How to Choose Mutual Funds

Maybe you have used a variety of internet websites to select some mutual funds based on your own criteria. What criteria do you use in your selection process?

For a "do-it-yourselfer" information is knowledge and here are some points to consider from BourGroup and Phillip D. Bour, CFP®:

This blog post describes what I do and by no means is how other planners/advisors approach their work. It is in no way a guarantee of success and past performance and ratings is no guarantee of future results (as a matter-of-fact, the criteria below change daily, weekly and monthly and have to be constantly revisited for any particular fund you are researching). It is a process and there is no assurance that it will work consistently (nothing does) but you have to start somewhere because at some point you need to make a decision.

First things first though:

(1) Decide what the asset allocation is that you are targeting (for example: 30% large-cap growth; 35% large-cap value; 8% small-cap growth; 12% small-cap value; 5% emerging market international; 10% Europe/Asia international). If you are in "accumulation mode" in your life (still working and paying off a mortgage) then no bond exposure may be needed because "paying off the mortgage" is your bond portion of your portfolio. Since every extra payment on principal gains you a risk-free return at your mortgage rate less the effect of savings from taxes, it is a tax deduction on your principal residences and similar to a bond return. Of-course, this depends on the interest rate you have on your mortgage and your marginal tax bracket, and it won't help your "investable portfolio" by itself be less volatile (since you are 100% invested in stocks there so risk tolerance and time horizon are to be considered also) but if you have a mortgage it is something to think about.

If you are not at these targeted allocations right now (and everyone's is different, these are just examples) then determine what yours will be, stick to them when you get there, and work towards them now. You could just rebalance and get there but I like the idea of "redirecting" rather than "rebalancing". This way you dollar-cost average into the styles that you are behind in with your target allocations.

I (and BourGroup) do not use mid-cap funds at all and yet they have been the best performing over the past few years. My reason though is that it is too difficult to not have overlap as mid-cap companies often are picked up by large-cap and small-cap funds as they grow or decrease and become "value companies". This does not mean I missed out on those mid-cap returns because the large-cap and small-cap funds had their dose of them, too, but the risk is a little more balanced when within other categories. As the old sauce commercial said "...its in there...".

If you have not done this exercise of determining your asset allocation, it is useful - I believe essential. I would be glad to help. For example, mid-cap growth has been the best performing lately (keep in mind the time period this was written) but also the most volatile fund style meaning more risky - more risky than even small-cap funds which have up to now been the riskiest. Not true any more. Some investing concepts and styles do change over time.

You can find this information (risks and returns of investment vehicles) at http://www.morningstar.com/ also. The RISK associated with each style of fund is important since RISK/RETURN is the real issue in my opinion. As I state in my investment philosophy: the objective is not to maximize returns but to minimize risk and thereby optimize returns based on that level of acceptable risk specific for your needs.

International used to be thought of as a diversification tool (when U.S. stocks go down, Int'l. goes up). Also, no longer true as they are all highly correlated over the past few years with no change expected in the future.

"Emerging Market International Funds" (unlike most Europe/Asia large-cap funds) is an asset class that is less correlated with the U.S. However, it has a very high risk level. Hopefully, you have no more than 5% of your total portfolio in this risky area but, then again, every individual is different and the amount of concentration in each asset class and each style (growth versus value) within them is unique to the investor.

(2) This selection criteria is based on actively-managed mutual funds. There are ETF's, ETN's, closed-end funds and a myriad of other choices as alternatives. Caution is in order. ETF's are just the broker's solution to mutual fund family's indexed funds. Good? Bad? No, just different. This post is not meant to explain the differences but you need to understand the pros and cons and this is why you might consider the one-time meeting with a knowledgeable financial planner.

Now we are ready to begin. My fund criteria that I use for myself and for my clients:

(0) Before beginning, know what the goals/objectives/financial needs are and decide on what styles of funds I am looking for and I only use (Large-cap growth; Large-cap-value; Small-cap growth; small-cap value; International; Emerging Market International). Maybe bond funds, depending on circumstances.

But never hedge funds, shorting stocks, commodities, puts, calls and all the other varieties of risky options that are available to richer and more sophisticated investors who have money to "burn". Much talk is bantered around these days that these riskier alternative options are now accessible to all investors and should be a part of a diversified portfolio (to smooth out volatility) but that has not been analyzed thoroughly nor been proven.

My selection criteria:

(1) Fund, at least, has been around for 10 years (do not expect returns in one year that are exceptional year after year).

(2) Fund manager has been managing the fund for 10 years (but would accept a little shorter time period)

(3) Rate of return in excess of 10% (stocks) 5% (bonds) for the 10-year period. I do not select based on the 6 month, 1-year, 5-year returns - they can be ANY return really. It is the consistent, long-term return I look at even though acknowledging that past performance is no guarantee of future results.

