The 4 Rs of Selecting Mutual Funds

Picking new mutual funds, or assessing the ones you already own, isn’t that difficult. Really.

The numbers on this page are organized to simplify your efforts.

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 each of these characteristics.

* 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. For instance, look on the previous page, S13, in the right-hand column, at the “small growth” category. The first fund on this chart is RS Emerging Growth. Go four columns to the right and you’ll note that in the fourth quarter of 1999, this fund generated 75.1% in total returns (share price appreciation plus dividend yield).

Now go one more column to the right; you’ll see that for the entire year, the fund gained a staggering 182.5%.

Obviously, just by looking at these returns, you can tell that this fund has been doing phenomenally well recently. But in a year like 1999, be particularly careful not to be swayed by raw return figures. For instance, you’ll notice that a number of funds besides Emerging Growth have generated unprecedented returns in 1999, largely on the spectacular growth in foreign and technology sector stocks.

So, how can you tell if this fund, on the basis of its returns, was better than average?

Take your finger and place it on the 1999 total return figure for RS Emerging Growth. Now go all the way down the column to the bottom of the chart. 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 65.7% last year. Clearly, even the average small-growth fund did spectacularly well. But in 1999, Emerging Growth did considerably better.

After noting short-term performance, go 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 of the funds in our tables. You can see that RS Emerging Growth has more than doubled the performance of its peers over the last three years.

There’s another way to look up long-term performance. Look at the second column in each table. It ranks 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). RS Emerging Growth’s “1” score indicates 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 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 left corner of this page. 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. High volatility 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 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 on S16 showing the best-performing real estate funds. Even the top fund in this category scored only two stars. Why? Real estate investment trusts have been out of favor for a few years now.

By contrast, technology funds (also shown on S16) have performed well in the last decade. So within the broad category of technology sector funds, all of the tech funds that made our “top funds” list got five stars, whereas no real estate fund came close. So if you are interested in a real estate fund, the category rating might be more valuable than the star rating because the former tells you which funds have performed best in that category.

* 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.

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. Funds with sales charges, or “loads,” are usually sold by brokers or other financial advisors and are often a way to pay for advice.

The long-term effect of sales charges is an ongoing controversy, but it is important to note that return figures and Morningstar ratings do not take these sales charges into account.

* 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 onto 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 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 international bond fund category (on S15), Alliance North American Government Income fund lost 26.1% in its worst three-month period. However, DFA Global Fixed-Income lost just 0.3% during its worst three-month stretch.

Another thing you’ll see in our tables, under “Mngr 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.

*

Times staff writer Paul J. Lim can be reached at paul.lim@latimes.com.