said Amy C. Arnott, editor of Morningstar Mutual Funds, “size is an important factor,” especially for funds “that focus on small-capitalization stocks or a specialized area of the market.”
Speedboats are much more maneuverable than battleships, after all, and a small fund can move more nimbly, though that is no guarantee the moves will be on course.
