HOW TO IDENTIFY GREAT MUTUAL FUNDS

There are a lot of approaches to identifying great mutual funds, and I’ve experimented with all of them over the past twenty years. The method that appeals to most investors is also one of the least

effective—investing in funds highlighted in the financial press. Alas, these funds all too often disappoint after making the headlines. Here’s a strategy for selecting excellent funds—ones that should continue to be excellent—that doesn’t involve elaborate computer models or laborious analysis. Rather than

focusing on hot- performing funds, it adheres to your diversifi- cation model developed in chapter 3 by identifying the best funds in each investment category. So you can enjoy great investment performance within the parameters of sensible diversification.

Here’s the way for you or your investment adviser to find great investment candidates among the many thousands of available mutual funds:

Identify funds that have ranked in the top 25 percent (the top quartile) compared with their peer group for the past one, three, and five years. 

A strict screening process. Lots of funds—in fact, between four thousand and five thousand funds—rank in the top quartile of their peer groups over one of those periods, and the ads for such funds are quick to point that out. But only a select few are consistent enough to outperform three- fourths of their competitors over all three periods.

• Be sure you’re comparing apples to apples (e.g., a small- company growth fund versus all small- company growth funds)

• Beating 75 percent or more of a peer groupover three time periods is indeed a stringen test of a fund manager’s skill. Yet, still, a lot of funds fit the “all- star” bill. Here’s how many funds met the test in selected investment categories in early 2006:

128 large- cap funds

247 mid- cap funds

123 small- cap funds

40 international stock funds

27 multisector bond bunds

62 intermediate- term government bond funds

82 intermediate- term corporate bond funds

Including all fund categories, over sixteen hundred funds beat their respective peer groups over the past one, three, and five years, so there’s no dearth of excellent choices, whether you invest on your own or through an adviser. 

• While top quartile funds are more likely to perform well compared with their lower-ranked brethren, they might falter later on, so you need to check up on them periodically.

©2006 Jonathan D. Pond from You Can Do It! The Boomers Guide to a Great Retirement.  Reprinted with permission from HarperCollins Publishers

I will be live as this month's Ask The Author Wednesday, December 20th from 2-4pm, to answer your money questions. Leave a comment below and be sure to join me on the 20th.

Read another excerpt from You Can Do It!
Buy You Can Do It:

Barnes & Noble

Amazon

Book Sense