Lipper Inc. quietly announced last week that it is changing how it presents its research, modifying its rating system effective in November. The new system uses a numeric scale where the top 20 percent of funds – the Lipper Leaders – will get a mark of “5” on a bottoms-up scale that runs from 1 to 5. It’s a 180-degree change, because the new high mark is the low score under Lipper’s current system.
The change brings Lipper in line with many other independent research firms – most notably Morningstar Inc. – where top performers get the most points on the ratings scale.
But if Lipper, one of the most established and respected observers of the fund world, can change the way it rates funds, investors should consider whether the way they pick funds is in need of an upgrade.
Long-term happiness with a mutual fund is often traced back to what someone was thinking when they made their first purchase. If the bull-to-bear-to-bull swing of the last decade, the fund scandals, huge interest-rate shifts and more have taught us anything, it’s that keeping your selection process static and rooted in the past is folly.
Furthermore, the development of new analytical tools – like the Lipper ratings, which debuted in 2001 – has made the process easier.
Developing a system based on your personal beliefs is crucial. That said, here is my six-step program to use as a guide.
Deciding first what the money must accomplish allows me to properly set my expectations.
Generally speaking, I dislike funds with above-average costs and managers with a tenure of less than 10 years. I avoid funds with sales charges, not because load funds are bad but because they’re inappropriate for someone who doesn’t rely on an adviser for guidance.
Success depends on having trust in the fund, whether it is the manager’s expertise or the common-sense simplicity of indexing.
Delve into a fund’s newsletters and reports, which may offer insight into the manager’s style and discipline. If a fund’s own paperwork doesn’t help convince you to take a leap of faith, keep looking.
This is also the time to factor in the fund firm’s past behavior. If there are scandals or troubles in management’s past, you must be convinced the worst is over.
When performance is the first selection criteria, investors tend to chase hot numbers. While I want the fund’s asset class to drive the decision more than raw results, you ignore the past at your own peril.
My initial cut is for funds in the top 25 percent of their peer group over the last five years. Consistency is key too.
I look for holdings that are consistent with a manager’s discipline, and examine what a fund is allowed to invest in, which shows how the portfolio might change over time.
For tie-breakers, I compare expense ratios and turnover (the lower the better on both fronts), tax-efficiency (unless the fund is in an IRA), and overlap with my current holdings.
I start my file on any new fund with a detailed list of the factors that convinced me to buy, which makes it easier years later to answer the question “Would I buy it again today?”
Chuck Jaffe is senior columnist for MarketWatch. He can be reached at jaffe@marketwatch.com or at Box 70, Cohasset, MA 02025-0070.
