How to Narrow the Mutual Fund Field

Picking new mutual funds, or assessing the ones you already own, isn’t as difficult as it may seem. Really.

Most of what you need is on these pages, which should go a long way toward helping you identify the best funds for your portfolio.

How? As with selecting a good diamond, there’s a system you can use to find good funds. Instead of the four Cs--cut, carat, color and clarity--fund investors must consider the four Rs: returns, ratings, risk and (expense) ratio. (OK, it’s really three Rs and an E.)

Our lists of funds, compiled by fund tracker Morningstar Inc., provide information on all of these characteristics and more.

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* Let’s start with returns.

Obviously, before selecting a mutual fund, you’ll want to look at its track record. Past performance isn’t a guarantee of future returns, but it can be an indication of competence and consistency.

Performance return figures are simple to look up in our charts. Look at the upper left-hand corner of this page, at the “Large Value” category. The first fund is Legg Mason Value. Go four columns to the right and you’ll note that in the first quarter of 1999, the fund delivered a total return (that’s share price appreciation plus dividend yield) of 18.7%. Go one more column to the right and you’ll discover that over the last year, the fund advanced an impressive 49.9%.

Obviously, just by looking at these returns, you can tell that this fund has been doing well recently. But for the sake of argument, let’s say the numbers were considerably lower. How could you tell if this fund, on the basis of its returns, was better than average?

Take your finger and place it on the one-year total return figure for Legg Mason Value. Now go all the way down the column to the bottom of the chart. There you’ll find that the average large value stock fund--that is, funds that invest in the type of stocks that this fund buys--generated a total return of just 2.4% over the last year.

But don’t stop there. Financial planners advise clients to look at long-term performance numbers. To help you do that, we’ve provided three-year annualized return figures for all of the funds in our tables. You can see that Legg Mason Value has beaten its peers over the last three years as well. (By the way, the fund’s unusually good performance for a value fund can be explained by its sizeable holding in America Online, which at one point was a value stock but, as Legg Mason has held on, has become a growth stock.)

There’s another way to look up long-term performance. Look at the second column in each table. It ranks the funds by total return over the last three years, expressed by the percentile in which their performance ranks within the category (1 to 100, with 1 being the top performers). Legg Mason Value’s “1” score indicates that this fund beat 99% of its peers over the last three years.

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* Next let’s turn to fund ratings.

Here we’re talking about the different rating systems that Morningstar uses to judge funds against their peers.

Category ratings, which you’ll see as the first column of each table, assess a fund’s “risk-adjusted” performance over the last three years relative to other funds in its category. The ratings are 1 to 5, with 5 being the best.

For instance, take a look at the Small Value category on this page. You’ll notice that Longleaf Partners Small Cap, the first fund in this table, scored a category rating of 5. This means Morningstar considered this fund one of the best in risk-adjusted returns over the three-year period among those that invest in small domestic value stocks.

At the same time, Dreyfus Small Company Value scored a 3, which puts it around the middle of the pack in risk-adjusted performance in its category.

What does risk-adjusted mean? Morningstar judges each fund’s overall performance against its downside volatility. The idea is that you don’t necessarily want to earn the highest returns if a fund also is extremely volatile. High volatility makes some investors nervous, and it increases the chance of loss if you need to sell at a bad time.

So Morningstar believes consistency of performance, as well as above-average performance, is important in judging returns--and whether a fund is a good choice for the typical investor.

(In this sense, the third R in our system, risk, is folded into Morningstar’s ratings.)

You’re probably more familiar with the rating system shown in the third column of our tables--Morningstar’s famous three-year “star” rating, which also has a 1-to-5 scale, with 5 being the best.

As with the category ratings, the star ratings are handed out on a bell curve: The highest-rated 10% of funds get a 5, the next 22.5% get a 4, the next 35% get a 3, the next 22.5% get a 4 and the lowest 10% get a 1.

What’s the real difference between the category rating and the star rating? In awarding stars, Morningstar compares funds not against others in specific categories, but against others in one of just four much broader groupings: domestic stock funds, international stock funds, taxable bond funds and tax-free bond funds.

What this means, in effect, is that specific categories of funds that are out of favor in a given period will tend to have more funds with lower star ratings. And, conversely, funds in categories that investors have favored lately will tend to have more funds with higher star ratings.

For instance, take a look at the table showing the best-performing Diversified Emerging Markets Funds, on the next page. You’ll notice that even the best-performing fund in this category scored only three stars. And the rest scored just two. Why? Emerging-market stocks have been out of favor for the last few years (though some perked up in the first quarter).

European stock markets, by contrast, have performed well in recent years. So within the broad category of international stocks, all of the European stock funds that made our “Top Funds” list got five stars from Morningstar, whereas no emerging-market funds came close.

So if you are specifically interested in emerging-market stock funds, the category rating may be more valuable than the star rating, because the former tells you which funds have performed best in that specific category.

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* After you’re done considering a fund’s returns, ratings and risks, factor in its costs.

Our tables show fund fees in the column labeled “Exp Ratio,” for annual fund expenses as a percentage of assets. The average for each category is shown at the bottom of each table.

If a fund charges more than the average, it should be producing above-average returns for shareholders as well. Keep in mind that some types of funds are more costly to manage than others. For instance, the staffing needed to properly research obscure emerging-market stocks is likely to be greater than that required for a fund investing in well-known companies here at home. So judge a fund’s expense ratio relative to that of its peers.

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* There are other things to consider.

On the far right side of each table is a very useful column labeled “Worst 3 mos.”

You’ll often hear financial planners advise investors to consider how much they’d be willing to lose in a fund. Would you be willing to hold on to a fund even if its value plunges 33%? What about 50%?

If you want a fund that will let you sleep well at night, you may want to peruse this column to see how much each of the funds you own--or want to invest in--has lost in its worst three-month period. (This figure is no guarantee of future performance, of course.) The differences among these figures can be considerable.

For instance, in the Intermediate Government Bond category (also on the next page), Huntington Mortgage Securities fell 19.7% in its worst three-month period. But SunAmerica Federal Securities lost just 2.4% during its worst three months.

Another thing you’ll see in our tables, under “Mngr Tnr,” is how long each fund’s manager has been running the portfolio. (The number is expressed in years.) That can be another indication of a fund’s consistency, although even veteran managers can hit dry spells.

Paul J. Lim can be reached by e-mail at paul.lim@latimes.com.