Picking Mutual Funds for Tough Economic Times

What's important when you're choosing a mutual fund? Not many of the criteria you may be used to looking at.

Not 10-year track records, magazine rankings, star managers or even stars, as awarded by one mutual fund ranking company, according to a slew of experts who spent this week speaking to a group of financial writers and editors.

All of the above can be misleading and even counterproductive. The truth that many in the fund industry know is this: The vast majority of funds fail to beat the markets they claim to master. The top-earning funds tend to become the laggards. The superstars get drowned in cash and "regress to the mean," a statistician's term for back with the rest of the guys.

This is a good time to focus on the fundamentals of mutual fund choices, because many of the competitive differences among funds have been buried by the remarkable and probably unsustainable stock market returns of the last 15 years. Sooner or later, those returns will fall back to earth, or worse. Fund problems that have been obscured will become apparent. And the industry as a whole will be fighting harder for your dollars.

The experts who spoke last week tended to be highly regarded, well-educated, and armed with years and pounds of academic, statistical and practical research.

Here's the what is state of the science (art?) when it comes to picking funds:

Performance? Sort of. Experts say past results really is no indicator of future results.

In fact, Hulbert found the correlation between past returns and future returns to be statistically insignificant unless at least eight years of returns were considered. Even then the correlation was pretty weak.

There's no such thing as a hot hand. Nevertheless, funds do tend to get points for really long, steady performances that beat the market.

How do you find these? Not by aiming for the funds that top the 10-year returns list. Such a fund might have just been in the basement 10 years ago, or spent 9 1/2 years languishing before it took off. In gauging performance, look at the continuity the manager has turned in. If you want to find a fund to beat the market, try to find one that has beaten the market in every year of the last nine or 10.

Popularity, or lack thereof. The only investment philosophy that works over the long term is contrarianism. Those stocks that are undervalued by the crowd have made Warren Buffett and many of his disciples rich.

How does that translate to mutual funds? Typically, a successful small fund will start strong, pick up millions of investors and billions of dollars and then lose its way.

When funds get to a very large size, they can't be managed.

Too much money often changes a fund manager's style or ability to move in and out of favored stocks without distorting the performance of those stocks. Look for funds that meet your criteria but haven't been plastered on the cover of Money magazine yet.

Cost. This may be the most crucial factor affecting a fund's performance, but the news is not so encouraging. Average fund expenses have increased, even as assets have exploded and we should be receiving economies of scale.

What does that mean? That means today's stock fund has to beat the market by about 35 percent just to meet the market, after expenses. No wonder most funds lag the market. The more you pay to be in a fund, the more that fund has to stick its neck out just to give you mediocre results.

Don't pick a fund just by cost, but put that criterion up high on your list. In selecting a money market or bond fund, the fund's fees and expenses might be the most important factor in whether it makes you money or not. As competition in the mutual fund industry heats up, put some heat on your fund companies to bring their expenses down and keep them down.

Does it fit you? This is the single most important factor in selecting a fund. It should fit in two ways: Its investment approach should fit with your overall portfolio. So if you already own a large company growth stock fund, you probably don't need another.

Balancing your portfolio so that you know which types of funds you should be holding is the most crucial investment decision you can make. But besides fitting your portfolio design, the funds you choose should fit your risk tolerance. That's a measure that's hard to determine. Look at how far your target fund varies from the market, and imagine it doing that much worse than the market during a bear period of 20 percent declines.