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How Do You Decide What Funds to Buy?

I’ve been working to rationalize my fund selection process and make it more systematic. But it still remains a bit of a work in progress.

I’m curious as to the process my fellow MFOers use to winnow the universe of funds and find those worthy of their investment dollars.


  • Would it be worthwhile to start with the question, "why do I need another fund? Is there something that my portfolio isn't doing for me that I need it to do, or am I looking for a successor to a fund currently slotted-in?"

    I fear that too many of us are, like small sociable rodents, irresistibly drawn to bright shiny objects for which we have ... uhhh, no real need.

  • @David_Snowball

    Good point - I was being broad to elicit a variety of responses.

    Along your lines, how about limiting it to either of these circumstances:

    (1) I need (or I think I need) a new fund in an existing fund category.

    (2) I've decided to change my allocation and add a fund in a new category.

    In both cases, how do I determine the best fund for me to invest in?

  • MJG
    edited August 2015
    Hi MrRuffles,

    I do not have a rigid formulaic set of rules, but I do deploy a generic set that serve as guidelines to reduce the selection field to manageable proportions.

    Here is my candidate set, not necessarily in order of importance and it is not necessary that all need to be satisfied. Flexibility and gut feelings are important contributors to the final judgment. Here are my golden 11 rules:

    1. A mutual fund that fits nicely into the more important asset allocation plan. Check the Morningstar fund asset distribution.

    2. Low costs, like below the category average by at least 25%.

    3. Low turnover rate, like 50% annually or less. I want a decisive management that is committed to its decisions.

    4. Positive Excess Returns above appropriate benchmark for various, but not necessarily all, longer-term timeframes. That means mostly positive Alphas and Information Ratios above zero after examining different timeframes.

    5. An understandable investment selection policy that offers the potential for market outperformance. Something unique that warrants the extra costs.

    6. Seasoned and stable fund managers with quantifiable track records.

    7. Trustworthy fund firm with deep pockets to hire superior fund managers and research teams.

    8. Gut feeling that this fund will deliver the goods over time.

    9. A commitment to stay the course with the selected fund to allow a proper test period, like maybe at least 3 years unless circumstances drastically change.

    10. A default option to hire an Index fund if nothing satisfactorily surfaces.

    11. The fund should have a near zero cash position. I’ll do my own cash management.

    12. I’m sure I forgot something. Others will add to this incomplete list. No great discoveries in my golden 11.

    Please keep in mind that I’m a very senior investor in the Required Minimum Withdrawal phase of my investment life. On average, I probably adjust my portfolio about twice a year. I’ve never been a very active trader. I am slowly moving my portfolio towards a higher percentage of Index products primarily motivated by cost considerations.

    Each of us have different goals, timeframes, and portfolio ambitions. What I do might not mesh in any way with your investment and financial profiles whatsoever. When investing, nothing is ever cast in stone.

    I wish you the very best success in your mutual fund decisions. But remember that in the long scheme of happenings, it is really a small matter. Your asset allocation decision has far more influence on your investment success.

    Best Regards.
  • Among things worth mentioning aside from your own personal need for the fund, which is paramount:

    1. Low costs but not just by expense ratio, but by dollar amount. A large fund with a lower expense ratio but a higher dollar amount in fees than a smaller nimbler fund may not be such a bargain. Large funds tend to get bloated and are not run as efficiently.

    2. Manager investment in the fund. Managers who eat their own cooking tend to treat shareholders well. Look for greater than $1 million for the manager.

    3. Low portfolio turnover or low assets or both. Trading costs money so low turnover is generally better, but if you like a manager who trades aggressively, then look for a fund with a small asset base. Trading has a market impact cost so a bloated fund that trades aggressively will suffer.

    4. Fund shops that are not publicly traded. Fund companies that are traded on the stock market have two sets of shareholders--the shareholders of their funds and the shareholders of the fund company. Those two sets of shareholders have conflicting interests. Fund company shareholders want funds to get as big as possible to collect as much management fees as possible. Bloated funds tend to underperform, so fund shareholders want smaller nimbler funds.

    5. A willingness to close funds at an appropriate size.

    6. Consistent outperformance as opposed to volatile outperformance. Some funds with great returns are too streaky and just have a few great periods and a lot of terrible or mediocre ones.

