Picking Good Mutual Funds

A Simple Method for Picking A Good Mutual Fund

Not all mutual funds are created equal. Some are indeed great investments. But many mutual funds are poor investment choices for one basic reason: they fail to employ a solid investment philosophy.

It is not uncommon to find mutual funds that are called “index funds.” Index funds basically employ a blind investment strategy: they buy a little bit of every company in a stock index. Now, some financial managers see this as a good investment strategy because it gives you instant diversification. The problem is that index funds are not selective enough in their diversification: they spread your money between good companies and bad companies, as well as expensive companies and cheap companies. In our uncommon opinion, index funds are not rational choices for maximizing your investment return.

Mutual fund investing has many benefits, and perhaps the best one is that the majority of your research comes in the form of identify a good mutual fund manager who you can trust with your investments. Once you’ve done the work upfront, you can enjoy consistent returns that beat the markets.

So how do you find a good Mutual Fund?

Follow these 8 rules and you’re sure to find a good fund with a trustworthy manager.

Rule 1: Only invest in a mutual fund that has been around for at least 10 years

Rule 2: Avoid funds with high-expenses (above 1.35%) and only go with no-load funds (funds that don’t charge to purchase or sell shares)

Rule 3: Only invest in a mutual fund that has a 10-year, 5-year and 3-year return that beats the S&P 500 (aim for at least 12%)

Rule 4: Never invest in a mutual fund that has lost money in any three-year period and avoid funds that lose money two years in a row.

Rule 5: Look for consistency: choose three different three year periods of time and see if the fund has consistent returns over each of those periods above your goal (e.g. 12%).

Rule 6: Look for consistency II: Do the three-year, five-year and ten-year average annual returns and make sure they all fall above your goal (e.g. 12%)?

Rule 7: Look for consistency III: Make sure that the mutual fund does not rely on luck. In other words, don’t pick a mutual fund that had abnormally good returns in one year. Such a year might artificially make the fund look good, when in fact the manager just got lucky.

Rule 8: Never invest in a fund that seems to employ a blind or random investment philosophy. In other words, don’t invest in a mutual fund whose manager neglects to discriminate between good and bad companies, but instead invests your money with, for example, all the major “energy” companies. This is a recipe for disaster.

Using these methods, we’ve identified these three excellent mutual fund choices (as of November 2005):

FPA Perennial Fund (FPPFX)

Three year 18.53 +5.5% on the S&P

Five year 16.96 +5.5% on the S&P

Ten year 15.89 +6.6% on the S&P

2002-2004 14.52% Average annual return

1999-2001 19.40% Average annual return

1996-1998 16.50% Average annual return

Investment Strategy: “The managers believe that owning high return-on-equity companies over the long term produces high shareholder returns and that a patient investor can take advantage of price opportunities or market inefficiencies to periodically acquire the securities of such companies at attractive prices.”

ARIEL FUND (ARGFX)

Three year 15.95 +3% on the S&P

Five year 13.65 +2.5% on the S&P

Ten year 14.84 +5.5% on the S&P

2002-2004 14.94% Average annual return

1999-2001 12.41% Average annual return

1996-1998 23.28% Average annual return

Investment Strategy: “We believe successful long-term investing results from disciplined research, not from impulsive speculation or arbitrary guesswork. Since 1983, we have pursued an investment agenda that emphasizes small and medium-sized companies whose share prices are undervalued.”

Muhlenkamp (MUHLX)

Three year 22.77 +10% on the S&P

Five year 14.48 +3.5% on the S&P

Ten year 15.83 +6.5% on the S&P

2002-2004 17.5% Average annual return

1999-2001 15.35% Average annual return

1996-1998 21.7% Average annual return

Investment Strategy: “Invest in the common stock of highly profitable companies, as measured by Return on Equity (ROE), that sell at value prices, as measured by Price to Earnings ratios (P/E).”

Bonus: Low P/E 12.9