3 Steps to Finding Mutual Fund Winners
By Ron DeLegge
August 16, 2010
SAN DIEGO (ETFguide.com) – How can you find the best mutual funds for your investment portfolio? New research shows that mutual fund investors should be paying attention to more than just advertisements by top rated funds.
Step 1: Stop Focusing on Past Performance
A Standard & Poor’s report titled, “Does Past Performance Matter” showed that very few funds consistently repeat top performance. Through the five years ending March 2010, just 1.7% of large cap mutual funds, 2.2% of mid cap funds and 4.6% of small cap funds kept top have rankings over five straight 12-month periods. What does it mean?
Identifying past winners is the easy part, but buying those kinds of funds won’t guarantee future success. In fact, year-to-year, quarter-to-quarter, the list of top performing mutual funds are ever-changing. In other words, it’s a moving target. And just like Hollywood, it’s a landscape littered with lots of one-hit wonders.
Step 2: Start Focusing on Fees
The best indicator of future performance isn’t your mutual fund’s historical performance but its fees. Mutual funds with higher fees have a higher performance hurdle. This is a fundamental truth recognized by the greatest investors of our time.
“If you have 2% a year of your funds being eaten up by fees you’re going to have a hard time matching an index fund in my view,” stated Warren Buffett in a television interview a few years ago.
For that reason, many wise investors are opting to make low cost index mutual funds and index exchange-traded funds (ETFs) the foundation of their investment portfolio.
For instance, the Schwab U.S. Broad Market ETF (NYSEArca: SCHB) charges just 0.06% annually. In other words, a person with $500,000 invested in SCHB would pay just $300 in annual fund fees. That compares favorably to the $6,000 or so in fees the typical stock fund investor would pay to have the same $500,000 managed. The larger your investment account, the more you have at stake.
Step 3: Look for Low Tax-Cost Ratio
In a recent ten-year study, Lipper estimated that buy-and-hold investors with mutual funds held inside a taxable account are giving away 1.13% to 2.13% annually. Taxes are an additional cost burden that most mutual fund investors forget to add to their tab. How much tax is your mutual fund socking you for?
One useful measure is called the tax-cost ratio. The tool tells you how much in tax is being subtracted from a fund’s annualized returns. Like expense ratios, the lower a mutual fund’s tax-cost ratio, the better. According to Morningstar, the average tax-cost ratio for stock mutual funds is 1% to 1.2%.
Funds with a zero tax-cost ratio haven’t paid out any taxable distributions. Certain fund families like the Sector SPDRs have achieved this rare but outstanding distinction. Morningstar lists average tax-cost ratio data for three, five and ten-year periods.
In summary, the best way to find mutual fund winners is to concentrate your attention on the little stuff that matters.