In theory, picking a good mutual fund should be easy. Just find a fund with an experienced portfolio manager who has consistently outperformed the fund’s relevant benchmark and buy some shares. Then repeat in each portion of the market so that you have a well-diversified investment mix.
In reality, while it’s possible to evaluate past performance and choose from funds that have peer-beating records, the more difficult job is to identify funds that have a high probability of continuing that performance. Performance is fleeting. Even funds that have performance among the best in their category may have built good returns on a small number of incredibly well-timed investments. Alternatively, some very good funds could have excellent long-term performance and good future positioning skewed by the impact of one or two investments that didn’t work in their favor.
Identifying funds with a repeatable process to add value beyond just buying the whole market is an ongoing and involved task.
A lot of things can change about a manager or a fund from year to year. We work to learn as much as we can about the manager or fund, so we are comfortable with its stability and understand how it will fit into our clients’ portfolios.
Important questions that we ask include:
- How much of rising market returns does the manager earn and how much does the fund participate in declining markets? (Ideally, actively managed mutual funds capture most of – if not more than – a climbing market’s return and are able to avoid the full extent of downturns.)
- How much flexibility does the manager have? (When we choose mutual funds, we generally prefer managers who are not constrained to invest only in a specific portion of the market regardless of whether it is in or out of favor at the time. We use exchange-traded index funds to get this inexpensive broad diversification instead.)
- Have there been any changes to the manager or management team recently? If so, how have those changes influenced the fund’s investment outlook or process?
- How are decisions made to buy and sell a stock or bond?
- Does the fund invest only in long-only positions in stocks or bonds or does it use derivative products to emphasize or de-emphasize certain exposures in the fund? (We’re not against fund managers who use of derivatives to some extent as long as the process and purpose are very transparent.)
- Has the manager’s investment philosophy changed recently?
- How much new money has been invested in the fund lately and has that affected either the number or the quality of holdings in the fund?
- What have been the recent trends of the manager for underperforming or outperforming the fund’s relevant benchmark? Why has this underperformance or outperformance occurred?
- Have there been any changes to the basic characteristics of the fund? Expense ratio, portfolio turnover, number of holdings, risk measures, etc.?
- Does the fund have an institutional share class available so that we don’t have to pay the higher retail share class management fees? Or, can we aggregate client accounts to get into funds that otherwise would have an unapproachable minimum investment?
- How will this fund fit in with the other funds in a client’s portfolio? Are there other funds that could do a better job?
- Is there a low-cost passively managed investment like an exchange traded fund that could be used in place of this fund which would provide similar investment returns?
How do we get this information? Mostly through conference calls with the manager, reading annual and semi-annual reports for the fund, reviewing analyst’s reports and other third-party reviews.
This process doesn’t guarantee selection of the best future performance. In fact, we guarantee that in hindsight you will find better performers in every category over various time periods. But if the fund advances through our decision tree and we have high conviction in its expected returns compared to its known risks, then it makes the cut.
The worst thing we could do would be to constantly turn over our list of preferred funds in pursuit of the absolute best performance. It would create unnecessary reach for fractionally better results and drive up transaction costs.
That is not to say that we are not searching for new funds that offer attractive expected returns with better risk management. We certainly make changes. We just are not inclined to do it on a whim because a certain fund’s holdings were more in favor last quarter or last year.
~ Brooks, Hughes & Jones, Partners in Wealth Management, Tacoma, WA