    7. A low downside capture ratio and a high upside one. Less downside with more upside is generally the way to go.

    8. A high active share ratio. If you're going to pay extra for active management, better to have one who deviates from the index as much as possible.

    9. Buying when a great manager underperforms. while investors routinely chase hot performance, it is often better to find a good manager and wait till he or she underperforms before buying. Most good managers have slow periods and when they're hot they tend to cool off. You don't want to buy at the peak.

    10. Tax Considerations. If you are investing in a taxable account, pay attention to how tax efficient the fund has been in the past.

    11. A deep and talented analyst pool. Don't just look at the manager, see if there is a research team to back that up and see if that team is long tenured.

    12. A manager owner of fund company. A manager who owns the fund company will probably stick around. A manager who is an employee of the firm may jump ship at any time.

    Hope this helps.

  • MJG and Lewis have pretty much hit the factors I use (along with several I don't place as much weight in). Of the factors given, the ones I consider most important (not in any particular order):

    1. Cost - I'll pay transaction fees for institutional shares, because over the long term that's going to save me money. I also have (soft) cost limits in mind for bond funds, domestic equity, etc. I'll stretch 10, maybe 20 basis points if a fund is otherwise very attractive.

    2. Funds that are more flexible, but also disciplined (don't use techniques just because they are allowed to). Examples might be FPNIX and funds managed by Michael Hasenstab. Or funds that have a distinctive approach that seems to have more substance than a fad (e.g. RPHYX). "Unconstrained" doesn't impress me - that's saying what's allowed, not what to expect.

    3. Does it fit well into my portfolio - in an area that is underrepresented, or as a potential replacement for a long term disappointment?

    4. Is the long term performance (with the current management team) solid? A fund needn't do well year by year - different management will do better in different markets - but it should not gyrate all over the place, and management should show some degree of adaptability. (Don't ride Enron down to zero because it looks like a better and better bargain.)

    5. Management diversification. I'm disinclined to buy a fund managed by the same team as a fund I already own, or a second fund from a small shop (assuming the funds share analyst research and have similar styles).

    6. A fund company that has a record of good management transitions. That could mean team managed funds, or just a family with good practices like T. Rowe Price.

    7. Low to moderate turnover.
    8. Low to moderate size (but see, e.g. FLPSX).

    I'm less inclined than some to look at metrics like alpha. Since I'm seeking funds that are more distinctive, they may not correlate well with the "typical" fund. Lower correlation can severely distorts some of these metrics. Related to that, a fund may be grouped together with the "wrong" funds.

    Metrics like Sharpe ratio avoid the benchmark selection question. (But you have to pick the right funds to compare. Otherwise, the Sharpe ratio may suffer the same problem of bad grouping.)
  • @MrRuffles #6 and #7 on @LewisBraham 's list for 90 - 95% of money; whatever is hottest for 5 - 10% of money...just to keep portfolio interesting.
  • All these factors are great, I'll add one more, which may be controversial, I'd love to hear opinions:

    A new fund from a management team with a great track record, especially if it's in the space where that team made its mark. Recent successful, examples are several key managers from Wasatch packing up and starting Grandeur Peak, and Andrew Foster leaving Matthews to found Seafarer.

    Starting with fresh cash, a manager will buy his / her best ideas, and the asset base should be low enough for them to do it easily. If you buy into a fund that's already fully invested, they'll have other considerations (taxes, mostly) that may keep them holding onto ideas that aren't quite as good as some new ones.

    A new fund, all their holdings with be "buys." An older one, many will be "holds."

  • edited August 2015
    I see if manager has skin in the game. If he doesn't I will not buy the fund. PERIOD. The only exception is Index funds.

    If I own an actively managed fund and manager sells his stake, I follow him out. No one went broke paying taxes. If I'm that good that every fund I sell is always at a profit, so be it.

    I never reinvest dividends in taxable accounts. Forces me to rethink/rebalance my investments, and for every fund I sell at a profit, forces me to sell another at a loss to help with tax planning.
  • First you need to articulate the reasons why you need a new fund, then you can narrow your search to funds that are consistent with the goals you have. If you're replacing an existing fund, think about the reasons why you're dissatisfied with your existing fund, and find a new fund that doesn't have those characteristics. If you're supplementing an existing fund, think about why you want two funds instead of one, and pick the new fund on that basis.

