Mutual funds: How one pro picks winners

September 16, 2005

It's not just about media hype and past performance, this expert says. We asked him to share his insights.

Not many high school students are able to master the complexities of the stock market, but Eric Tyson was. He was even making important financial contacts early-Martin E. Zweig, the noted investment market analyst, helped him produce the winning entry for his high school's science fair. His subject: what influences the stock market.

Tyson went on to earn his bachelor's degree in economics at Yale and his MBA from the Stanford Graduate School of Business. A management consultant to Fortune 500 financial service firms, and a financial planner in his own right, Tyson also writes extensively on personal finance. He's got a syndicated newspaper column, Investors' Guide, and more than a dozen books to his credit, including Mutual Funds for Dummies (Wiley Publishing, 2004).

Recently, Tyson shared his guidelines for choosing mutual funds with Senior Editor Kathleen McKee.

Absolutely not. That's one of the biggest mistakes people make when they pick funds. The big danger is that the market forces that produced the high returns of certain funds inevitably change. The classic example is tech stocks in the late 1990s. Funds that were overloaded on tech stocks did extremely well, so people piled into those funds and later got their heads handed to them.

So past performance is irrelevant?

No; but it shouldn't be one of the first things you look at. In fact, if a fund has very high returns over a recent performance period, it should raise a red flag. It's potentially taking extreme risks that are going to backfire when market forces change. If you're going to choose funds because they're at the top of performance charts, you also need to prepare yourself for them being at the bottom someday. It's a little counterintuitive, but it's a very important concept for people to understand.

Let's say you know what type of fund you want (small-cap, foreign, value, etc.). What do you then look at, in order of importance?

First, look at the fees. If a fund doesn't have relatively low fees, I'm not interested. Over time, high fees will take a big bite out of your returns, so stick with funds that have lower annual operating expenses. Look, also, to see if the fund has a 12b-1 fee (used for distribution costs such as advertising and promotion), because most funds that have 12b-1 fees tend to have high fees overall.

Second, what's the mutual fund company's track record, not just with the fund you're interested in but also with similar funds? For instance, Fidelity has dozens of international stock funds, some of which have good track records. But when you look at Fidelity's overall international track record, it isn't so hot. So all things being equal, I'd rather invest with a company that has done a good job with a greater portion of their international stock funds or whatever type of fund you're interested in.

Third, avoid fund companies that put their profits before their shareholders' interests, such as those that have been involved in the recent industry scandals. There are plenty of other companies out there that are ethical and honest in their dealings with investors.

Most serious investors consider a fund's "risk adjusted" performance. What is it exactly, and how important is it?

Risk adjusted performance examines the fund's performance in terms of how much risk it incurred to get those returns, to give you a sense of whether you could have achieved the same returns with less risk. It's a very important measure because it can indicate what sort of upside you can expect in an up market and how severe of a hit you'll take during a downswing. If you're not comfortable with the fund's performance during tough times-and are fearful of a repeat-then look elsewhere.