(4) No-load only

(5) Expense ratios less than 1.5% for small company and international funds

(6) Expense ratios less than 1.0% for large company and bond funds (although, not unreasonable to use .50% for bonds these days) for actively managed funds

(7) SHARPE RATIO that is positive (this is a simple division of [ (Ave. Return - U.S. Treasury 3 month return) / Standard Deviation] and is reported by Morningstar for a 3-year period, but http://www.quicken.com/ reports for the 5-year and 10-year periods also. I like that for comparison shopping. Note: the Sharpe Ratio has not been a good indicator for alternative investments like hedge funds.

(8) ALPHA is positive (this is the return in excess of what was expected, so if this is positive then the fund manager has added value over just using an indexed fund). The problem with this at Morningstar is that it is only for 3 years and I like to look at 10 years. So I use http://www.quicken.com/ for this also to see the 10-year Alpha number.

(9) The SIZE of the fund in millions of dollars (A large-cap fund really does not matter much because the stock market is currently about $15 TRILLION in size so a large-cap fund with $1 to $40 BILLION in assets managed is still a small % of the total market and remember that 80% of that $15 TRILLION is in large-cap companies). Now for small-cap funds, I would prefer to see that amount at less than $1 BILLION thereby giving the fund manager room to get in and out of small-cap companies easier.

(10) BETA. I use this to evaluate the total portfolio for risk as it relates to the market (Morningstar uses the S&P 500 to equal the market which is really inappropriate because small-cap gets missed and international, too, but is the best we have for free website offerings). What I do is weight the market value of each position I own (and that my clients own) to the total portfolio (Fund x = $20,000; total portfolio = $100,000, so fund x = 20%). Then, I multiply this "weight" times the BETA for that fund (1.08, as an example) and get ".216" . Once done for all funds, I then add up all the weights and get a weighted-average BETA for the total portfolio and compare it to 1.00, that is the market. You can do this with BETA, but you cannot do this calculation with STANDARD DEVIATION. If greater than 1.00 then I know that we are taking on more risk than the market and should expect a higher return than the market over a long period of time, if it is less than 1.00 then we are taking on less risk. Remember, past peformance is no guarantee of future results.

(11) STANDARD DEVIATION. You can not weight the averages of this like BETA because of how different assets are correlated, but you can use it to compare the volatility of one fund to another if they are the same type of fund. The higher the standard deviation in relation to a similar fund then the more ups and downs it will experience - another measure of risk.

(12) TURNOVER. An indexed fund has a turnover rate of about 9%. A reasonable number for an actively managed fund is a range from around 20% (every five years the companies within it are bought and sold) up to 50% (companies are changed every 2 years). This has a cost and it is not reported by Morningstar as part of the expense ratio. These are transaction costs and they are not much but a 20% turnover rate may add another .2% to the expense ratio for example, where a turnover rate of 300% may add another full percentage point to the expense ratio. It can be calculated with formulas and is a good thing to do with a financial planner. This is not a show-stopper necessarily if the returns are over 13-15% for the 10-year period but it is something else to consider.

AND FINALLY,

(13) THE NUMBER OF COMPANIES IN THE FUND. This is one item of many of the above that makes one fund riskier than another and it is never even reported in all those fund reports in the financial magazines on the newstands (or that you may have a subscription to also). It is the EASIEST to understand. This is actually a very important statistic because a fund that has 50 companies in it could be a real winner or a real loser, therefore, very volatile and risky. On the other hand, a fund that has 300-500 companies in it is less risky because of the diversification but also less flexible and will follow the overall market more closely in many cases. A lot depends on the fund style. See a financial planner to evaluate funds thoroughly.

If you need your portfolio to live on you cannot be as aggressive as someone who is still adding to their nest egg. If one is withdrawing money on a regular basis to "live on", then everything changes. I recommend an emergency fund from 6 months (for a young, working couple) to possibly 5 years (for an older, retired couple who is quite risk adverse and is counting on their money to "live on"). This is a lot of money (for most areas of the country we are talking $10,000 - $15,000 when working and $50,000 - $100,000 when retired) and many people don't have it but are investing anyway. Not a good idea.

Many Nobel-prize winning economists have studied the markets over these past 100+ years and Large-Cap VALUE funds (you may have some of these companies in your individual stock selections) are the best return for the level of risk associated with them. They also go in cycles. For the years 2000-2005, they have done better than the overall S&P 500 (which is a growth-biased index). The investing community believes that Large-Cap GROWTH funds (some of these companies may be in your current portfolio, too) will become the rising stars over the next 5 years. Who knows? The reminder comes back, time and time again, that no one knows what will happen in the future. What we do know for sure is that past peformance is no guarantee of future results.

My point is, of-course, that you can never know when one style is going to be favored or not (mid-cap growth did even better than large-cap value over the 2002-2005 time frame but no longer on a risk-adjusted basis because mid-cap growth is now the most volatile style of investing) so the objective is to have a little bit of each and stay the course. Hence, my recommendation that you select your particular allocation targets before you ever try to select a mutual fund or individual stock company. Remember that diversification will not maximize returns though it will help to minimize those risks that can be diversified away but market, interest and some other risks will always exist if you are invested in bonds and stocks.