  • @MrRuffles: Remember, less is more! The fewer funds you own the better !
  • @expatsp Starting with fresh cash, a manager will buy his / her best ideas, and the asset base should be low enough for them to do it easily. If you buy into a fund that's already fully invested, they'll have other considerations (taxes, mostly) that may keep them holding onto ideas that aren't quite as good as some new ones.
    A new fund, all their holdings with be "buys." An older one, many will be "holds."

    That is an interesting idea, but how can you easily find them?
  • edited August 2015
    @VintageFreak I see if manager has skin in the game. If he doesn't I will not buy the fund.

    I like this idea, as well, although I would still look at the performance factor. Does anyone know of a list of fund managers who are invested in their own funds?
  • @little5bee: "That is an interesting idea, but how can you easily find them?"
    This site, and in particular David's profile of new funds, has been my main source of ideas.
  • @Ted Thanks! Do you happen to know when this article was published?

    @expatsp mine, too, thanks!
  • TedTed
    edited August 2015
    @little5bee: I believe the study was done in late 2014. Further to find managers who invest in their own funds, go to M*, put in fund symbol, click on filings tap at top right of fund snapshot, look at SAI
  • @Ted thanks again...I knew you would have the info at your fingertips!
  • edited August 2015
    I actually try and go one step further. It is not just about manager investment. It is about having SKIN in the game. It is not necessarily the same thing.

    For instance...
    Bill Miller having $1M in LMVTX and buying $70M yacht is NOT Skin in the Game.
    Berkowitz having $106M (by my last calculation some time back) in FAIRX IS Skin in the Game.

    I look at fund assets and try to make good faith determination if manager has invested token "pennies" in the fund or "real money". For a lot of managers even $1M is a drop in the bucket. It is not about $1M, it is about substantial net worth invested.
  • The article is from 2008. You can tell from the copyright at the bottom of the article. Or the fact that it talks about management investment in Schwab Yield Plus, that ultrashort disaster that serves as a poster child warning for fads and "safe" investments.

    Here are current M* columns that Ted has linked to here and here:
    Why You Should Invest With Managers Who Eat Their Own Cooking (M* March 31, 2015)
    Fund Managers Who Spit Out Their Own Cooking (M* May 26, 2015)
  • edited August 2015
    Regarding publicly traded mutual fund companies and those owned by publicly traded financial conglomerates, John Bogle is the master at explaining why they tend to do poorly compared to privately owned shops, i.e., Fidelity and Dodge & Cox,and mutually owned, i.e., Vanguard, shops. This is worth a read as I don't think this subject is discussed enough or understood by enough investors:
  • @LewisBraham With one exception, TROW? Also, doesn't this make the case to buy TROW, APAM, any others?
  • @LewisBraham. Would you say Artisan is an exception to that last rule, or too soon to tell?
  • beebee
    edited August 2015

    @LewisBraham With one exception, TROW? Also, doesn't this make the case to buy TROW, APAM, any others?

    I always thought TRP could "reward" its customers with shares of TROW as an incentive to move assets to TRP and a thank you for retaining their busienss...much like employees, customers need to be recruited, retained and rewarded.
  • @bee Wow, what a great idea! I've considered moving some assets from Schwab to TRP since I love TRP funds and I have to pay a transaction fee for them at Schwab. Since I also use Schwab Bank, it just seems like a hassle. But if TRP offered that, I would definitely move some money over...unfortunately, because of TRP's success, they probably don't need to offer any incentives.
  • T. Rowe is an interesting case as it isn't owned by a larger financial conglomerate such as a bank and has long specialized in no load funds. Yet I do think it has drifted some away from its original mission with advisor share classes and some funds seeming pretty bloated. That said, it remains better than other publicly traded fund shops and subsidiaries of publicly traded banks and insurers. Artisan, it's too soon to tell what will happen.
  • I can't add much in terms of how I evaluate funds because the points already made are excellent and cover most of what I pay attention to, but I also like focused funds where I feel pretty confident I'm really getting the manager's best ideas. That doesn't override other factors and in some cases increases their importance. For instance, I don't like funds with lots of assets to manage but I like them even less when they only have 20-30 holdings.

    In terms of past performance, I also like to research the manager's history with other funds and how they've done. On M* if you follow the "Management" link for a fund you'll see each manager and be able to click a link for "Other Assets Managed". I then look at how other funds did when that manager was in charge and if the time period is too long ago to be seen on M* I use Yahoo's Performance link for those funds. Yahoo seems to display all historical data whereas M* only provides the last 10 years.

