Cutting Through Mutual Fund Confusion
Andrew Leckey

Are mutual fund investors jumping from the frying pan into the fire?

Many have been aggressively shifting their mutual-fund money around in 2010, but often aren't as careful as they should be in selecting the new locations for their dollars.

It pays to take a deep breath before making changes in your portfolio of mutual funds. The manager of a fund, the past performance, whether the fund lives up to its name, its volatility and its expenses should be considered carefully.

"It is a mistake to think a fund's track record is the most important consideration because you should really be looking at the portfolio manager," believes Vern Hayden, president of Hayden Financial Group LLC, Westport, Conn. "For example, there may be a new manager at an existing fund who may or may not mess up the fund in the future."

A manager with a track record of 10 to 15 years, which includes some difficult markets, is his preference. If the fund didn't do any better than the average for its benchmark index, Hayden won't put in money because he only wants managers with proven ability to respond to bad times.

"I also wouldn't put much weight in the name of a fund since sooner or later they tend to deviate from their names," added Hayden. "Since it is almost impossible for an individual investor to talk to a fund manager, call the fund company and ask it to explain the fund's philosophy."

The most important consideration in selecting funds is the expense ratio, which is the percentage of fund assets paid for operating expenses and management fees, according to recent Morningstar Inc. research.

In every category of stocks and bonds, the funds with the cheapest expense ratios outperformed the priciest funds in total return over three- and five-year periods. The expense ratio includes fees such as accounting, administrator, advisor, auditor, custodial, distribution, legal and shareholder reporting. It does not reflect the fund's brokerage costs or any investor sales charges.

"Expenses are the best predictors of a fund's performance--bar none--and a good investing process starts there," said Russel Kinnel (cq), director of mutual fund research for Morningstar in Chicago. "If a fund treats investors well on cost, chances are it will treat investors well elsewhere."

Investors tend to read too much into recent performance, thinking a good year means a manager is brilliant and a bad year means a manager is an idiot, Kinnel said. Every fund has different parameters, every strategy and manager has bad years and even the worst managers can have some good years.

The best timeframe to scrutinize is from the point the manager took over the fund until the present, Kinnel advised. If the management record is short, look at the performance where that person was previously working. Single-year returns are worth considering only in terms of how volatile a fund may be, since mutual funds are long-term holdings.

For example, the respected Dodge and Cox Stock Fund (DODGX) has a 10-year annualized return of 5 percent to rank in the upper one-tenth of large value funds. However, since 2003 that has included two years with gains of more than 30 percent and one with a drop of 43 percent. The decade-long figure doesn't note the year in which it tumbled.

"The fund industry has gotten better about making fund names less misleading and, while some have vague names, those may be chosen on purpose because the manager has a wide-ranging style" said Kinnel. "The target-date funds are examples of the best-named funds because if it says target date 2020 that pretty much says that it is addressing your retirement in the year 2020."

In regard to mutual fund names, the SEC requires that a fund whose name notes a particular investment or industry (such as a stock or bond fund) must invest at least 80 percent of its assets in that type of investment. A fund whose name indicates a particular country or geographic region must disclose in its prospectus the criteria used to select investments to meet that standard.

In bond funds, terms such as short term or long term must also meet certain criteria in the maturities of their holdings. The name rule does not, however, apply to fund-name terms such as balanced, small-capitalization, growth or value, as opposed to a specific type of investment.

Index funds, a low-cost mutual fund answer that many experts prefer, are noteworthy as investors pull money from stock funds into bond funds. Lack of an active manager and active trading mean fewer expenses.

"Investing with mutual funds basically means you give up the chase for perfection," believes Paul Merriman, editor and publisher of www.fundadvice.com, Seattle. "I like index funds instead of actively-managed funds, so the energy that would have been devoted to the market can instead spent on family, career and future."

He'd put money in about 10 different index funds, including not only the Standard and Poor's 500 index, but others such as large value, small value, small-growth-and-value and emerging market funds. There should also be a bond component in the overall investments.

While you must spend some time determining the lowest-cost index funds, Merriman concluded, you needn't spend much time monitoring them after that.

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