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Picking Mutual Funds: What Works and What Doesn't

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Mutual funds are big business, with more than $11 trillion in assets under management. Investors are confronted with a dizzying array of funds from which they can choose. As of December 2012, according to data compiled by Dimensional Fund Advisors, there were 3,705 domestic stock funds, 815 international stock funds, 357 emerging stock funds, 1,289 U.S. fixed income funds and 204 global fixed income funds. All of them are vying for your business. How should you go about selecting the ones that are right for you?

Here are some guidelines that may help you:

Recognize How Difficult It Is to Select Managers With Skill

Finding a fund manager who demonstrates skill in "beating the markets" is a daunting task. One study looked at fund returns over a 32-year period from 1975 to 2006. Only a tiny percentage (0.6 percent) were deemed to evidence skill as opposed to luck. These results are not surprising. Actively managed funds are burdened by high fees and expenses. In addition, the instant dissemination of information worldwide has made markets more efficient. It's not a level playing field for active managers. These are formidable obstacles to overcome.

Star Ratings Are Not Predictive

There has long been a spirited debate over whether Morningstar's "star" ratings are predictive of future results. The pros and cons are nicely summarized in this article.

Recent research by Dimensional Fund Advisors casts serious doubt on the predictability of past star ratings on future returns. Dimensional looked at all 14,822 U.S.-based mutual funds and sorted them by their Morningstar rating at the end of 2007. It then plotted the performance of these funds over the subsequent five-year period based on each fund's percentile rank in its respective peer category. If a high-star rating was predictive, you would expect high-star-rated funds to achieve high relative returns and lower-star funds to report lower relative performance.

Instead, the study found nearly 30 percent of the funds across all star ratings didn't even survive the subsequent five-year period. The funds that did survive displayed a broadly dispersed relative five-year performance. Based on this data, there does not appear to be reliable evidence that high-star ratings are predictive of persistent outperformance.

Other Metrics Aren't Predictive

Dimensional also looked at whether a financial metric known as the "Sharpe Ratio" was predictive. The Sharpe Ratio measures the expected return of fund per unit of risk. A positive ratio is indicative of better historical risk-adjusted performance.

The study looked at the U.S. fund universe of more than 12,000 funds. If the Sharpe Ratio was predictive, funds with the highest ratios in the prior five-year period should have continued their outperformance in the subsequent one. The data did not support this premise. There was no statistical difference in the subsequent performance of the high- and low-ratio funds. The study concluded that funds with high Sharpe Ratios "have no better chance than low-ratio funds of delivering exceptional performance in the future."

What Works?

Ironically, Morningstar has provided the strongest support for what investors should look for when selecting a mutual fund. In August 2010, it published a study that looked at star ratings and expenses ratios from 2005-2008. It then tracked those funds through March 2010. Here's the conclusion from the author of the study, Russel Kinnel, Morningstar's director of fund research and editor: "If there's anything in the whole world of mutual funds that you can take to the bank, it's that expense ratios help you make a better decision. In every single time period and data point tested, low cost funds beat high-cost funds."

The Takeaway

When selecting mutual funds, focus on low-management-fee index funds, passively managed funds or exchange traded funds.

Dan Solin is the director of investor advocacy for the BAM ALLIANCE and a wealth adviser with Buckingham Asset Management. He is a New York Times best-selling author of the Smartest series of books.

The views of the author are his alone and may not represent the views of his affiliated firms. Any data, information and content on this blog is for information purposes only and should not be construed as an offer of advisory services.