    Finally, on a slightly different note, I keep a list (in both a M* watch list and a spreadsheet) of any fund that has interested me over the years. Sometimes I get ideas from David's commentary or fund reviews, sometimes from the MFO discussion board, sometimes from an article on M* or elsewhere, and sometimes just from screening for funds with strong long-term performance records. Over the years I'm sure there are lots of sources that have contributed to my list. No matter where the ideas come from, when a fund sparks my interest based on many of the factors mentioned by others it gets added to the list and when I do have a need for a new fund that's where I go rather than starting with all funds and trying to find the one I like best. Right now I have about 125 funds covering pretty much any category I have ever been interested in and even some that I've never been interested in, I own 16 of them and I'm pretty sure it would take less than an hour to research and find a fund if I thought it was necessary.

    My spreadsheet gets updated once each year (other than adding something to the list) with annual performance records, cumulative performance records, AUM, expense ratios, turnover, manager tenure, number of holdings, active share and ulcer index to the extent available, and it also allows me to compare the performance and other stats from funds I've invested in to others that I have liked for one reason or another. Since I don't turnover funds very often it means I get some benefit from the work other than just choosing a new fund.

  • @LLJB...nice work.

    Do funds also fall off your list?

    What are you most recent "add-ons" and might you indulge us with your sweet sixteen list?
  • The question should be when to sell funds. Far too much time and effort is wasted on the buying aspects while little to no time is spent on exits. To quote two famous designers of trading and investing systems (loosely and in my own words) " the entry is probably one of the least important ingredients to wealth accumulation. It's the exiting that counts"
  • edited August 2015
    @Junkster, Great point. There's also a larger question about how well any individual fund fits into the whole of a portfolio and whether it is suitable for one's investment time horizon and risk tolerance. That should inform the buying and selling decision perhaps more than anything else. A bad or mediocre large-cap blend fund may in fact be more suitable for an investor than the best tech fund in the world if the investor doesn't have the risk tolerance to handle a tech fund. And figuring out when it's time to move on from a position is extraordinarily difficult as you say.
  • Hi Guys,

    I’m thoroughly enjoying and learning from this exchange. It’s being conducted in a civil way with emphasis on what works, or at least what is believed to work. Thank you all for many fine contributions.

    I’m going to change direction a little by discussing a selection rule that I once included in my fund selection rules for a portion of my portfolio, but now have serious doubts. The two funds that I selected based on this rule have been disappointments recently. They both were successes 15 years ago, but over the last decade there has been a disquieting erosion, a “regression to below the mean”.

    First the criterion. Choose a fund manager who has a storied personal success history who also has a focused fund holding approach. Not all managers are equal, and time will isolate skill from luck. All investment ideas are not equally promising. Managers who limit how far down the idea list they venture increase the odds for excess returns above benchmarks. Well, that was the logic backstopping the criterion.

    From my perspective and limited experience, that rule has not been especially productive. In fact, I now consider it a failed rule and have mostly abandoned it. Some things die hard but slowly since an accumulation of data is required.

    My 15-plus years of experimentation with the rule have been with the Masters Select Equity fund (MSEFX) and the Marsico fund (MFOCX). Both funds outdistanced their Benchmarks in their early history, sometimes by impressive margins. In the last decade, their performance have hit hard times and have generated negative Excess Returns. I’m incrementally reducing my positions in both funds.

    Both funds are supposedly managed by superstar managers. The MSEFX teams are carefully screened, selected, and monitored by a professional methodology developed by the Litman-Gregory firm. The methodology uses multiple filters to output likely “superior” management teams, and fires those that fail to satisfy expectations. The Litman-Gregory resources must exceed those accessible to individual investors by an order of magnitude.

    Tom Marsico managed the Janus fund to dazzling outperformance in the late 1980s and 1990s. Morningstar named him a fund manager-of-the-year for his terrific record. He is a talented and skilful stock selector who learned his craft under the legendary Fred Alger.

    Yet both managements have suffered poor performance for a decade. Regression to the mean is an irresistible force in the equity marketplace. Markets change and so must fund selection criteria.

    I hope this post adds to this expanding discussion and keeps it on target.

    Best Wishes.
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