Put Mutual Funds to the Five-Point Test - TheStreet

One of the biggest cliches in investing is "Past performance is no indication of future performance."

Well, that oft-repeated platitude isn't necessarily true. Past performance can tell you plenty about what a mutual fund might do in the future -- just not in the way that you think.

Frankly, you

don't

want to buy a fund that has done exceptionally well in the past year or two. A fund that's up a lot more than the market and its peers might have been taking on too much risk or just happened to be in one of two hot sectors that are about to go cold.

But that's just one of the things you need to think about when picking a mutual fund.

Here's a list of the most important items to consider before putting your money in a fund.

Expenses

No one can possibly predict what a fund's future returns will look like or know if a manager will continue to pick market-beating stocks. You can, however, find out exactly how much it will cost you to invest in a mutual fund every year. You just have to look at fund's expense ratio. And that's one constant you can count on.

The less you pay in expenses every year, the more money goes in your pocket. It's that simple.

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Low expenses are one of the major reasons that stock pickers have such a tough time beating index funds that track the

S&P 500

and the Wilshire 5000. Even if a manager can actually beat the market every year, that fund is going to charge you more money than an index fund.

So a manager has to deliver truly outstanding performance to beat the market after fees and trading costs, such as commissions. If you take into account expenses and trading costs, an index fund has a performance advantage of about two percentage points a year.

Expenses are more important than ever these days, when investors shouldn't expect to make more than 7% a year in the market over the next decade. That makes low-cost index funds even more compelling.

But if you

are

going to invest in an actively managed fund, you want to find one that charges less than average. The average U.S. stock fund charges 1.45% a year in expenses. That number is worth memorizing.

Performance

Of course, you do want to look at the past performance of a fund. But returns that have been too fantastic should be a warning sign.

A fund that's been really hot over the past year could have been taking undue risks. Maybe it made a big bet on one area that happened to be the place to be. But when that sector heads south, the fund could blow up.

Everyone saw that happen in the late '90s. Funds that were supposed to be diversified instead piled into tech stocks. Those bets paid off in 1999 but have caused a great deal of pain for investors ever since.

For example, the

(POEGX)

Putnam OTC and Emerging Growth fund was up 127% in 1999, beating 94% of other mid-cap growth funds. But the fund fell more than 45% in both 2000 and 2001, ranking in the bottom 2% of its category.

Instead, look for a fund that's been able to consistently beat its peers. You want to find a fund whose returns ranked in at least the top half of its category over the last five calendar years -- top 25% is even better. Before 1999, that Putnam fund badly trailed its peers for three years in a row. That should have been a tip-off that its triple-digit return in 1999 was probably a fluke. It certainly wasn't a result of manager skill.

You don't need a fund that's recently blown away the competition. You just want one that can deliver solid, respectable returns without taking on too much risk.

Too Much Money

Too much money in a fund is also a performance killer. For one, a manager who is running a fund that's taken in a lot of cash might be forced to buy more stocks and larger stocks just to put cash work. That can quickly change the style and makeup of a fund.

Ballooning assets can be particularly detrimental to the performance of a small-cap fund. The manager might not be able to put enough cash in any one stock to make a big difference in the fund's performance. And buying of too many shares in any one illiquid stock can create wild swings in that stock's price and actually hurt performance.

Of course, the hard question is, how big is too big? A good test is to avoid a fund whose asset level is higher than the median market cap of the stocks in its portfolio.

Size is also a good contrarian indicator: Do you really want to be jumping into a style or sector that everyone else also wants to be in?

Risk

You also want to avoid funds that have taken excessive risk to produce decent returns. Standard deviation -- an indicator of a fund's volatility -- is one basic way to measure risk. Is the standard deviation higher than that of similar funds and the market as a whole? (You can find this figure on

Morningstar's Web site.)

Manager

And you do want to find a fund that's been run by the same manager for the past several years. A three-year tenure is the bare minimum. None of the fund's numbers mean a thing if a new manager just came aboard.

Ultimately, to pick a fund that's going to do well in the near future, you have to make a call on which part of the market is going to do well. That's impossible to do. Instead, you want to spread your money across different parts of the market and different funds. Make that good funds.

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