Do You Know How to Choose a Mutual Fund?
For many investors, mutual funds and exchange traded funds (“ETFs”) are the preferred tools for investing (see our posts on What is a Mutual Fund and What is an ETF to understand the differences). When we think about choosing a mutual fund, what we really should be focusing on initially is the mutual fund company, rather than the fund itself.
Fund companies typically operate under either a “star model,” where they hire a highly successful investor to run the fund or a team-managed approach. Other differences in management methodology are distribution models (advertised approach or financial advisor distribution), passive or active management, and other niche identifiers (ex. Vanguard’s cost leader approach). In this post, we’ll focus on 3 key variables that successful mutual fund families often have in common.
1. Mutual Fund Costs & Fees
A mutual fund charges investors management fees, known as the fund’s expense ratio. Since all funds must disclose their annual costs, it makes for an easy data point to compare. However, investors can make the mistake of focusing solely on cost instead of using it as part of an overall suitability analysis. If a mutual fund charged you 2% annually but delivered you a net rate of return of 15% each year, would you choose it over a fund charging you 0.4% with a net annual return of 8%? Making cost the sole variable would be a mistake.
How should an investor look at cost? Investors should assess mutual fund cost by judging the overall value provided. Do you purchase a car strictly based on its cost, or do you also consider the vehicle’s track record, reliability, safety, and resale value? Do you judge a CPA or attorney only on cost, or do you consider their experience, personality, and reputation?
Everything we purchase is put through the lens of value, so our investments should not be any different. The interesting thing about investments is that sometimes the best options actually cost less than the average mutual fund, so investors really can get funds with long track records of solid performance, experienced fund managers, and good stewardship for a reasonable cost.
So, what is a reasonable cost? As always, the answer is not that simple. Fund expenses are typically higher for foreign mutual funds and the less liquid areas of the market (sector funds, small companies, etc.). Therefore, assigning a global cost as acceptable provides little value. We like to screen for funds that are in the lowest cost quadrant (less expensive than 75% of their peers).
2. Industry Experience
As in any profession, talent tends to rise to the top of the industry. For this reason, analyzing fund manager experience is a fruitful exercise. Most fund managers begin their careers as analysts looking to create an opportunity for themselves. Once fund managers have a track record, they may aim to work for a large mutual fund company where the asset base will be larger. Others may seek out a boutique investment shop steeped in success in a certain segment of the market.
Regardless, the most talented managers tend to get hired and retained by the best fund companies. Once managers secure a position at a top firm, there is not a better job to be had. They have reached the top of the pyramid, so they tend to stay for a long time.
3. Mutual Fund Performance
I saved performance as our last discussion point. Many investors begin and end with performance. However, performance alone may not satisfy investors.
All investors are pleased when the market is rising and their holdings follow suit. It’s when the market takes back from investors that we begin to really assess our risk tolerance, which is usually a poor time to conduct that exercise. Raw performance is certainly important, but if investors lose their ability to be long-term shareholders (by jumping in and out of funds) then they will not experience the actual returns of the funds they utilize. Often the real rate of return of fund owners is less than the fund itself due to poor decisions when it comes to buying or selling the fund.
Looking at the upside and downside capture ratios (how well or poor you do in a rising and falling market) can prove helpful in gauging what the risk and return path of a fund might look like in the future. Ideally, we could all find mutual funds that pace the market to the upside but also avoid losses when the market falls. More realistically, by looking at the capture ratios we can tell what the risk history has been for a given fund which might help us decide if a fund is appropriate for us as investors.
Each year Morningstar publishes a mutual fund screen that they title the “Fantastic x Funds,” with the x being the number of funds that pass the criteria of the screen. The criteria of the screen involve looking at cost, performance, stewardship of the parent company, managers that actually invest in their own funds, and volatility. In 2016 there were only 45 funds that received a passing grade out of 8,000 options (Kinnel’s Fantastic 45 Funds1.) As you might expect, the list is full of successful fund companies. There are plenty of factors to consider when allocating your capital to a mutual fund company. Analyzing cost, experience, and risk-adjusted performance is a great starting point to finding successful investment partners.
1 http://news.morningstar.com/articlenet/article.aspx?id=768923 (requires free registration to view)