How to Use This Guide to Top-Rated Funds

The tables above are our short list of best performers, an appetizer that we hope will whet your appetite for the full menu of top-rated funds from all categories shown on the following pages.

Are we trying to persuade you to become a momentum investor? Absolutely not. But readers have expressed an interest in identifying “top” funds in a simple format.

These funds have five stars in fund tracker Morningstar’s system, which means their impressive performance has been accomplished with a reasonable amount of risk. Remember that few financial planners would advise clients to select funds based solely on recent performance. In fact, many would argue that such a strategy could backfire if you buy funds at what turns out to be a peak.

As in previous quarters, the tables on the following pages are here to help you review, select and scrutinize funds.

How do you do that?

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.)

* Let’s start with returns.

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 tables. For instance, look on the following page, S15, at the small-growth chart in the upper right-hand corner. The first fund in this chart is RS Emerging Growth. Move four columns to the right and you’ll note that in the first quarter of 2000, this fund generated 19.4% in total returns (share price appreciation plus dividend yield).

Now move one more column to the right; you’ll see that over the last year, the fund gained a staggering 163.7%.

You can tell that this fund has been doing phenomenally just by looking at these returns. But in a momentum market such as this, be careful not to be swayed by raw return figures. This fund was up more than 50% between Jan. 1 and March 10, then fell fairly steadily until Friday as the Nasdaq dipped into a correction.

So, how can you tell if this fund, on the basis of its returns, is better than average? Look at the bottom of the table. There you’ll find that the average small-growth stock fund--that is, funds that invest in the type of stocks this fund buys--generated a total return of 92.7% in the last 12 months. Clearly, even the average small-growth fund has done spectacularly well recently. But RS Emerging Growth has done even better.

After noting short-term performance, move one more column to the right. 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 funds in our tables. You can see that RS Emerging Growth performed significantly better than its peers over the last three years.

* Next, look at fund ratings.

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 specific category. The ratings are 1 to 5, with 5 being the best.

For instance, take a look at the small-value category at the bottom right-hand corner of S15. You’ll notice that Royce Trust & Giftshares, 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 value-oriented funds that invest in small-company stocks. Dreyfus Small Company Value, however, scored a 3, which puts it in 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.

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 with others in specific categories but with 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 specific categories of funds that are out of favor in a given period will tend to have more funds with lower star ratings. 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 at the bottom of page S16 showing the best-performing precious metals funds. Even the top fund in this category scored only one star. Why? Precious metals funds invest heavily in gold and gold-mining stocks, which have been out of favor for several years.

By contrast, technology funds (shown at the top of page S16) have performed well in the last decade and a large number of them have five stars. Thus, if you are interested in precious metals, the category rating might be more valuable than the star rating.

* Factor in 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.

Keep in mind that some types of funds are more costly to manage than others.

* Other things to consider.

At the far right 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 plunged 33%? What about 50%?

If you want a fund that will let you sleep well at night, you might want to peruse this column to see how much each has lost in its worst three-month period. (This figure is no guarantee of future performance, of course.)

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