How to pick a winning mutual fund

For all the time investors spend talking about individual stocks, the vast majority of Canadians aren’t stock pickers at all, they’re mutual fund holders.

Numbers from the Investment Funds Institute of Canada bear this out. The Canadian fund industry manages $789 billion. Another $50 billion are invested in ETFs. But for being such a core part of our savings, relatively little has been written about how to choose the right mutual fund. For better or for worse, investors have largely left that task to advisers. But whether you’re picking a stock, ETF or mutual fund, you have to do your due diligence if you want a good return.

Morningstar, a Chicago-based company that rates mutual funds and other securities, determines whether or not a fund is a good buy  by rating it according to five Ps: people, process, parent company, performance and price.

People

Nick Dedes, a Toronto-based fund analyst with Morningstar, says it’s imperative that investors look at the team running the fund. Investors should look for an experienced fund manager who is backed by a strong team.

Management turnover is another factor to consider. Is a manager leaving every couple of years, or has he or she been at the helm of the fund for quite some time? You want to see as much stability in that position as possible, says Dedes.

It’s also a plus when the fund manager invests his own money in the fund, says Dedes, but you need to look at how their compensation is structured as well. “Most managers say they invest with a three- to five-year time horizon in mind,” he says. “If that’s the case we want to see compensation contingent on how the fund has performed over that period of time—not over one year.”

Process

Investors should look for funds that have a process that is “sensible, clearly defined, repeatable and something that can be implemented effectively,” says Dedes. It should be obvious how the managers are generating returns. Are they taking a value or growth approach? What risks are involved? What are they doing to add value that other managers aren’t?

The repeatable part is key. “You want to see an approach that isn’t a one-hit wonder,” says Dedes. A manager who buys stocks that are cheap and watches them appreciate over time is going to have a much better chance of repeating that approach.

Parent company

A fund company can make or break a fund depending on its policies and its own financial health. “The significance of this one may not be immediately apparent, but it’s important,” says Dedes.

One thing to look at is how companies treat fund capacity limits. If a fund gets too large it can become difficult for managers to find suitable investment opportunities for all of the cash. This problem is more common for funds that have very focused mandates. If a fund is allowed to get too big, the manager could be forced to take uncomfortably large positions in select companies or take positions in companies they wouldn’t have otherwise. Either course of action could hurt the fund’s performance.

You also want to see that the company has investors’ best interests in mind, which is not easy to do when it  must also appease shareholders. “It’s complicated,” says Dedes. “From a profitability standpoint companies want to bring in more assets, that’s good for business. But it could have a negative impact on fund performance.”

Performance

Investors tend to get hung up on past performance. The thinking is that if a fund did well over the last 10 years, it’ll likely continue to do well in the future. But that thinking can get you into trouble. Past performance doesn’t have much predictive value, says Dedes.

Still, there are some good reasons to look at what’s happened in years gone by. The main one being that it allows you to see how well a fund’s strategy actually works. Look at especially volatile periods, such as 2008 and 2009 to see how the fund performed. If the fund says it is sacrifices returns in an upswing for more protection in a downturn, look back and see if that actually happened. “The bigger concern would be if it did well in those years when it wasn’t supposed to,” Dedes says. “That means it deviated away from what you’d expect.”

The longer the track record the better. Be careful of funds that have only been around for a year or two, says Dedes. You can’t be sure why a fund did well or not with such a short time frame.

Also, when choosing which funds to buy, compare performance against the fund’s peers. Looking at a small-cap versus a large-cap fund doesn’t make sense. If you’re buying a balanced fund, make sure to compare funds that have the same asset allocation. Some have a 60% weighting to stocks, others have a 60% weighing to bonds so you can’t compare all balanced funds against one another.

Price

Fund fees are the final piece of this mutual fund picking puzzle. “Fees,” says Dedes, “are guaranteed to detract from overall performance.” If a fund looks attractive, be sure to check out the fee before buying. If it’s got a 4% management expense ratio, which some funds have, then consider looking elsewhere. High fees don’t always mean better managers, explains Dedes. “Many strong shops and investment mangers out there do charge reasonable fees.”

You should expect to pay around 2% for a mutual fund. But some fund types will cost you more. Emerging market funds, for instance, are more expensive than other funds so make sure to compare fees within a peer group.

There are other factors that you can consider when picking a fund, but you don’t need to make it any more complicated than it already is. Stick to these five Ps and you should be able to find yourself some solid buys.