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Five professional tools to see how the funds in your
401(k) measure up
By Jonathan Burton, www.CBSMarketWatch.com
How good are the mutual funds in your
401(k)?
It would be nice if there were a scorecard. But rating the
investments you hope will glitter in your golden years can be
confusing. That's one reason why so many
investors have embraced so-called target-date or life-cycle funds,
which take care of the guesswork.
Those who still want to pick their own 401(k) investment lineup
often don't know how, or where, to start. So
they wind up defaulting to funds with the best track records.
That's not strategy, it's
performance chasing by buying high and selling
low and it leads investors nowhere, says David
B. Armstrong, managing director at Monument Wealth Management in
Alexandria, Va.
"They're picking mutual funds
that have been doing very well and not giving proper consideration
to the appropriate allocation," he says.
To tell which stock funds in your retirement account are right for
you, look beyond performance. Take a page from the methods
investment experts likely used for your own
company's 401(k) plan. Here are five things to
keep in mind:
1. Expenses
In many cases, 401(k) plans offer one actively managed fund and one
indexed alternative. Since indexed management is usually cheaper,
make sure you're getting your
money's worth from an actively run choice.
Costs matter. An index fund that charges one-tenth of a percentage
point in yearly management fees, for example, has a full percentage
point head-start over a fund that takes 1.1%. Accordingly, the
manager of the more expensive portfolio has a steep hurdle in order
to deliver above-average returns over time.
Don't pay top dollar for mediocre results.
2. Risk-adjusted return
You can't judge a fund by its advertised
performance.
Understand the risks a manager took to generate those returns.
Maybe the fund loaded up on a hot stock or market sector, or the
manager traded frequently, playing the market's
momentum.
Otherwise, you run a risk too that
you'll fork over good money to a fund that
exposed you to more volatility that you can comfortably handle.
"Big stakes in any one sector is good reason to
dig deeper"says Christine Benz, director of personal
finance at investment researcher Morningstar Inc. "How does that fit with the
manager's strategy, and how has that played out
for the fund?"
One key measure of a fund's risk-adjusted return
is a technical term called standard deviation. It shows how much a
fund's performance varies, or deviates, from its
expected normal return.
You won't need a slide rule. Web sites such as
Morningstar.com do the math for you. Click on Risk Measures: The bigger the
number, the more risky the fund.
So if Fund A gained 11% with a standard deviation of 18, and Fund B
rose 10% with a standard deviation of 12, then Fund B achieved
almost the same results with two-thirds of the volatility and would
have a better risk-adjusted return.
"Standard deviation can help you see which fund
has had higher volatility and has probably been taking more
risks"
3. Results versus peers
You also want to look at a fund's performance
relative to its category. Investors frequently make the mistake of
comparing funds to "the market"
which usually means the benchmark Standard &
Poor's 500 Index (SPX:S&P 500 Index)
But the S&P 500 is a large-company U.S. stock index. The only
funds to rate against it are large-cap U.S. stock funds; anything
else is simply misplaced. A small-cap stock fund may look great
compared to the S&P 500, but it may have underperformed the
more fitting Russell 2000 Index benchmark. Similarly, an
international small-cap stock fund has no business in the same pool
as its U.S. small-cap counterpart.
Again, Morningstar.com makes this information readily available.
Click on "Total Returns" to see how
a fund stacks up in its category.
Be sure that all of your fund choices are related, says Armstrong,
the Virginia financial adviser. If they're not, you really can't determine
if the portfolio manager is doing a good job, or if you
should just buy an index fund.
4. Portfolio yield
Performance-chasing is bad enough, but investors also reach for
yield, the dividend income that can provide a
cushion in difficult markets.
"I've seen clients get stars
in their eyes over a high yield" Armstrong says. They
forget there's a reason for this excess payout, and not always a good one.
Beware of a fund with a yield that's out of
synch with its peers. Maybe the high yield comes from a heavy dose
of financial-services stocks or lower-quality investments. In that
case, not only is the yield shaky some banks
have cut or eliminated their dividends, for example, but even the most generous dividend
won't offset major declines.
5. Manager tenure
The big consulting firms that cobble 401(k) plans together grow
cautious when a fund switches managers, and you should too.
Fund companies will protest to the contrary, but new managers are
game-changers. While the fund's investment style
might not be drastically altered, and if it is
you have another problem, you can bet the
portfolio itself will get a makeover.
If a fund manager has been on the job for only a year, then the
fund's three- and five-year performance belong
mostly to someone else. You can be more charitable when a new
manager is a veteran who has experienced bull and bear market
cycles. On the other hand, if a longtime manager is retiring soon,
find out when the junior managers joined the fund.
Says Lou Stanasolovich, president of Legend Financial Advisors in
Pittsburgh.: "If a manager changes,
you're in effect starting a new
fund."
Jonathan Burton is an assistant personal finance editor for MarketWatch, based in San Francisco.
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