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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.



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