Gordon Powers

Research tells us that there are actually five principal financial goals in life.

Although the order varies among families and the list shrinks when you're talking to single people, most affluent adults want to:

  • Enjoy a comfortable retirement with little compromise to their standard of living and no fear of outliving their savings.
  • Have the opportunity to assist in financing their children's or grandchildren's education.
  • Have the chance, while they're still alive, to help relieve their children's financial burden, either through a legacy or through gifts.
  • Provide leisure opportunities and quality health care to their aging parents.
  • Leave a donation for a favourite institution or cause.

So, assuming that, like many Canadians, you use mutual funds as the means to make these disparate goals a reality, where should you start? Well, trying to identify absolute top performers in advance is a low-percentage game at best.

Nonetheless, despite volumes of research attesting to the folly of looking at past returns alone, most investors still seek tomorrow's winners among yesterday's top performers.

Forget it.

The primary value past return data provides is to flag the real losers, not pick sure-fire winners.

The conditions that made a fund great in the past tend to change. For one thing, success often brings a rush of money into a fund, forcing it to adjust its approach. And fund managers today come and go with increasing regularity.

The truth is, much as you may wish to know which particular funds will be really hot, you can't. You can, however, narrow the field dramatically by focusing on the correct factors, suggests Morningstar, a research firm that evaluates funds across a variety of criteria.

According to its findings, the best predictor of a manager's relative performance is his or her fund's expense ratio.

Morningstar found that, as a group, cheaper funds beat their more expensive counterparts in pretty much every asset class and time period.

"Investors should make expense ratios a primary test in fund selection. They are still the most dependable predictor of performance," Morningstar concluded. "Start by focusing on funds in the cheapest or two cheapest quintiles, and you'll be on the path to success."

I'd argue that performance that's consistent with expectations is another criterion to watch for, as is sticking to a specific investment style.

Morningstar attempts to capture these and other "soft" factors in its Stewardship Grades, highlighting companies that do a good -— or poor — job of aligning their interests with those of their shareholders.

The company has added this new element, in part at least, because investors have tended to overreact to its popular star ratings, which were designed to describe a fund's past performance compared with the risks it was taking.

Fund marketers, particularly in the United States, like to hype those ratings, knowing that many investors tend to view the number of stars as an indicator of which funds were likely to perform best.

Studies show that more than 90 per cent of all money flowing into funds finds its way into those that carry four- or five-star ratings.

There are four components considered in Morningstar's stewardship grading process: corporate culture, manager incentives, fees, and regulatory history.

Funds with top grades in these areas are more likely to survive and deliver competitive risk-adjusted returns, the firm believes. The areas that are most predictive include:

  • Corporate culture (funds run by companies that put unitholders first have delivered strong risk-adjusted returns)
  • Fund manager incentives (managers who invest in their own funds and get paid to deliver strong long-term returns have outperformed)
  • Fees (cheaper is better, just about every time)

Morningstar recently published its updated grades for 26 Canadian fund companies (unlike its U.S. counterpart, which drills down to individual funds, it's still operating at the company level here in Canada). And the results are instructive.

While there were no Fs handed out, just four companies received an A grade. Seven earned a B, 13 a mark of C, and two firms came in with a D.

What's interesting is that those top performers — Capital Investment Asset Management, Mawer, Leith Wheeler, and Steadyhand — all have three things in common: they don't advertise much, their funds are cheaper and, when compared to the competition, their asset base is quite small.

Perhaps you should have a look.