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Mutual Funds
Picking a Mutual Fund
by
Marco den Ouden
This article was originally
written for the March 2006 Rich by Thirty
Newsletter. It
has been updated to reflect current values
and the different audience for this website.
Every year from October
through February a plethora of books come
out analyzing Canada’s mutual funds and the
fund companies go into an advertising blitz
promoting their wares. It’s RRSP season.
Everyone scrambles to put extra money into
their RRSP in time for the tax deadline –
which has now passed as it was February 28th.
Picking the right mutual fund
for you is no easy task. There are over 6000
mutual funds to choose from. Believe it or
not, there are almost three times as many
mutual funds as there are stocks trading on
the Toronto Stock Exchange - 7644 mutual
funds to 2230 stocks (as of June 15, 2007).
Even if you add in the stocks on the TSX
Venture Exchange, there are more mutual
funds than stocks in Canada – 7644 funds to
4586 stocks. Just on sheer numbers it seems
easier to pick a stock than a mutual fund!
Not only that, but mutual
funds generally under-perform the benchmark
indexes. As of June 15th, the one year
return on the TSX Composite Index was 26.1%.
Only 429 of the 7644 mutual funds have done
as well or better than that. No wonder some
writers on the stock market swear by Index
Funds.
But you should consider too
that there are different kinds of mutual
funds that serve different needs. Not all
are equity (or stock) funds. There are bond
funds, money market funds, dividend funds,
foreign funds, sector funds, US funds and
hedge funds. In fact, of the universe of
7644 Canadian mutual funds, only 679 are
Canadian Equity Funds. And of these, only 45
have a one year return as good as or better
than the TSX. In other words, if you had
picked a Canadian stock fund at random a
year ago, you had a slightly better than one
in twenty chance of beating the index. When
this article originally appeared in Rich
by Thirty in March 2006, the odds of
beating the index with a Canadian equity
fund was slightly better than 50/50. The
spectacular performance of the TSX over the
last year has narrowed the field
considerably.
Rich by Thirty, of
course, is targeted at young investors. And
young investors should not consider anything
else than stocks or stock mutual funds in my
opinion. That’s also the opinion of Peter
Lynch.
Gentlemen who prefer bonds don’t know
what they’re missing!
- Peter Lynch
In Beating the Street,
Peter Lynch writes that from 1926 to 1989,
there was only one decade, the 30s, when
bonds outperformed stocks. He points out
that $100,000 invested in long term
government bonds for that period would be
worth $1.6 million but the same invested in
the S&P 500 would be worth $25.5 million.
That’s quite a difference!
And yet, writes Lynch, the
American public continues to be afraid of
the stock market. Despite the huge
difference in returns, the majority of
Americans in 1990 were in bonds or other
investments instead of stocks.
The key to success in stock
investing, says Lynch, is to keep investing.
To add to your holdings regularly. And to
not get shaken out by the occasional
correction. He notes that if you had
invested $1000 in the S&P 500 Index every
year on January 31st from 1940
to1992, your $52,000 investment would be
worth $3,554,227. And, if you had the guts
to invest an extra $1000 every time the
market dipped 10%, something that happened
31 times in that 52 year period, your
investment of $83,000 would have grown to
$6,295,000.
If you’re a young teen, think
about this. Say you’re 13. In 52 years you
will be 65 and retired. If you can manage to
save $1000 every year from baby-sitting, a
newspaper route, lawn mowing, allowance and
other ways of making money and put it in an
equity mutual fund and do this religiously
year in and year out, you will be a
multi-millionaire when you retire! Just
$1000 a year!
So…I hope I’ve convinced you
that if you’re going to put some money into
a mutual fund, it should be an equity mutual
fund. But how do you pick one? You can, of
course, pick an index fund and be done with
it. If you have only little better than a
one in twenty chance of beating the index
with an equity fund, maybe there’s a way to
beat those odds. In fact, there is. I
devised a way of analyzing mutual funds a
few years ago that I call simply…
Marco’s Power Performers
The methodology is really
simple. It’s easiest if you have a computer
and an Internet connection but it can be
done manually using mutual fund tables
published in your newspaper at the end of
every month.
In selecting a mutual fund,
you want a fund that has a consistent record
of growth. You want one that has done well
both short and long term. The mutual fund
tables published in the newspapers always
list three performance figures – the one
year return, the three year return and the
five year return. These returns are given as
an annualized compounded figure. This means
the average return for each year over the
period. For example, if a fund is said to
have a five year return of 25.3%, it means
that it will have returned an average of
25.3% every year over the five year period.
The actual individual years could be
different. It could be 7.3% in 2001, 9.6% in
2002, 66.7% in 2003, 25.6% in 2004 and 19.9%
in 2005. (That’s from an actual case.)
What I have done with my
Power Performers is to use the dynamic
interactive search functions at a website
called
Globefund.com to give me a list of
all the mutual funds with a return of 15% or
better over a five year period. I then use
the website to sort these from high to low.
Then I copy and paste the page in my
computer and sort them further. I am looking
for funds that have a 15% average return in
each of the one year, three year and five
year periods. So now I go and delete the
ones that miss for the one year and three
year periods.
I now divide the list further
into three categories – my Super Power
Performers or funds with better than 25%
return in each period, my Power Performers
or funds with better than 20% in each
period, and my Performers or any that are
left with just a 15% or better return. Over
the last few years the numbers of funds that
qualify have varied from none to over a
hundred. For January 2006, there were 130 of
which 39 were Super Power Performers, 29
were Power Performers and 62 were
Performers. For May 2007 there were 205 of
which 26 were Super Power Performers, 48
were Power Performers and 131 were
Performers.
At a minimum, one should
invest in Performers. If you can put money
into Super Power Performers, even better.
Because we are looking for consistency, it
is best to select a fund that has about the
same return in each period. Be particularly
wary of any that have a huge return for the
one year period. This results in something
called front end skewing. The more recent
numbers skew the longer term numbers and
make them misleading.
You will find the 26 funds
for May 2007 listed on this website at
May 2007 Super Power Performers. If
you want to research these further, you
could go to the Globefund website and use
the fund filter function to select funds
with a five year track record better than
25%. There are actually 41 of them though
only 26 qualified as Super Power Performers.
Next you want to click on the Annual tab to
get the year by year results. You can then
weed out any that have anomalies such as a
very high return in one year and a loss in
another. If you click on any particular
fund's name, it will bring you to a more
detailed page which includes any
restrictions on sales of the fund as well as
a handy risk measure chart which shows the
best and worst 12 month period since the
fund's inception.
You’ll also note that many of
the funds are sectoral. That is, they invest
in specific sectors of the economy such as
resources. Many are small cap funds. Small
caps are good and my preferred
investment. There are also a considerable
number of emerging market funds. With the
economies of Asia and Latin America starting
thriving as a result of economic reforms and
free trade, these funds are a good place to
park at least some of your money.
If investing in stocks seems
too risky for you or too time consuming,
consider investing in mutual funds instead.
I actually invest in both. And as often as
not, my mutual funds do as well as or better
than my stock picks. |
