How to Pick Good Mutual Funds

July 14, 2007

At this point the fund companies have restricted trading to the point where it is not possible to trade funds actively without getting into trouble.  For this reason, if you want to hold actively managed open ended mutual funds, a longer term strategy needs to be employed.  The strategy I describe here is heuristic - that is it is not a closed algorithm that can be automatically applied.  It is simply a collection of rules and guidelines which, together with some applied common sense, should give superior results.

This description assumes that you are using Fasttrack, but there may be other software out there that can be used as well.  Fasttrack charts are zero-based on the left.  That is, they really show % change, not the value of the fund.  Hence when you chart two funds, you immediately see which one has done better, and it does not matter that one fund started at $10.00 and the other at $15.00 - that is, after all, irrelevant.

You may start out by deciding on a certain allocation:  so much for domestic, foreign, emerging markets, real estate, natural resources, etc.  Fasttrack makes this part easy, since there are pre-made families of funds in different categories.  So pick a category, say domestic small caps.  Unfortunately, Fasttrack includes both foreign and domestic small caps in one family, so you have to delete the foreign funds and form a new family.

(1) Rank by total return for the following time periods:  3 months, 6 months, 1 year, and 2 years.  Exclude all funds that did not beat the corresponding index (IWM) for those periods.  This gives you 4 lists of funds.  

(2) Look at the funds that are in all of the 4 lists.  There may not be any funds that have been this consistent.  In that case, look at the funds that have done well recently.  Narrow down the list to those funds that have good long term records and excellent short term records.

(3) Get rid of the funds that have loads or minimum initial investment limits that are too high for you.  Also get rid of the funds that are closed to new investors, or that have redemption fees unless you hold for a long time, say 1 year.  Also, get rid of the funds not carried by your broker, in my case TDAmeritrade.

(4) This should give you a fairly short list of funds.  After that, you have to decide how many funds you want to hold in that category.  Give some preference to small funds, as they can be more nimble than large funds.

This does not take much time if you make proper use of the sieve functions in Fasttrack.  The really time-consuming thing is step (3) above.  I did the steps for the domestic small cap category in about 3 hours, and came up with over 200 funds that are in all 4 of the lists.  Surprising, since most managers supposedly do not beat their average.  Maybe so, but it is possible to find those that do, and stick with them until they begin to fail the test.

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