Rules of selecting the perfect mutual funds

Rules of selecting the perfect mutual funds

Today choice is a problem. Especially in the case of mutual funds, the array is mind boggling. So how does a common investor go about selecting the right mutual fund? Financial expert Mehrab Irani attempts to solve this problem by introducing the rules of selecting the perfect fund.

Today choice is a problem. Whether the exercise is one of spending or of investing, wherever we go, there is a plethora of choices. Especially in the case of mutual funds, the array is mind boggling - so how does a common investor go about selecting the right mutual fund. This article attempts to solve your problem of plenty as far as mutual fund investments are concerned by introducing you to the "rules of selecting the perfect fund". Yes, my friend, mutual funds have has its own rules which no textbook or formal education will teach you but you have to learn the rules otherwise your dream of becoming successful mutual fund investor would be greatly impaired.

 

Rule 1: Select Funds with Low Expense Ratios

 

Costs matter - and their impact is likely to grow in importance in the years ahead. It is costs, pure and simple, that have accounted for - and will continue to account for- the lion's share of the shortfall of the typical mutual funds in the stock market. Remember, these costs are borne out of the returns and to that extent, take a portion out of them. So it is obvious that in times of low returns these costs will chew up a higher part of the market return which ought to be available for you. As these costs are raked from the table of the market casino, the croupiers with the largest rakes are the fund managers. The fees and expenses you pay to them are rising even faster than the industry's soaring asset base. But, yes, larger fund groups have lower costs. Thus you owe it to yourself to select from among funds where the manager-croupiers exercise at least some restraint, evidenced by expense ratios that are well below industry norms.

Rule 2: Emphasize Funds with Low Portfolio Turnover

 

Once your money is invested in a fund, most funds continue to buy and then sell securities unremittingly, and then sell them and buy them over and over again. The shorter the holding period of a stock the more akin to short-term speculation than to long-term investing, is the philosophy. It's such an irony of faith that the mutual fund managers and distributors advocate "long term investing" through their funds while their funds themselves are slaves to short term trading strategies. So who pays for these transactional costs of churning the portfolio-you of course-from your returns. This high turnover is in part the product of trading by hyperactive portfolio managers, anxious to garner a performance edge on their peers, however fruitless the quest. But there is also turnover among the managers themselves. All too often when a manager departs, the new manager's broom sweeps clean, as he reorders the portfolio to comport with his own strategies. So, be aware, not only of a fund's turnover rate, but also both its management and company's propensity to move managers around, sometimes seemingly at the drop of a hat. Turnover costs can cut your long-term returns by a meaningful amount, so do your best to find funds both with portfolio holdings and portfolio managers that will stay the course.

 

Rule 3: Realize that commissions are Fund Costs Too

 

As impatient, aggressive fund managers buy and sell stocks at a furious rate, they pay virtually no attention whatsoever to the brokerage and commissions such activity will require you to pay. So look for efficient funds - not only those that have been so in the past, but those that have policies that emphasize on-going efficiency with minimum commissions and brokerages.

 

Rule 4: Be Careful About What You Pay for Fund Selection Advice

 

Many investors need sensible advice in fund selection and asset allocation-and many do not. If you are convinced you do not need advice, it is unwise to pay for it, either in the form of front-end sales commissions or fees paid to registered investment advisers and financial planners, usually beginning at about 1% of assets and paid directly by the investor. The best advisers help you minimize the costs of the croupiers in the stock market casino by steering you toward funds with low expenses, low turnover, and high tax-efficiency. Equally important, they can also help you to minimize the many pitfalls of fund selection, provide you with sound asset allocation guidance, and give you personal attention. If you are among the many investors who need this sort of advice, get it. But be sure to carefully select your adviser and know exactly the fees involved.

 

Rule 5: Beware of Past Performance to Predict Future Performance

 

For your dream of a perfect plan to be realized, you must select superior mutual funds. To an amazing extent, investors rely on past performance to make their selections. However there is simply no way of predicting a fund's future success based on its past track record. Indeed, the one thing that appears certain about the future relative performance of successful funds is this - performance superiority will not be sustained. This pattern is called "Reversion to the Mean," a sort of law of gravity that seems to be almost universally applicable in the financial markets. It is not a statistical aberration. Reversion to the mean or the law of averages, then, seems almost preordained in fund performance, frustrating the dreams of so many investors who invest on the basis of past returns. Finally, index funds alone have relative predictability. They provide precisely the market's return, less their costs, decade after decade after decade.

