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MERs offer best guide to funds' future peformance

Let's talk about the way you choose mutual funds.

Do you pay attention to management expense ratios? Do you put a lot of credence in past performance? Are you into more arcane indicators like alpha, beta and portfolio turnover?

A new study by a Boston-based investment research firm shows that only a select few of these criteria are much use at all in picking funds.

MERs may be the most useful indicator, Financial Research Corp.'s study shows. Past performance, surprisingly, can be reasonably useful as well. As for most everything else, it's of limited use, or no use at all.

The study begins with some caveats about the difficulty of predicting future fund performance. Most important, it notes that top funds can regress to the average or fall below average, only to be replaced by funds that were previously underachievers. The higher a fund's ranking, the less likely it is that it will sustain that level of performance.

Still, there are indicators that can help increase the odds of picking funds that will beat the average fund in their category in the years ahead. This might not strike you as an ambitious goal, but it does make for sound investing.

"If an investor can consistently achieve slightly better than average returns each year over a 10- to 15-year period, then cumulatively over the full period they are likely to do better than 80 per cent of their peers," the study says.

FRC tested 18 different fund selection criteria to see how useful they are in predicting above-average returns. To do this, the study examined 15 years' worth of data on funds that ranked in the top 10 per cent for each of the criteria.

Specifically, FRC analysts looked back at how these top funds scored on a rolling quarterly basis over one-, three- and five-year periods, then tracked them over subsequent periods of one, three and five years (a rolling quarterly analysis just means starting the one-year measurement on Jan. 1, then starting a new one-year period on April 1 and so on).

The most interesting findings relate to the usefulness of past-performance numbers, which have long been a source of confusion for investors.

The fine print in mutual fund ads always cautions investors that past performance is no indicator of future returns, and yet it's only human nature to gravitate to funds that have done great things in the past.

Fund companies themselves play on this by sometimes hyping past returns in their advertising.

The FRC study found that previous returns were a moderately useful indicator when choosing global and international equity funds, and an exceptional indicator for selecting bond funds.

For the international-global categories, 74 per cent of funds that were in the top 10 per cent of their class over three- and five-year periods were above average over the following three and five years.

Among bond funds that focus on government issues, 100 per cent of top performers managed to stay above average over the next five years.

FRC didn't look at Canadian equity funds, but for U.S. equity funds it found that past performance was only of use in the very short term.

Funds that were in the top 10 per cent for a one-year period had a 67-per-cent chance of being above average in the next year.

Perhaps the most useful indicator analyzed by FRC is the management expense ratio, which measures the continuing cost of owning a mutual fund.

Add a fund's MER onto its posted returns and you'll know how much the fund really made.

Funds that ranked among cheapest in their category by MER generally had a good chance of outperforming over time frames of one, three and five years, the study found.

Low MERs were found to be an excellent indicator for government bond funds and a good indicator for U.S. equity, global and international equity and corporate bond funds.

Among the indicators found to be of little or no use were a fund's asset size, the length of tenure of its manager and its level of portfolio turnover. Ratings produced for U.S. and Canadian funds by Morningstar Research Inc., were also found to be of minimal use in predicting above-average performance.

Beta, a measure of how volatile a fund is compared with its benchmark stock index, was found to be almost useless for predicting future equity fund performance.

Still, beta is definitely worth checking (you can find it in fund reports) because it has solid value in forecasting how volatile a fund will be in the future.

The FRC study isn't a blueprint for successful mutual fund selection; no such help is available.

Still, it does offer useful guidance to investors and financial advisers on recognizing useful information and tuning out the static.

© 2007 The Globe and Mail. All rights reserved.

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