Those most elusive of magic bullets -- indicators that would predict the future performance of mutual funds -- may now be in reach for investors.
It's been a long time in coming. Hundreds of studies showed that past performance could be deceiving, though many investors had a tendency to look at that as a major driver of their fund choices. Factors such as fund size provided only limited guidance.
But recent research now suggests that there are reliable ways to pick funds.
The most notable advance has occurred with the ubiquitous Morningstar star system. Throughout the 1990s, academics complained about the stars. Studies showed that the system was almost useless for predicting future performance. Top-rated five-star funds didn't necessarily outdo funds carrying the lowest ranking of one star.
Hearing the complaints, Morningstar revised its stars in 2002. Now the new system has been operating for more than five years, and the results are noteworthy. On average, funds that received five stars in 2002 went on to outdo four-star choices over the next five years. Four-star funds surpassed those with three stars, and so on. The results proved consistent in nearly every category.
The average five-star international equity fund returned 20.05% annually during the five years. International funds with four stars returned 19.73%, and three-star winners returned 18.85%.
The system had particularly strong predictive value for balanced funds, which hold mixes of stocks and bonds. During the five years, the average five-star balanced fund returned 11.08%, while one-star funds returned 8.14%.
Morningstar improved its approach by making some common-sense revisions. Under the old system, funds were lumped into broad categories, such as domestic equity. In the taxable fixed-income category, Treasury funds were grouped with portfolios specializing in junk-bonds, which are rated below-investment grade. Such comparisons were worthless. Just because junk bonds outdo Treasuries one year does not predict that the winners will excel in the next 12 months. Now under the new system, the risk-adjusted return of each fund is only compared to its peers. Junk bond funds compete against each other.
While the stars can offer some important guidance, an even more reliable measure may have emerged in the past year: fund trading costs.
"Trading costs can provide an important indication about future performance," says Gregory Kadlec, a professor at Virginia Tech, who published a paper on costs along with Roger Edelen of University of California, Davis and Richard Evans of the University of Virginia.
The research paper provides some indications of how investors can use trading costs. More detailed guidelines are likely to appear soon, since Morningstar and other fund trackers are working to develop easy-to-use systems.
Fund trading costs consist of the brokerage commissions paid to purchase securities and other one-time expenses associated with buying and selling. Examining 1,700 funds, the researchers found that the average trading cost was 1.4% of a fund's assets. But those are only average figures. Many expensive funds have trading costs of more than 2.5%, compared to cheap funds that have burdens of less than 1.0%.
While academics have long known about trading costs, this is the first study to provide a detailed picture of how important trading costs are. Since the costs are subtracted directly from returns, expensive funds labor under a significant burden.
The odds of an expensive fund outdoing a cheap one are poor indeed.
Trading costs are not included in the more familiar expense ratios, which consist of management fees and other perennial costs. Many studies have shown that expense ratios have predictive value; on average, funds with high expense ratios trail competitors with low expenses. In the recent study on trading costs, the average expense ratio was 1.2%.
"In many cases, trading costs are more significant than the expense ratio," says Roger Edelen, one of the authors of the study on costs.
Though funds must disclose expense ratios, data on trading costs are not yet published. To get a rough idea of total trading costs, start by checking the costs of brokerage commissions.
In the past, finding brokerage costs was difficult. But in response to the fund scandals of several years ago, the
has begun requiring funds to disclose more data. Information on a fund's brokerage costs must appear in a document called the Statement of Additional Information.
In some cases, shareholders must request these from companies, but major fund families such as Fidelity and Vanguard list the documents on their Web sites. In many instances, large funds spend a relatively low percentage of their assets on brokerage costs because of economies of scale, while small funds face heavier burdens.
, which has $41 billion in assets, pays brokerage expenses equal to 0.06% of assets.
Fidelity Select Technology
, with $1.7 billion, spends 0.33% of assets on brokerage commissions.
Besides brokerage commissions, funds are burdened by a factor known as market impact. This occurs when a trader buys or sells. If the trader is bidding to make a big purchase of a stock, he may put upward pressure on the share price.
Say the trader wants to buy 100,000 shares of a stock priced at $25. He may be able to purchase the first 10,000 shares at $25. But then, the price may begin to rise in response to his demand. The trader may have to pay $26 to get the next 10,000 shares.
To avoid funds that have heavy costs connected to market impact, investors can search for managers that do relatively little trading.
But low turnover in itself is not a guarantee of low costs. For example, funds that trade big blue chips tend to have lower trading costs. This occurs because a single trade has little impact on the price of a giant like
In contrast, one big trade can push up the price of a small stock.
Large-cap funds with low turnover include
Davis New York Venture
Neuberger Berman Partners
The real usefulness of the recent studies will come when investors start combining the various indicators. If funds have low expense ratios and trading costs -- and five stars from Morningstar -- then the odds are very good that they will excel in the future.
Stan Luxenberg is a freelance writer who specializes in mutual funds and investing. He was formerly executive editor of Individual Investor magazine.