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Using Lipper Rankings to Choose a Mutual Fund |
by S. Wade Hansen
Finding the Top Performing Mutual Funds
If you are participating in a company 401(k) program or are working with a financial planner, chances are good you are investing in mutual funds. The question is, which funds should you be putting your money into? 
Sure, you will naturally want to diversify your money among different asset classes. But when you are looking at various large-cap stock funds, for instance, how do you choose which large-cap stock fund to buy?
Let's take a look at one way you can evaluate similar mutual funds.
Lipper Leader Rating System
The Lipper Leader Rating System is often cited by financial planners and other investment professionals because it is relatively easy to understand. Here is how the rating system works, according to Lipper: Lipper Leader ratings are derived from highly sophisticated formulas that analyze funds against clearly defined criteria. Funds are compared to similar funds, and only those that truly stand out are awarded Lipper Leader status.
Funds are ranked against their peers on each of four measures: Total Return, Consistent Return, Preservation, and Expense. A fifth measure, Tax Efficiency, applies in the United States. Scores are subject to change every month and are calculated for the following periods: 3-year, 5-year, 10-year, and overall. The overall calculation is based on an equal-weighted average of percentile ranks for each measure over 3-year, 5-year, and 10-year periods (if applicable).
For each measure, the highest 20% of funds in each peer group are named Lipper Leaders. The next 20% receive a rating of 2; the middle 20% are rated 3; the next 20% are rated 4, and the lowest 20% are rated 5.
NOTE: Lipper Leaders have Changed As of 7 November, the Lipper Leaders Rating System changed. While the formulas and the underlying methodology remain the same, the numeric organization of the system changed so that the highest 20% are rated 5 or Lipper Leaders and the lowest 20% are rated 1 for each measure. Let's take a deeper look at the criteria Lipper uses in calculating the scores for each fund.
Total Return reflects a fund's historical total return performance relative to peers.
Consistent Return reflects a fund's historic returns, adjusted for volatility, relative to peers.
Preservation reflects a fund's historical loss avoidance---capital preservation---relative to other funds within the same asset class.
Expense reflects a fund's expense minimization relative to peers with similar load structures. In other words, does the fund charge lower fees for similar services.
Tax Effeciency reflects a fund's historical success in postponing taxable distributions relative to peers. Because we all want to postpone paying taxes as long as possible, having a fund with high tax efficiency can boost your portfolio. [Learn more about how you may have to Pay Taxes on Mutual Funds with Losses if you're not careful.]
In each case, the overall calculation for each factor is based on an equal-weighted average of percentile ranks for the specific metrics of each characteristic over 3-year-, 5-year, and 10-year periods (if applicable).
NEXT: Learn how to Diversify Your Portfolio with Exchange-Traded Funds (ETFs)
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