How To Pick a Winning Mutual Fund

For most investors, beating the market is the holy grail of investing.  So few people manage to do it that those who do are elevated to the status of legends by the investment community.  How else could you explain the popularity of such stock-picking wizards as Warren Buffett, Peter Lynch, Bill Miller, and Marty Whitman?  Those who manage to accomplish this difficult feat are generously rewarded over time.  Suppose you begin investing $500 per month in your 401k at the age of 25 and continue investing $500 per month every month until retirement at age 65.  If you achieve the average market return of let’s say 10% per year you would end up with a nest egg of approximately $3,162,040 at retirement on an investment of only $240,000 of your own money.  Those are outstanding results any way you look at it.  However, if you managed to beat the market by a healthy 2% per year, you would end up with a fortune of $5,882,386 or over 86% more!  It’s easy to see many investors expend so much time and energy trying to out-perform the indices.

What does it mean to “Beat the Market?”

Beating the market means different things to different people.  For some, it means beating the return of the S&P 500 year in and year out.  For others, it means beating the return of the S&P 500 over some long time period, perhaps 40 years, but not necessarily ever single year during that period.  For economists, academics, and many professional money managers, however, it means achieving an “alpha” greater than zero.  Alpha is a statistical measure designed to compare the risk-adjusted return of a mutual fund to an appropriate benchmark index.  This index could be anything from the S&P 500 to the EAFE index of developed foreign markets to the Russell 2000 US small-cap index or any combination thereof.  The idea is that at any given level of portfolio risk, an active fund manager should be able to out-perform an unmanaged benchmark in order to be worth the high expense ratios they charge.  Otherwise, you would be better off simply buying the index.  An alpha of greater than 0 means a mutual fund achieved superior risk-adjusted returns than the benchmark over a given period.  Similarly, an alpha less than zero means a fund performed poorly relative to the benchmark and implies the investor would have been better off buying an index fund.  An alpha of 0 represents a wash.

Seeking Alpha

So how do we use this information to pick mutual funds likely to out-perform in the future?  The short answer is that you can’t.  The large majority of mutual funds chronically under-perform the over-all market and even among those funds that manage to out-perform over some short period of time, how do you know which are likely to do so in the future?  As every mutual fund prospectes reiterates time and again, past performance is no guarantee of future returns.  But all is not lost.  There are a few characteristics to look for and a few strategies to employ that will increase your odds of beating the market somewhat without taking on too much additional risk. 

Broaden Your Investment Horizons 

To begin with, you want to initially focus your search on so-called “go-anywhere” funds.  These are funds with a relatively loose investment mandate allowing them to invest in any market segment the manager sees fit.  They may own mostly mid-cap domestic stocks one day, foreign large value stocks another day, and a healthy dose of government bonds yet another.  In other words, you are basically giving your manager free-reign to invest your money as his (hopefully) extensive experience and investment accumen sees fit.  Most funds have a mandate forcing the manager to choose stocks from within an artificially narrow investment universe such as large-cap value stocks.  Not so for go-anywhere fund managers.  If large-cap value stocks seem too expensive, the manager is free to move money elsewhere.  This gives them maximum ability to leverage their experience and shop where the bargains are, so to speak.

Go Small

Smaller-cap markets, both foreign and domestic, tend to be less-efficient than markets for well-followed large-cap stocks uin the view of many investment professionals.  Thus,  mispricing of risk is likely to be much more prevalent on the smaller end of the spectrum.  Inefficient markets can be a gold mine for those with the knowledge, experience, and nimbleness to exploit them.  If you want to go the small or micro-cap route, it is absolutely imperative that you choose a mutual fund with a small asset base and relatively stable asset flows.  Coping with volatile asset inflows and outflows is a full-time job for most managers and you want him to be concentrating on uncovering bargains, not doing accounting entries.  Furthermore, the smaller the sum of money the manager has to invest, the smaller down the market cap spectrum he can go, thus making it more and more likely his hours of meticulate research will pay off and the more he can concentrate on his best ideas when that research uncovers a genuine bargain.

 Go Cheap

Study after study shows the single most accurate indicator of future mutual fund performance is low expenses.  All else being equal, a mutual fund with an expense ratio of 0.5% stands a better chance of beating the market than a fund with an expense ratio of 1.5%.  This makes intuitive sense because the higher-priced fund would have to out-perform the cheap fund by 1% per year just to break even.  When you are trying to beat the market, every little bit counts.  Don’t put yourself at an unnecessarily large disadvantage by choosing an expensive fund.

Finally, once you’ve created a short list of likely candidates, look up the alpha of your list of potential mutual funds over the past 3, 5, and 10 year periods.  You can get Modern Portfolio Theory statistics, including alpha, on the Risk section of http://finance.yahoo.com/.  For example, here are the risk statistics for Marty Whitman’s Third Avenue Value fund (TAVFX). As you can see, the fund has a strongly positive alpha in each of the time periods given and has an EXCELLENT alpha of roughly 6 in each of the 5 and 10 year time periods.  This is a good indication that the manager of this fund might be skilled and has an above-average chance of beating the market in future periods.  If a fund does not have a significantly positive alpha over at least the 3 and 5 year period, don’t even bother continuing.  It is unlikely the manager possesses much investment skill.

Hedge Your Bets

Even after you’ve done all this and picked a fund you think is a sure winner, your odds of success are still pretty low.  It is incredibly difficult to beat the market and while doing this research will definitely increase your odds slightly, they are still decidedly against you.  Therefore, I urge everybody considering pursuing this strategy to dedicate no more than a maximum of 15 or 20% of your portfolio to it.  If you turn out to be wrong, the damage to your portfolio should be minimal.  Of course, your upside will be similarly limited, but even a 0.5% to 1% increase in your yearly returns can have a huge impact on your end balance.  Good luck!  If you have anything to add to this strategy, please leave a comment and share your wisdom with the group.