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Course 411
Buying Rookie Funds

Introduction

Colonel Tom Parker had to be one of the smartest people in music history. He knew potential when he saw it. In 1954, Colonel Tom heard a young Elvis Presley singing on Louisiana Hayride, a live Saturday night country music show. He struck up a business relationship with Elvis, snagging some tour dates. Less than a year later, the Colonel took exclusive control of the King's career. The rest is history.

Every mutual fund investor hopes to spot up-and-coming mutual funds and get in on the ground floor of a great new investment. Granted, investing in a new fund is a gamble. Without Morningstar ratings and a few years of return and risk information as guides, how can you be sure you are getting the Next Big Thing? Nothing's certain, of course, so we suggest you ask the following questions before buying a new fund.

Has the Manager Run a Mutual Fund Before?

Favor new funds run by managers with some previous mutual fund experience, and be sure to scrutinize their records. Some prospectuses will include the manager's experience, while others won't. Check out the fund family's Web site for more information, or examine the fund's Fund Report, if available. (Morningstar doesn't always have Fund Reports for brand-new funds.) Be sure that the manager will be practicing a similar style at the new fund as he or she did with their previous fund.

What Is the Manager's Strategy?

You need to understand the manager's strategy to set realistic expectations for your investment. When the market does X, what can you expect from this fund? Also, when those inevitable dry spells come, you'll understand why, and you won't be tempted to cut the fund loose.

Further, you need to know what the portfolio looks like today, because it can give you some idea about the fund's future risks. Remember, since these are new funds, you don't have historical risk measures, such as beta or standard deviation, to serve as clues about riskiness. Funds that feast on expensive, high-growth stocks will probably carry higher betas and standard deviations than those funds that look for underpriced securities. Funds owning fewer stocks will generally be more volatile than those holding many. Finally, managers who concentrate in particular sectors will probably give you some volatility, too. You can find all this information by scrutinizing a fund's portfolio information on Morningstar.com.

How Much Will It Cost?

When stocks are up 20% per year, costs might not seem important. After all, a 2% expense ratio off a 20% return leaves you with an 18% gain - and who would complain about that? But if your stock fund were to return, say, 8%, that 2% expense ratio leaves you with just a 6% gain. One fourth of your return has just gone to cover expenses. Now that's a big deal. And regardless of the level of returns, paying more than you have to can cost you tens of thousands of dollars or more in compounded returns over time. So when evaluating rookie funds, be sure to consider their expense ratios. For some context on whether a fund's costs or on the high side or relative low, look for the "Fee Level" on the quote page for that fund. You'll see a fund's expenses described as high, above average, average, below average, or low.

You'll notice that new funds are more likely to carry "high" or "above average" expense ratios than older funds. That's often because small, new funds don't enjoy the same economies of scale that older, larger funds do: Larger funds have more shareholders to cover expenses. So when buying a rookie fund, you'll want to be sure that the fund's family has a history of bringing down costs as assets rise. You can determine a fund family's practice by examining the expense ratios of the family's more established funds--is the Fee Level "average" or below?

Will This Fund Offer Any Extras?

You want your funds to be dedicated to you. Low costs are one way to express devotion, of course. But also favor rookies that vow to control their asset sizes by closing to new investors at particular asset points. As funds grow, managers can be forced to compromise their strategies to accommodate all that new money. But funds that close before becoming too large don't face that problem.

Look for managers who align their interests with yours by investing in their own funds. At Longleaf Partners, for example, fund managers can't own anything other than Longleaf Funds. Because these managers are shareholders, too, they are likely to keep costs lower and minimize taxable distributions.

New funds can certainly offer opportunity, but we recommend that you build your core around funds that have established track records and use rookies at the fringes of your portfolio. Consider investing a little in a rookie fund and dollar-cost averaging into it over time.

Quiz 411
There is only one correct answer to each question.

1 Which rookie fund shouldn't you consider?
a. One run by a manager with a previous track record.
b. One run by a manager with no mutual fund experience.
c. One run by a manager with no mutual-fund experience working for a reputable fund family with an established strategy.
2 Why is it important to examine a rookie fund's portfolio?
a. To set realistic expectations for the fund's performance.
b. To get a handle on the potential risks of the investment.
c. Both.
3 Why should you favor managers who invest in their own funds?
a. Their interests are aligned with yours.
b. They are better investors.
c. They have more experience.
4 Why do rookie funds often cost more than established funds?
a. Because rookie funds are investing in harder-to-research stocks.
b. Because rookie funds generally have fewer shareholders to cover costs.
c. Because all new funds are overpriced.
5 Rookie funds should:
a. Make up the core of your portfolio.
b. Be held in small quantities, if at all.
c. Be bought in large quantities.
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