How to pick the best funds

There are thousands of funds on the market. Some are well managed and reasonably priced, but most are not. And buying the wrong one can make a dramatic difference to your pocket: in 2005, for example, the best fund in the European Excluding UK sector (which contains 99 funds) was Premier European Growth, which returned 37.8% and the worst, Aberdeen European Opportunity, returned 16.9%. So how should investors go about choosing their funds for 2006?

The first thing to do is to look at past performance, says Mark Atherton in The Times. This is far from fool-proof (past success is no guarantee of future success), but it's true that some funds do perform consistently well. Take a look at a fund's year-on-year track record for the past three or five years. If it has managed to stay in the top quartile in every year, it's doing extremely well, says Atherton.

Two investment trusts that have made the top quartile for five years straight are British Empire Securities & General, and Caledonia Investments; they also rank first and second in their sector over five and seven years. Funds with a similar record include Fidelity Special Situations, M&G Recovery and Jupiter European Special Situations.

One with a shorter record, but which is worth considering, is the Investec Global Energy fund. It is only one year old, but has been propelled to the top of the performance chart with a return of 80%, thanks to the soaring oil price. If you think the oil price boom isn't over yet, it might be no bad place to put your cash.

Adrian Jackson, the energy equity analyst at Investec, told Paul Farrow in The Sunday Telegraph: "We are not going to see such a blockbuster year in 2006. But demand for oil is still running at between 1.5 million and 2 million barrels a day."

Still, investors shouldn't confuse a bull market with smart investing: many of this year's star performers are commodity funds and their performance is as much down to luck on the part of their managers (being in the right place at the right time) as to skill. If the commodity market stumbles next year, many funds will be hit hard. The same goes for many of the emerging market and Japan funds that have outperformed so nicely this year.

Anyway, says Magnus Grimond, also in The Times, quantitative assessments alone aren't the best indicator of a good fund. Investors need to add some qualitative research to the figures. The Financial Services Authority (FSA) warns investors not to rely on past performance figures, and the result of this is a small number of companies that analyse the past history of funds, but add "bells and whistles" to the basics. Citywire, for instance, has a rating system that follows fund managers (about 3,000) as they move firm, rather than following fund performance, on the basis that it is managers who add real value to a fund. Then there's Moneyspider, which rates funds against four key parameters: how they perform against their sector, against all funds, against the FTSE 100, and against cash.

One thing the Moneyspider system throws up is that some of the best funds come not from household-name firms, but boutiques. More than 70% of the funds offered by Margetts, Rathbone, Marlborough and Neptune are rated A or B (A = highly rated, E = poorly rated) by the system, thanks to their record of consistent positive performance. It's a shame, says Bill Ross, MD of Moneyspider, that many investors (and their financial advisers) haven't heard of these relatively unknown firms "and are therefore missing out on great opportunities".

Finally, those looking for fund rankings should look at Lipper, a Reuters firm that rates global mutual funds based on financial performance, costs, reliability of returns and how well a fund avoids losses. None of these systems can guarantee a fund will make investors the best returns in the markets, but if a fund scores well with all three firms, it does at least provide a degree of assurance that they are reasonably well run, not too expensive and less likely to lose you money than more lowly rated funds.

The top performers

Moneywise magazine combined Lipper and Moneyspider's methodologies (see above) to identify the funds that can be considered to be the market's winners over the past three years. Their UK all companies winner was Saracen Growth Alpha, which has seen 120% growth over the time period and which is ranked number two in its sector on Citywire, which credits manager Jim Fisher as being "one of the industry's more experienced figures".

Another top performer is the Invesco Perpetual Corporate Bond fund, which tops both Citywire and Moneywise's UK corporate bond funds league table, and has been awarded a 1' for consistency.

Both Citywire and Moneywise, despite their different methodology, agreed that the New Star Strategic Income fund was their UK equity income fund winner.

Citywire's number one UK all-companies fund manager is Ed Burke, manager of Invesco Perpetual UK Aggressive, a fund which has seen 152.8% growth over three years.

Finally, Malborough Special Situations won the Moneywise's UK smaller companies category and was runner up on Citywire.