Don’t Play in the Street
How to Choose a Mutual Fund…
Trying to choose a mutual fund that will beat The Market is a daunting task. In 1998, ten mutual fund experts were asked by USA Today to pick two actively managed mutual funds that they believed would outperform The Market that year. None of the funds picked beat the market. This experiment was doomed from the beginning. No one (not even today’s greatest financial minds) can always accurately predict the market in the short-term. In light of this fact, how can you find a good mutual fund? Below are a few key characteristics to look for…
Choosing the right mutual fund begins with determining your investment horizon. If you expect to use your investment assets within three years, you should consider something other than an equity fund. If you have a longer time horizon, seek out mutual fund managers whose investment strategy matches that horizon. Most mutual fund companies are willing to discuss investment suitability, which includes an ideal holding period for an investor.
It is important is to pick an investment strategy that you can easily understand. The investment industry often sells complicated investment products as sophisticated ways to grow your money. Last year the NY Times wrote an article on this very topic. For most investors, the more complicated an investment is, the more likely it is to lead to losses due to unknown or poorly understood risks. In their book The Permanent Portfolio, Rowland and Lawson insist, “If you don’t understand how an investment works within about five minutes, walk away. Even if you miss a hot new opportunity because you don’t fully understand it, there will be duds that you will also avoid by staying away. The most successful investors on the planet have no shame in admitting they avoided an investment that they didn’t understand. So don’t let anyone make you feel guilty for staying away from something that doesn’t make sense to you.”
Mutual fund investors may want to consider investment managers who have proven themselves not only over an extended period of time but also through numerous market cycles. A long-term fund performance record (we recommend a rolling 5-year average annual return since manager inception versus a comparable benchmark) should highlight the manager’s investing abilities. It is often said that “the market never repeats itself but it often rhymes.” Looking at the performance of a mutual fund over a period longer than the current manager’s tenure may not provide helpful data.
Investment team turnover is a key element when trying to determine the future success of a firm or fund. At most firms, the research analysts bring the majority of investment ideas to the table. We recommend looking for low turnover of research professionals leaving the firm. Ideally, as the company grows, additional research personal should be added. The right mix of both seasoned and novice analysts is important. Adding seasoned analysts should provide an immediate increase in the team’s circle of competence. However, too many recently hired seasoned analysts have the potential to change the company culture or even the firm’s investment strategy.
The investment firm’s ability to effectively communicate with shareholders and prospective investors is a critical component that is often overlooked when seeking a good mutual fund. Investment firms should be willing and able to communicate regularly with regard to portfolio performance, holdings and market outlook. Communication can come in many different forms: email, phone calls (inbound and outbound), quarterly commentary, conference calls, mailings, etc. Large-scale communication should take place at least quarterly. Intraperiod communication should also be a prerequisite if the market or fund performance warrants it. There should be a direct correlation between poor performance and the number of attempts to communicate.
Once you have put in the research and selected a fund that meets these criteria, continued due diligence is important. Even a good mutual fund may underperform relative to its benchmark in the short-term. During these periods, the highest quality investment firms remain consistent with their investment strategy. Although performance is important, the focus should be on portfolio management tenure, research professional turnover and firm communications. If too many changes are taking place at the investment firm, or if at any time you feel out of the loop or uncomfortable, this may not be the fund or investment firm for you. Always keep in mind your time horizon, and if nothing fundamental has changed, you may want to stay patient. According to a recent Morningstar article, Bad Timing Costs Investors 2.5% a Year, investors who make poor market timing decisions may end up hurting themselves.
All investments are subject to risk, including the possible loss of the money you invest. Past performance does not guarantee future results. There is no guarantee that any particular asset allocation, or mix of funds, or any particular mutual fund, will meet your investment objectives or provide you with a given level of income.