How to find winning mutual funds

Zoomer | January 1st, 2006

Figures don’t lie – or do they? Over the 12 months to Aug. 31, the Scotia Canadian Blue Chip Fund gained just a shade under 50 per cent for its investors. Not many people would turn up their nose at that.

Looking back at the historical returns, the fund shows an average annual compound rate of return of 14.3 per cent for three years. Over five years, it’s 15.8 per cent. Very respectable, you might say. Impressive recent returns and a fine longer-term record as well. That’s good enough for my money!

Well, is it? The problem is that a strong one-year performance can inflate mediocre long-term numbers, making the fund appear to be much stronger than it actually is.

For example:

  • Would your thinking about the Scotia fund change if you were told that in every year from 1993 to 1998 it was a below average performer?

  • In fact, in four of those six years, it actually finished in the bottom quartile of its peer group, the Canadian Large Cap category.

That puts a rather different spin on things. Now we start to wonder if the fund has really turned around or if it’s just the beneficiary of the rising tide the TSE that lifted all Canadian equity funds over the past year.

Finding the good funds
Investors need a wide variety of tools to determine a fund’s effectiveness and the probability that it will succeed in the future. There are no guarantees, of course. Funds once very solid have fallen into obscurity. Some funds at the bottom of the heap a few years ago have risen to the top because of a managerial change.

But, over the long haul, consistency shows through. Managers may move on, but a strong fund company is always able to replace those people with equally good, or better, successors.

Every fund has its ups and downs. To invest in a fund – or to pull your money out – on the basis of a single year’s performance is short-sighted. In most cases (there are exceptions), mutual funds should be considered as a long-term investment. So it’s important to be able to identify funds with proven staying power over time.

Right now, we have no simple way of doing that. So Mutual Funds Update has devised a new rating technique to do the job. We call it the Consistency Rating©.

Here’s how it works:
We look at the quartile ranking for a fund over any given time period. To illustrate, we’ll use the quartile rankings currently available on Globefund, a free service available to everyone with Internet access.

  • Globefund shows annual quartile rankings within each fund category for all calendar years from 1993 to 1999.

  • It also shows the year-to-date quartile ranking – to Aug. 31 at the time of writing. So we have a maximum of eight quartile rankings per fund to work with.

  • A ranking of 1 means the fund was in the top 25 per cent in its category in that given year.

  • A ranking of 4 means it was in the bottom 25 per cent.

  • By adding the quartile rankings and dividing by the number of periods under review, we get the Consistency Rating (CR for short).

    • For example:

    • A fund that was in the first quartile for every period would receive a CR of 1.00, a perfect score.

  • A fund that was in the last quartile for every review period would get a score of 4.00 – the lowest point on the scale. It’s not complicated – you can calculate it yourself for any fund in which you are interested. But the results can be quite surprising.

    • We worked out the Consistency Rating for funds in three Canadian equity categories, using only those that had records dating back to 1993. Here’s a look at the best and worst performers in the broadly-based Canadian Equity group. Only funds that are currently available to the general public (either directly or in an alternative form) and have broad distribution are considered.

    Canadian Equity Funds (diversified)
    The Best                                                            Consistency Rating
    Universal Future                                                         1.625
    Standard Life Ideal Equity                                           1.750
    AIC Advantage                                                           1.875
    Green Line Canadian Index                                         1.875
    Four tied                                                                    2.000

    The Worst
    University Avenue Canadian                                        3.625
    Global Strategy Canada Growth                                   3.375
    Industrial Growth                                                        3.375
    Investors Retirement Mutual                                        3.250
    Trans-Canada Value                                                           3.250

    Top and bottom funds

    • The real surprise was to find Universal Future Fund all alone in the number one position. This is a good fund and it consistently gets a $$$ rating in the annual Buyer’s Guide to Mutual Funds. But because of its emphasis on technology stocks (about half the portfolio) it is generally considered to have above-average volatility. The excellent CR score shows this is not a concern. Over the eight time periods surveyed, the fund was in the first or second quartile on all but one occasion. Moreover, the fund has been directed by the same manager, John Rohr, over the entire period, so there is stability at the top.

  • The Standard Life Ideal Equity Fund, which came in second, is a segregated fund that we have consistently rated very highly.

  • The good CR score of the AIC Advantage Fund may surprise many people because this fund, and Advantage II which is the version currently on offer, had a poor year in 1999 when financial services stocks tanked under interest rate pressure. But over the longer term, this fund has been a steady performer and investors who dumped it may regret their hasty action.

  • The high score achieved by the Green Line Canadian Index Fund gives added credence to those who argue that index funds deserve a position as a core portfolio holding.

    • The worst CR scores
    Two stand out:

    • Global Strategy Canada Growth Fund has been managed by Tony Massie since 1992. He came to GS with a strong reputation, but the weak results show he has not been able to deliver the goods.

    • Also worth a comment is Investors Retirement Mutual Fund. This fund has almost $2 billion under management. That’s a lot of money to be invested in a fund with such a weak CR score. If you’re in it, perhaps it’s time to switch.

    Abridged from the October issue of Mutual Funds Update, a monthly newsletter edited and published by Gordon Pape.