David O’Leary, founder and principal of Kind Wealth, suggests tracking a fund’s performance backward to see how well risk was managed in times of crisis.Glenn Lowson/The Globe and Mail
Mutual fund companies spend a lot of marketing dollars touting performance, but it's not widely known that the average mutual fund underperforms its benchmark index.
On the bright side, that means a vast number beat their benchmarks – and many leave them in the dust. The trick to finding winners, fund researchers say, is to know where to dig.
That can be challenging because mutual fund companies are not required to give much information about their offerings – a brief description, periodic performance, fees and a few top holdings.
Christopher Davis, director of research at Morningstar Canada, says the first clue to a good fund is finding managers who go above and beyond to explain their objectives.
"It makes sense to invest with managers who give good information on their websites, have insightful fund-holder letters and provide context and insight into why they are doing what they're doing," he says.
He suggests looking for portfolio managers with specific strategies to outperform the broader markets, and being wary of those simply rehashing market news.
"If you see they are simply reacting to the latest news, they may not be making good decisions," he says. "Look for a strategy that makes sense and can be repeated again and again."
He also recommends doing detective work to examine managers' track records and reputation in the business media.
"It's better to have seasoned, stable management that has been there for some time. If a fund has a good record and the manager is new, the record isn't very meaningful," he says.
While smaller fund companies can provide fresh market perspective, Mr. Davis says they often can't compete with bigger firms that have research departments, ample resources and a wide global reach. "If a manager has been successful, one reason is they are backed by a large team of analysts to provide them research," he says.
But the most quantifiable measure of how well a fund will do comes down to fees, he says. The fee on a mutual fund, known as the management expense ratio (MER), is a percentage of the total amount invested, and it goes to the mutual fund company each year. If a fund gains in value by 10 per cent one year and the MER is 2.5 per cent, for example, the investor will realize a gain of only 7.5 per cent.
Over the years, Mr. Davis says, a lower MER is guaranteed to boost returns. "All things being equal, cheaper is always better," he says. "Research shows again and again that fees are the best predictor of long term performance."
Like many fund-tracking websites, Morningstar has a system that ranks mutual funds from best to worst. Mr. Davis says fund ratings can give insight into the quality of management, but he admits they have flaws. "It merely tells us that a fund has been successful, not that it will be successful," he says.
Mutual fund researcher David O'Leary, founder and principal of Kind Wealth, says a lack of information from mutual fund companies stacks the cards against investors looking for professional active management.
"I think the average person is probably not going to do a very good job at it. It is really tough," he says.
For investors with limited resources, Mr. O'Leary agrees the best quantifiable measure of how well a fund will perform is the fee. "If you're going to focus on only one thing, price is the biggest," he says.
Beyond fees, he suggests tracking a fund's performance backward to see how well risk was managed in times of crisis. Search the Internet for a chart to compare how the fund performed when the technology bubble burst in 1999, for example, or the financial crisis of 2008. It might provide insight into how well risk is managed ahead of the next market crisis.
"You can see these periods and find how they did. Was the fund performing worse than the index or better than the index when the market fell apart?" he says.
He also warns investors not to rely on the top stock holdings listed on the fund company's website. "In any given moment what they own in the portfolio is not particularly useful because it can change at any moment. It's also out of date. You could be looking at something they held six months ago," he says.
One option for investors who normally buy mutual funds on their own is to seek information through an accredited advisor, who could have enough leverage to pry more information out of a mutual fund company. "As an advisor, if you are recommending clients, the companies that sell the funds are probably going to give you more of their time," he says.
Investing in mutual funds through advisors has a price, though. In most cases they are compensated by the mutual fund company through a commission embedded in the MER, and it is often hard to tell whether they are acting in the client's best interest or the mutual fund company's.
Advisors can also be compensated through fees when the fund is purchased or sold, known as front- or back-end loads, or a deferred sales charge (DSC).
Mr. O'Leary says investors should refuse to pay any loads.
"If you're dealing with an advisor who is trying to sell you a back-end load or DSC fund, I would strongly consider going somewhere else to get advice. They're very close to being made illegal," he says. "They are now illegal in the U.K. and Australia."