The wrong way to pick funds

By Pat Regnier, assistant managing editorMarch 10, 2010: 9:13 AM ET
(Money Magazine) --- Photographer friends tell me that if you're
picking out a point-and-shoot camera you shouldn't focus much on the
megapixels. That measure of a camera's resolution is hyped by
manufacturers, but most cameras on the market give you all the pixels
you'll need.

So when I was buying a new camera recently, I chose ... the model with
more megapixels.
Call it the data dazzle. Your mind tends to hook on to any number that
helps you compare various choices, even when you know the information
isn't actually helpful.

I thought of this after reading a proposal to fix the retirement
system from the Squam Lake Working Group, made up of some of the
nation's top economists. One of their ideas is to create a simple
one-page disclosure label for the mutual funds in 401(k) plans.
You'd see data such as the fund's costs and its likely risk. What you
wouldn't see: its performance record.

"We don't think it's very informative," says Dartmouth economist
Kenneth French, who worked on the proposal. French is also a director
of a firm that runs low-cost funds, which would tend to look good in
this light. But I think he also has the evidence on his side here.

*The past is past:* At least when I paid for extra megapixels I got
them. But performance numbers represent returns that have already been
earned. Your returns are in the future, and it's notoriously hard to
pick tomorrow's winners and losers. Ask anyone who bought Bill
Miller's Legg Mason Capital Management Value fund in 2006 (see below)
--- or sold it in 2008.

*Returns push your emotional buttons:* Performance stats can be worse
than uninformative. They can actually de-inform, making you forget
about data that matter. Although low expenses add up to a big
performance edge over time, nobody ever fantasized about paying just
0.25% for a fund.

But when you see a fund that has earned 15% annualized returns over a
decade --- as some emerging-markets funds have --- it's hard not to
imagine how cool it would be to own a piece of that.

*Managers know the game:* Returns drive fund sales. That gives
managers an incentive to seek short-term glory at the expense of
long-term strategy.

One way for a fund to look good, says Santa Clara University finance
professor Meir Statman, is to invest outside its category. A fund that
focuses on large U.S. companies might add shares of small tech
companies when they turn hot. That will score good relative numbers
for a while but expose investors to unexpected risks.

If you just can't ignore performance numbers, make it a rule to look
at them last, after you've made a short list of funds with low
expenses and experienced managers. You'll be two steps ahead of the
Source: CNN.Com