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Tips to picking good funds in the future
Qualitative factors are critical to picking future winners

Funds analysts and experts have been dumped on over the past couple of years for failing to pick above average mutual funds in their annual fund guides and in newspapers. With manager changes and fund company consolidations it becomes difficult to know tomorrow's winners. However, there are a few mutual fund characteristics that should give you a clue to a fund's future potential. Don't get me wrong, this isn't perfect but it's as good a guide as any to picking solid funds.

Costs matter

Most fund rating methods use the same approach for all funds. Frankly, most are based primarily or exclusively on past performance so fees are rarely, if ever, explicitly factored into ratings. While management expense ratios (MERs - a fund's management fees and operating expenses expressed as a percentage of a fund's total value) shouldn't be the focus of investors' fund picking efforts, an investment's total costs are more important for some funds than for others.

For example, investors looking for a bond fund would be quite successful if the first screen was the fund's MER. Why? Bonds simply don't have the potential to deliver big returns as do stock investments, so fees are likely to be a bigger factor in a fund's future performance. On the other hand equity fund MERs are less important. Hence, costs are always a factor, just more or less of one depending on the type of fund we're talking about. However, with equity funds, the tally of costs goes far beyond the published MER. While the MER sounds like an all-inclusive expression of fund-related fees, think again.

Recall that an equity fund's manager is paid to make buy and sell decisions for the fund on a continuous basis. If you've ever bought stocks directly, you know there is a commission charged for both buying and selling stocks. Who pays for those charges in a fund? Well, fund unitholders do but it's not a cost that is included in the MER figure. In fact, you'll have to dig deep just to find the number and jump through a few more hoops to calculate it as a percentage, like the MER. Last summer, I wrote this article for Canadian MoneySaver magazine on the true cost of owning funds. It showed that a fund's true cost can sometimes be as high as double the posted MER. (Note: Since that article was written, GST and other expenses previously excluded are now required to be included in the MER. However, commissions on stock trades remain excluded from MER calculations.)

While actual brokerage charges can only be found in a fund's annual information form (AIF), there is a more accessible figure that will allow you to get a sense of a fund's trading costs without having to do a bunch of work. In a fund prospectus section on fund-specific information, there is a table entitled "Ratios and Supplemental Data". In the last row of that table, you'll find the fund's portfolio turnover rate (i.e. trading frequency) for the five most recent calendar years. The turnover rate is in percentage terms, and expresses the proportion of the portfolio's assets that are traded each year. Since trading costs are a direct result of turnover, they can be estimated quickly with this figure, as follows:

  (portfolio turnover rate in percentage terms) x (0.003)

To illustrate, let's use the Yorkton Knowledge Industries fund. In 1999, it had a published MER of 3.1 per cent and turnover of 269 per cent. We can estimate trading costs at 0.81 per cent (269 x 0.003), bringing total costs to 3.91 per cent.

Generally speaking, equity funds with total fees of 3 per cent or more should be avoided. There are some exceptions in specialty categories, but that's a good rule of thumb.

Style factors

Investors have enjoyed tremendous returns from equities and bonds over the past fifteen to twenty years. However, the next fifteen to twenty years are unlikely to be as buoyant. This opinion has been echoed over and over during the past couple of years by such investing legends as John Bogle, Warren Buffett, Sir John Templeton, and numerous academics. I have a bias toward value-based managers to begin with, but given this dimmer view of the future, I maintain that holding value managers for the core of your portfolio will be more important than ever.

What if I'm wrong (along with Bogle, Buffett, etc.) and the future will be better than we think? Okay, I still say value is the way to go because it provides better risk-adjusted returns. Study after study has shown that stocks with lower price-to-earnings and price-to-book multiples produce superior returns over time - an anomaly that has persisted over a very long time frame.

Intuitively, it makes sense: buy stocks at a lower price and you'll likely earn a higher return over time.

Management structure

This last criterion is the most subjective of all, and it refers to whether or not a fund's success is the result of one individual or of an entire team. This was the focus of my October 2000 research article on manager turnover. This may or may not be important right now, but over a long period of time, continuity is important. For instance, CI Harbour and Mawer Canadian Equity are both fund emphasizing larger Canadian stocks. While their approaches differ somewhat, they both look to buy growth companies at very reasonable prices. While CI Harbour is more dependent on Gerry Coleman (its lead manager), the Mawer offering has greater depth in management and a philosophy that runs firm wide. I wouldn't hesitate to recommend Harbour fund, but all things being equal, it may be preferable to have a fund with great continuity.

There simply is no secret to picking funds. Ironically, the criteria used to pick funds is similar to that used by money managers when choosing stocks - good management, a solid track record of success, an efficient cost structure, and the ingredients needed to fuel future growth. While the computer-driven fund picking methods of the world can be helpful in sifting through the ever-growing universe of mutual funds, it should only be a starting point. Add in some qualitative information and some factors that we know impact future performance to some extent (like costs and stock valuation multiples) and you'll have a better chance of picking a good fund, than if you went strictly by annual mutual fund books and website rating services.

Next Week: the weaknesses of fund rating services.

Dan Hallett, CFA, CFP is the President of Dan Hallett & Associates Inc. in Windsor Ontario. DH&A is registered as Investment Counsel in Ontario and provides independent investment research to financial advisors. He can be reached at dha@danhallett.com
 
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Disclaimers: Consult with a qualified investment adviser before trading. Past performance is a poor indicator of future performance. The information on this site, and in its related newsletters, is not intended to be, nor does it constitute, financial advice or recommendations. The information on this site is in no way guaranteed for completeness, accuracy or in any other way. More...