ROBERT R. THOMAS, CFA, is vice-president and director of investment for the Aris Corp. of America in State College, Pennsylvania. His e-mail address is rthomas@ariscorporation. com . RICHARD C. MUSAR, CPA, is business development manager for the Aris Corp. of America. His e-mail address is rmusar@ariscorporation.com .

o pick the winning horse in thoroughbred racing involves research into the record of the horse, trainer and jockey as well as into how the horse performs under different weather and track conditions. Even then, there is no guarantee of choosing a winner. When a CPA firm that offers financial planning takes on the task of helping clients identify specific stock mutual funds that meet their stated goals and objectives, careful research also is required—and a surer outcome hoped for. Instead of trying to pick the winner in a field of 12 horses, CPAs have to advise clients which of the more than 5,000 domestic equity funds will parallel the results of today’s high-flying stock market. Bonds (and by extension bond funds) are clearly rated by Moody’s or Standard & Poors, but equity mutual funds (like horses) involve more of a gamble. CPAs need to know how to handicap the race, evaluating stock funds to find the winners and weed out the losers.

Fortunately, there are some proven methods CPAs can make use of to recognize high performers. By heeding the commandments that follow, CPAs can better judge which of the myriad funds available today will best meet a client’s investment needs.

MEET THE CLIENT’S OBJECTIVES

When choosing stock mutual funds, it’s important for CPAs to keep the client’s investment goals in mind and customize the mix of funds to reflect them. For example, if the client is an aggressive investor focused on long-term growth and unconcerned about dividends, buying shares in a small cap fund may be a good choice. (See the mutual fund glossary on page 23.) On the other hand, if the client is retired, he or she may need the extra income dividends bring. In this case, CPAs should look into funds that specialize in large cap stocks or consider a fund that invests primarily in high-dividend utility stocks.

CPAs also must consider whether the funds they are evaluating include international stocks. If the client already has decided to allocate 10% of his or her assets to foreign investments, the CPA should not skew that decision by recommending funds that have significant international holdings. To avoid overallocating, CPAs should keep in mind that international funds are made up entirely of stocks from outside the United States while world funds comprise both domestic and foreign securities. For instance, Janus Worldwide has 30% of its assets in U.S. stocks even though it is commonly considered an international fund.

Fund managers can also trip up a client’s asset allocation goals by changing directions. CPAs should be on the lookout for funds that are undergoing a style shift such as when the fund manager begins to invest differently, perhaps putting a chunk of the fund’s assets into a different market sector. For example, because of the current success of large cap funds, some small cap fund managers have started to buy blue-chip stocks. However, the small cap manager may not understand the large cap market as well as someone who specializes in it. The situation is akin to having an orthopedic surgeon perform heart surgery—the manager is operating outside his or her area of expertise and this can cause the fund to underperform in different market cycles.

CORRECTLY EVALUATE FUND RETURNS

Many investors—and the CPAs who advise them—simply compare a fund’s rate of return with the S&P 500 index. However, unless you have invested in a large cap fund that consists only of S&P stocks, this technique will not give you an accurate picture of how well the fund is performing. To compare apples with apples,

CPAs need to look at funds—or an index—with assets similar to the benchmark’s. If the fund under consideration is a small cap fund, compare it with other small cap funds or with an index such as the Russell 2000. CPAs also must be careful when comparing large cap funds with each other. There are two different styles of large cap funds—large cap growth and large cap value (see glossary). For the first quarter of 1999, growth funds outperformed value funds, as shown in the exhibit on page 22. As tempting as it is to put all the money the client has designated for large cap funds only into growth funds, this strategy could land you in the buy highsell low trap. CPAs should protect their clients by diversifying and investing in both value funds and growth funds. After all, today’s large cap market winners may be tomorrow’s losers.

To hedge against a bear market, find out how a fund you are considering has done when prices are down. CPAs can research a fund’s historical performance by subscribing to one of the three large databases—Morningstar, Weisenberger and Ibbotson— that track fund performance on the Internet. (See the list of Internet resources below for information on how to contact these companies.) How did the fund do when the market dropped in 1990 and again in 1994? What about during July and August of 1998? Don’t choose a fund that performed significantly below the market average in tough times, even if it does well when markets are flush.