Six steps to help create a system for rating funds

The Baltimore Sun

Lipper Inc. quietly announced last week that it is changing how it presents its research, modifying its rating system effective in November.

The new system uses a numeric scale on which the top 20 percent of funds -- the Lipper Leaders -- will get a mark of 5 on a 1 to 5 system. It's a 180-degree change because the new high mark is the low score under Lipper's current system.

The change brings Lipper in line with many other independent research firms -- most notably Morningstar Inc. -- where top performers get the most points.

But if Lipper, one of the most established and respected observers of the fund world, can change the way it rates funds, investors should consider whether the way they pick funds is in need of an upgrade.

Long-term happiness with a mutual fund is often traced to what someone was thinking when they made their first purchase. If the bull-to-bear-to-bull swing of the last decade, the fund scandals, huge interest-rate shifts and more have taught us anything, it's that keeping your selection process static and rooted in the past is folly.

Furthermore, the development of new analytical tools -- such as the Lipper ratings, which debuted in 2001 -- has made the process easier.

Developing a system based on your personal beliefs is crucial. That said, here is my six-step program -- which started many years ago with nine points -- to use as a guide. Come up with your own plan of attack -- writing down your criteria in order of importance -- before buying your next fund.

Step 1: Determine why I want or need a new fund.

Hobbyists make impulse buys, select the flavor du jour, or add to a collection, rather than building on a strategy. Deciding first what the money must accomplish -- whether it's diversification, growth, stability, income or something else -- allows me to properly set my expectations.

Step 2: Cut to the asset class first, then apply the selection criteria.

Generally speaking, I dislike funds with above-average costs and managers with a tenure of less than 10 years. I avoid funds with sales charges, not because load funds are bad but because they're inappropriate for someone who doesn't rely on an adviser for guidance.

I also make sure the minimum initial investment -- or regular deposits to avoid the required deposit -- are within my budget; there's no sense fixating on a fund you can't afford.

Step 3: Learn the story of the fund and its manager.

Success depends on having trust and confidence in the fund, whether it is the manager's expertise or the common-sense simplicity of indexing.

To find a compelling reason to buy, delve into a fund's newsletters and reports, which may offer insight into the manager's style and discipline. If a fund's own paperwork doesn't help convince you to take a leap of faith, keep looking.

This is also the time to factor the fund firm's past behavior into play. If there are scandals or troubles in management's past, you must be convinced the worst is over or you should move on.

I want to finish this step able to articulate my knowledge of a fund well enough to justify its place in my portfolio to, say, my wife. If I can't explain my interest now, I won't be able to stick with the fund when the market gets hairy.

Step 4: Examine peers, check returns.

When performance is the first selection criteria, investors tend to chase hot numbers. While I want the fund's asset class to drive the decision more than raw results, you ignore the past at your own peril.

My initial cut is for funds in the top 25 percent of their peer group over the last five years. Consistency is key, too. I'll sacrifice some upside potential for a smooth ride.

Step 5: Choose the finalists, get independent research and read the prospectuses.

I look for holdings that are consistent with a manager's discipline, and examine what a fund is allowed to invest in, which shows how the portfolio might change over time. If a fund's holdings -- or a Morningstar, Value Line or Lipper Leaders report -- don't sit right, I move on.

For tie-breakers, I compare expense ratios and turnover (the lower the better on both fronts), tax-efficiency (unless the fund is in an IRA), and overlap with my current holdings.

Step 6: Jot down my thinking and write the check.

I start my file on any new fund with a detailed list of the factors that convinced me to buy, which makes it easier years later to answer the question "Would I buy it again today?" Then I fill out the application.

If I'm not excited by my pick, something is wrong. If that rush is missing, I hold off, refine the search and start over.

Charles Jaffe is senior columnist for MarketWatch. His mailing address is Box 70, Cohasset, MA 02025-0070.

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