 

Rule 6: Rely on Past Performance to Measure Consistency and Risk

 

While the dream of the perfect investment plan will rarely be fully realized, there are ways to avoid having it become a living nightmare. If past fund performance cannot foretell the future, it can still be an important consideration in selecting funds that have a fighting chance to earn consistent returns relative to peer funds with similar styles and objectives. Compare, for example, a large-cap blend (growth and value) fund with other large-cap blend funds, and see how it stands each year. The "good" fund is in the top half in seven years, in the bottom quartile but once. The "bad" fund is in the top half five times, but in the bottom quartile, four. It is consistency of return, not aggregate return, that tells the important story to the intelligent investor. So, careful analysis of past performance can tell us a lot about return. But it can also tell us a lot about risk. Risk is a crucial element in investing. Generally speaking, value funds carry distinctly less risk than growth funds, and large-cap funds carry less risk than small-cap funds. For example, small-cap growth funds carry 65% higher risk than large-cap value funds. The character, integrity, stability, and judgment of a fund's management are the qualities on which your dream of the perfect plan should rely. In all of your searching for the quantities that describe investment returns, so don't ignore the qualities of those who will be the stewards of your precious assets.

 

Rule 7: Consider the Implications of Asset Size

 

Any investor seeking the perfect plan must be aware of asset size and its implications for the future returns of the funds selected. By far, the biggest problem is that investors seeking extraordinary future returns focus on extraordinary past returns, frequently accomplished when a fund was small. Such returns are simply not repeatable; indeed they may not even be honest. Size, as such, is not necessarily bad. A giant market index fund, indeed, may have inherent advantages over a very small one. And the past record of a fund investing in large-cap stocks on a long-term basis is likely relevant even if the fund has grown to a large size. But giant size limits the investment universe from which a manager must select the fund's investments, as well as limiting (for better or worse) his ability to actively trade the fund's holdings. As a result, funds that were once actively managed gradually come to resemble market index funds, without disclosing it, and without the benefit of low cost that indexing provides.

 

Rule 8: Don't Own Too Many Funds - And Don't Trade Them

 

Last but not the least - limit the number of funds you own, and don't trade them. To paraphrase the old adage, "too many funds spoil the perfect plan." Why should this be so? First, the more funds you own, the greater the chance that a truly inspired fund selection will have its success spoiled by another fund that falls on its face. The problem has been called "diworsesification," for it leads investors to build a portfolio of funds containing so many individual stocks that it becomes contradictory for the holder. Even more counterproductive is the active trading of mutual funds. Typically, an investor today holds funds for but three years, an absurdly inadequate time frame for appraising the results of an investment program that should be inherently long term by nature. What is worse is that the funds may have been ill-selected in the first instance - funds with inflated performance, funds investing in hot market sectors, funds advertised on television, funds that trade actively and relinquish much of their profit to taxes, funds with high costs that didn't seem to matter when their past records looked so good. But the worst aspect of trading funds is that it allows the counterproductive emotions of investing to supersede the productive economics of investing. The dream of a perfect plan will never come true if mutual funds are traded as if they were stocks.

 

Conclusion

 

To conclude, there are many simple and avoidable mistakes which investors commit while investing in mutual funds, particularly at the time of the selection of funds. Don't let the "problem of plenty" lead you to make inappropriate decisions. Kindly note, that simple logical things work far better in the market place rather than complex algorithms, theorems, formulas, risk measurement principles, fund performance criteria etc. And there is no other place to test your virtues than investments - be it common sense, logical thinking, patience, perseverance, mental balance, emotional intelligence, performing under stress etc. Investing is not about beating the market or anybody else, its simply beating your own self, your own negative traits and once you are able to master your own self and become a complete human being, then only you would also become a successful mutual fund investor. Articulate your investment goals, know your time horizon, recognize your risk appetite, understand your need for income and growth, invest regularly although it may be in small lots, do your thinking and research and after doing it don't panic just because the market went against you, accept your mistakes and flaws and follow the above mentioned rules to select the right fund for you - remember money is made at the time of investment, it is only realized at the point of sale.