Narrowing 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.

* 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 to the lower left-hand corner of this page, at the small-value category. The first fund is the Van Kampen American Value fund. Go four columns to the right and you'll note that in the second quarter of 1999, the fund delivered a total return (that's share price appreciation plus dividend yield) of 21.3%.

Now go one more column to the right. There you'll discover that while this fund hasn't done quite as well year to date, it's still up a respectable 17.7%.

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 year-to-date total return figure for Van Kampen American Value. Now go all the way down the column to the bottom of the chart. There you'll find that the average small value stock fund--that is, funds that invest in the type of stocks this fund buys--generated a total return of 6.3% in the first six months of the calendar 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 Van Kampen American Value has beaten its peers over the last three years as well--in fact, it's done more than twice as well.

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). Van Kampen American Value's "1" score indicates that this fund beat 99% of its peers over the last three years.

* 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 mid-cap value category on this page. You'll notice that Weitz Partners Value, 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 medium-sized domestic value stocks.

Dreyfus Mid-Cap 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 on S15 showing the best-performing precious metals funds. You'll notice that even the best-performing fund in this category scored only one star.

Why? Precious metals funds, which tend to invest in gold-related stocks, have been out of favor for several years, as gold prices have plummeted.

By contrast, communications funds (also shown on S15) have performed relatively well in recent years. So within the broad category of communications funds, many of the telecom funds that made our "top funds" list got five stars from Morningstar, whereas no precious metals funds came close.

So if you are specifically interested in precious metals 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.

* 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-markets 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.

* 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 (on the following page), Huntington Mortgage Securities fell 8% 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


About Morningstar

Mutual fund information in this section and the tables on S12-15 are based on information from fund tracker Morningstar Inc.

Morningstar is a privately owned company founded in 1984 to provide investors with information from an independent source for use in making investment decisions. Its "star" rating system is used by financial planners, cited in advertisements and used as a guide by investors and the media.

As the Chicago-based company has grown, its staff of analysts, writers and programmers has introduced print and software products for individual and professional investors. These include the investor guides "Morningstar Mutual Funds"; "Morningstar FundInvestor"; "Morningstar StockInvestor"; CD-ROM "Morningstar Principia Pro Plus for Mutual Funds, Closed-End Funds, Stocks, and Variable Annuities/ Life"; and Morningstar's Web site at http://www

To learn more about Morningstar and its products, call (800) 735-0700.

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