How To Find The Best Funds

Mutual funds are like horses — both have performance charts, but past results don’t guarantee a win tomorrow.

Trend lines will help you identify which funds are on the way up, and which are on a slippery slope.

Some funds may produce fabulous results — but keep the Maalox handy!

With more than 1,500 mutual funds to choose from, it shouldn’t come as a big surprise that some are very good, some are very bad, and most float somewhere in the middle of those two extremes.

Obviously, you only want the very best ones for your portfolio. To heck with all the rest.

You and every one else.

There are just a couple of problems. For one, trying to pick the best funds isn’t easy. That’s why people like me write books on the subject. For another, the best funds for you won’t be the best funds for someone else. It all depends on what you’re trying to achieve.

But there are some broad guidelines you can use to at least narrow down the field. Here they are.

Track record. Mutual funds are like horses, in the sense that they have a performance record that any one can look up. They’re also like horses in another way — the results of last year’s races are nguarantee that they’re going to win tomorrow. Past performance is simply an indication of form — nothing more.

But the track record at least gives you some idea of how the fund has performed historically. And a fund that has consistently been in the first or second quartile of its category over several years (in other words, the top half) will likely continue to outperform.

Just remember when you’re studying the numbers not to give too much credence to short-term results. Most equity funds will be negatively affected by downward moves in the market. Since performance numbers are recalculated monthly, this will be reflected in the results for all years being reported. The shorter the term you’re looking at, the greater the impact of the most recent results.

The converse is also true, of course — upward moves in the equity markets will give a bigger boost to short-term (six months to three years) returns than to longer terms (five and 10 years).

I’m often asked what rate of return is necessary for a mutual fund to get back to a break-even point after a down year, taking commissions into account. Not surprisingly, there are a number of factors that come into play.

For starters, the lower the sales commission, the faster you’ll recoup any losses. That’s why it’s often (but not always) better to choose a back-end load sales option or a no-load fund.

Next, remember that equity funds don’t increase by a predictable amount each year. They follow the fortunes of the stock market. History shows that if you invest in good equity funds when the market is going through a tough period, you can expect to reap excellent returns when it rebounds.

You can find the performance history of every mutual fund in the country in a number of places. Most major newspapers publish monthly surveys of fund performance. Several organizations offer software that tracks fund results and allows you to compare those in which you’re interested to the rest of the field. There are several annual mutual fund guides which assess comparative fund performance on a quantitative and qualitative basis. So there’s no shortage of performance information. It’s simply a matter of taking time to find it.

Trend line. Just because a fund has a great 10-year record doesn’t mean it’s still doing well. You have to look at the trend line — how is the fund doing in comparison to others in the same category?

Volatility. Most Canadians are cautious by nature when it comes to their money. They don’t like a lot of risk, and they don’t like to own securities that bounce up and down like India rubber balls. Ulcers we don’t need.

That’s why most people wouldn’t put their money into a fund like Cambridge Growth, even though it gained almost 72% over the 12 months to Feb. 29, 2000. Their nerves couldn’t take it. Want proof? Look at the fund’s year-by-year results during the ‘90s.

1990: – 0.7%

1991: +13.6%

1992: + 2.6%

1993: + 61.7%

1994: – 21.3%

1995: + 2.7%

1996: + 6.7%

1997: – 31.5%

1998: – 39.1%

1999: – 19.4%

Be honest now. Sure, ‘93 was a great year. But would you have stayed in after that big 21% loss in ‘94? Or after the back-to-back-to-back losses of ‘97, ‘98 and ‘99? Maybe you have nerves of steel. Most people don’t.

That’s why it’s essential to look at volatility when you’re trying to pick the best funds for your personal needs. Fortunately, the information is easy to find. Most of the business papers include volatility rankings in their monthly mutual fund reports, so you can tell at a glance how much grief you’re letting yourself in for.

The economy. Some types of funds will outperform others at certain stages in the business cycle. For example, you can make good money in a recession, especially in the early stages, by putting money into bond funds. That’s because the Bank of Canada usually moves aggressively to lower interest rates when the economy turns sour, in hopes of encouraging investment and consumer spending. Bond prices rise in a falling interest rate environment, so bond funds will do well.

Stock funds are normally the best performers when the economy is beginning to turn the corner into a recovery phase. The typical pattern is that stock prices get beaten down to bargain basement levels during a recession. When economic conditions start to look better, cheap shares attract investor attention and the markets take off.

The bottom line is that picking the winners isn’t easy. But if you make the effort, there are a lot of valuable clues available to put you on the right track.

Adapted from Making Money in Mutual Funds by Gordon Pape, published by Prentice Hall Canada.