A 10-minute test for mutual funds

By Morningstar

These days, it seems that everyone has a 10-minute test for picking stocks. Because there are now more than 8,000 mutual funds, the ability to figure out quickly which ones are worth detailed examination is as crucial in the fund realm as it is in the stock realm. Let's go through Morningstar's 10-minute test for mutual funds to help you narrow your focus.

A caveat before starting: Many of the rules have exceptions. However, if you apply these shortcuts, you'll significantly increase your chances of eliminating duds.

Examine what the fund owns

You should have an idea of what you want your asset allocation to be -- how much money you want in stocks and bonds -- before you start looking at funds.

If you're looking at a stock fund, ask whether it owns lots of big, recognizable companies that can make it suitable as a core holding. Or is it a small-cap fund that owns businesses that you haven't heard of before, making it a good candidate for a supporting player in a portfolio? Is the manager impressed with earnings growth, or is he or she more value-oriented, trying to buy stable earnings or assets at a deeply discounted price?

If it's a bond fund, does it hold longer-term bonds whose prices may bounce around as interest rates move, or is a shorter-term fund that will remain steadier but typically pay you less interest?

Avoid high expenses

Mutual funds are one of the few areas of life where paying more rarely gets you a better product. Fees cut into performance in a big way over the long term.

For example, say you invested $4,000 a year for 30 years in each of two funds, one charging 1% a year and the other charging 2%. Assuming you earned an identical pre-expense return of 9% in both funds, at the end of the period you'd have accumulated $453,000 in the cheap fund and $378,000 in the more expensive one.

It's best to avoid any stock fund charging more than 1.25% and any intermediate bond fund with an expense ratio above 0.75%. You may have to pay extra for specialized fund types, but there's rarely a good reason to pay more than 1.5% for any type of fund, no matter how exotic.

Look for experienced management

Another factor to consider is manager tenure. A manager who's been through a bear market or, better still, a couple of the market's routine ups and downs is more likely to stick to his or her style when the going gets tough instead of trying to time what's hot.

Sticking to a style is a strong prerequisite for long-term success in money management. Look for a manager with at least five years' experience. If a manager hasn't been running a fund that long, try to see whether he or she has managed other funds successfully.

Avoid fast traders

Although there are a handful of managers who have earned their keep by using fast-trading strategies, you can live a long and happy life without having such a fund in your portfolio. That's because quick trading doesn't exhibit the business approach to investing that Morningstar favors, whereby one tries to purchase a piece of the future profits of a business at a cheap or reasonable price.

Quick traders also lose a large chunk of gains to the tax collector. Moreover, the commissions for all those trades cost shareholders money and aren't reflected in the expense ratio. If you're looking to winnow down the fund universe to a more manageable group, look for turnover ratios of 50% or less on stock funds, which imply that the fund is holding a stock for two years, on average.

Look for managers with skin in the game

Check how managers are compensated -- specifically, if their compensation is based on longer-term performance (preferably five years) to show that their interests are aligned with those of long-term investors.

For the same reason, check whether they have a significant portion of their own money in the fund. If it's a veteran manager running a core holding, a good yardstick would be an investment of $1 million in the fund. These details can be requested from a fund company or found on the company's Web site.

Check how investors have used the fund

Check out Morningstar's new Investor Returns data, which can give you an idea of the typical experience for investors in the fund. Is the fund so volatile that people tend to misuse it, piling in after extended strong performance only to sell their shares after a cold streak when the fund is about to rebound again?

Keep in mind that investors don't misuse only volatile funds. The Jensen Fund (JENSX), for example, exhibits minimal volatility relative to its large-growth peers. However, because it goes through periodic flat spells, it appears that investors often misuse it, based on its 10-year annualized return of 9.5% and its investor return of 5.9%. At a certain point, such discrepancies are not the fund's fault. Investors have to be responsible for their own misuse of mutual funds, and this case probably serves as an example of that.

Look at long-term performance

Performance is usually the first thing that captures investors' attention, but it makes them forget about all the other important things that often result in or are the precursors to good performance. Moreover, investors often imbue short-term performance with too much meaning.

Morningstar's advice on judging a fund's performance is that longer time periods provide the most insight into how a fund is apt to behave in the future. Five years should be the minimum, and 10 years is preferable. Keep in mind the dates of manager changes so that you attribute the correct performance to the manager who is running the fund now. The Morningstar Rating for funds is based on longer-term performance, when a fund has it, and adjusted for volatility.

Beyond the 10 minutes

Read Morningstar's fund analyses after you've completed the 10-minute test. The analysts try to be sensitive to a particular fund's quirks, indicating when you should overlook things like fees (rarely) or recent performance (less rarely). The analyses are also sensitive to what could go wrong with a fund -- or at least what could put it in a slump -- and conclude as firmly as possible whether a fund is a buy or sell.

This article was reported and written by John Coumarianos for Morningstar.