By Jonathan Burton, MarketWatch
SAN FRANCISCO (MarketWatch) -- It's the quest for the Holy Grail of mutual funds.
When choosing actively run funds, several key variables are within investors' control. Performance isn't one of them. But expenses, risk, manager experience and tax-efficiency are qualities that can be judged before you buy.
"Not many funds are low cost, low volatility and high tax efficiency," said Kevin Ellman, a financial adviser at Wealth Preservation Solutions in Ridgewood, N.J. "As a result, if you're going to spend for active management, you'd better get a lot for your money."
Such valuable stock funds are hard to come by. With the help of investment-research firm Morningstar Inc., MarketWatch screened for diversified U.S. stock funds open to new investors that deliver on five crucial points.
Funds had to provide low risk, above-average returns, expenses below their category average, manager stability and high tax efficiency -- viewed over five years through July.
Sector funds and other specialized portfolios weren't considered; neither were funds-of-funds and retirement-oriented "life-cycle" funds. For good measure, every fund needed a minimum initial investment of $3,000 or less.
Some quests turn out to be largely solitary pursuits. Of 2,500 domestic stock funds with five-year records, just 24 diversified portfolios passed this strict screen.
Risk and reward
The initial step in the process is to determine how a fund manager generates return. After all, results hinge on risk. The question is whether a top-ranked fund is taking excessive risk to generate impressive returns. Better to invest with a risk-averse manager who brings top long-term gains.
"If you find two funds that are equal in return, a good tie-breaker would be the fund with lower risk," said Jim Peterson of the Schwab Center for Investment Research. "These are the attributes of successful funds."
Each of the funds that passed the screen gave shareholders above-average five-year gains without swinging for the fence. Morningstar measures a fund's performance over a U.S. Treasury note's risk-free return versus similar funds. To gauge risk, Morningstar registers fluctuations in a fund's monthly returns against comparable funds. The least-volatile portfolios are considered low risk.
The screen's all-around winner on a risk-reward basis was the Fairholme Fund /zigman2/quotes/200889155/realtime FAIRX -4.63% , which invests mostly in midcapitalization U.S. stocks. Managers Bruce Berkowitz and Larry Pitkowsky fill their $1.1 billion portfolio -- which holds just 17 stocks -- largely with insurers and telecommunications firms whose shares trade at a sharp discount to the managers' estimate of market value.
Choices in small-capitalization stock funds are slim. Small-caps have been performing in a big way, and many of the best funds have shut their doors rather than risk a flood of money upsetting their investment strategy and style.
Strong options are still open to new investors, however. The UMB Scout Small Cap Fund /zigman2/quotes/204948822/realtime UMBHX -3.55% is one of them. Lead manager David Bagby steers this $360 million portfolio -- a reasonable size for a small-cap discipline -- toward companies with a consistently improving financial position, healthy free-cash flow and catalysts that can push shares higher.
In contrast, large-capitalization funds have been wallflowers, but there are signs that large-cap is coming into its own again.
The $5.2 billion American Century portfolio focuses on dividend payers, so it's heavy on the utility, energy and financial-services sectors and light on technology and health care. Meanwhile, Mairs & Power has almost 20% of its $2.5 billion asset base in health care. The large-blend fund sticks to its knitting, with many of manager Bill Frels's holdings based in the fund's home state of Minnesota.
Next, focus on expenses. Costs matter. Annual expenses detract from return, year after year. The miracle of compound interest works in reverse with high-cost funds: pay more, pocket less. Moreover, studies show that low-expense funds are more likely to outperform their costlier counterparts over time.
"Expenses are good predictors of future returns," said Russ Kinnel, Morningstar's director of mutual fund research. "If you screen for low-expense funds, you're significantly improving your chances of success."
The Vanguard Group is synonymous with thrift, but other big fund companies do a good job of keeping annual costs down.
American Century Equity Income, for example, charges 0.99% for management, and large-cap growth Fidelity Contrafund /zigman2/quotes/202430342/realtime FCNTX -4.01% demands just 0.92%. Franklin Rising Dividends Fund /zigman2/quotes/208345193/realtime FRDPX -4.22% -- among only a handful of "load" funds to make the screen --- charges 1.25%, about 15% less than a typical midcap fund.
Many fund companies with less money under management also treat shareholders fairly with costs. UMB Scout Small Cap's 0.89% expense ratio is dirt cheap for a small-cap fund. Heritage Mid Cap Stock Fund is a bargain among midcap growth offerings with its 1.20% fee.
Voices of experience
Experience counts. It's tempting to latch onto a high-profile manager with a good year or two piloting a high-octane fund, and with a small amount of money that might be acceptable. Yet the core of an actively managed stock-fund portfolio -- 60% to 70% of your total allocation -- calls for market veterans who have been at the helm for at least five years.
"Five years basically covers a whole market cycle," said Roy Weitz, publisher of watchdog Web site FundAlarm.com. "You want a seasoned manager who has been through good and bad markets. And they're not, for the most part, still trying to establish a reputation -- with all that implies."
Newcomers to the five-year roster include Fairholme's Berkowitz, UMB Scout's Bagby, and Mairs & Powers' Frels. Another recent member is John Hussman of the Hussman Strategic Growth Fund /zigman2/quotes/203176466/realtime HSGFX +0.57% , whose risk-managed approach has given shareholders a smooth ride down Wall Street.
Among the more senior managers on the list are William Lippman, co-manager of Franklin Rising Dividends; co-manager Thomas Putnam at FAM Value Fund /zigman2/quotes/200830531/realtime FAMVX -3.82% , a highly regarded midcap blend portfolio -- each at the helm almost 19 years -- and Philip Davidson, American Century Equity Income's co-manager who joined in 1994.
Taxes with a small 't'
Finally, investors in taxable accounts should be sure that managers are looking out for their interests. With taxes, what you keep matters more than what you make.
"Focus on after-tax returns, because that's what you take to the grocery store," said Scott Kays, an Atlanta-based financial adviser.
Yet realize that an overemphasis on taxes can cost you as well. Many times, tax-efficient funds lag the performance of less tax-sensitive rivals. Ideally, you want a fund manager to deliver high absolute returns with a solid dose of tax awareness.
Morningstar.com provides a "tax cost ratio" for funds. Tax cost ratio is essentially the difference between pretax and after tax returns. For example, if a fund has a 1% tax cost ratio over five years, then shareholders lost about 1% on average each year to taxes.
Among the top funds passing the screen, Fairholme, FAM Equity-Income /zigman2/quotes/202319440/realtime FAMEX -3.69% and Franklin Rising Dividends allowed shareholders to keep the most from what they made. Fidelity Contrafund was another good friend to taxpayers.
The road less traveled
It quickly became evident that the search's ultimate goal was not to anoint one superior fund, but to find funds that shared attractive characteristics regardless of investment style -- growth or value -- and holdings - large-cap, midcap or small-cap stocks.
Many well-known funds and seasoned managers didn't vault the bar because either their expenses were too rich or the portfolio's risk relative to return was too high. While those funds aren't necessarily poor choices, the funds on this list leave little doubt that their managers are keeping shareholders front and center.
"A lot of funds are not really adding much value," said Ellman, the New Jersey financial adviser. "They're not giving you enough return given the risk they're taking with your money."
Ten low-risk U.S stock funds, by 5-year return
Fourteen additional qualifying stock funds
Source: Morningstar Inc. (Data through 7/31/05)