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Brian Preston’s Guide to Selecting Mutual Funds

July 31, 2008

Mutualfunds

The mutual fund universe is larger than ever and there are no signs of it slowing down. With more funds, more information, and easier access to this information, how can you go about selecting solid funds that are going to assist you in achieving your life goals?

With help from InvestorWords and BusinessDictionary, let’s begin with a quick recap of some key mutual fund terms:

  • Mutual fund – an open-ended fund operated by an investment company which raises money from shareholders and invests in a group of assets, in accordance with a stated set of objectives
  • Stock fund – a mutual fund which invests primarily in stocks
  • Bond fund – a mutual fund which invests in bonds, typically with the objective of providing stable income with minimal capital risk
  • Money-market fund – an open-end mutual fund which invests only in money markets, e.g. Treasury bills, certificates of deposit, commercial paper
  • No-load mutual fund – a mutual fund which doesn’t impose a sales or redemption charge, selling and redeeming its shares at net asset value
  • Index fund – a passively managed mutual fund that tries to mirror the performance of a specific index, such as the S&P 500

In terms of an overall approach to selecting mutual funds, I start with a general confidence in the economic theory of efficient markets.

(According to the strictest interpretation of the Efficient Market Theory, “… all market participants receive and act on all of the relevant information investment strategy would be better than a coin toss. Proponents of the efficient market theory believe that there is perfect information in the stock market. This means that whatever information is available about a stock to one investor is available to all investors (except, of course, insider information, but insider trading is illegal).

Since everyone has the same information about a stock, the price of a stock should reflect the knowledge and expectations of all investors. The bottom line is that an investor should not be able to beat the market since there is no way for him/her to know something about a stock that isn’t already reflected in the stock’s price.”)

As I see it, there are only about a thousand or so large, publicly traded companies listed on U.S. stock markets, e.g. General Electric, Procter & Gamble, The Home Depot, Pfizer, etc. At the same time, there are tens of thousands of analysts, journalists, and fellow investors who are scrutinizing these companies and their performance. With so many people looking at the same information, can you ever know something that hasn’t already been incorporated into the stock price? Short of having illegal insider information, I don’t think it’s possible.

Since outperforming the market here involves more luck than skill, I feel the best strategy for large-cap exposure in your portfolio is a very low-cost index fund (or, alternatively, an appropriate exchange-traded fund). With these super-efficient index funds, you’ll closely track the market while still outperforming about two-thirds of actively managed funds. The tax efficiency of index funds is a further advantage if you’re holding them in a taxable account.

Small-cap and international companies are very different. There are thousands and thousands of these companies … but there’s a relatively small number of people studying their cash flows, balance sheets, etc. With this information “fog”, it seems plausible to me that elite fund managers should be able to outwork, outsmart and outperform the overall sector.

So how do you find and choose these actively managed funds? In the show, I talk about a few “stats” you need to look at to really decipher if it is a solid fund or not. Information about individual funds can be found at Morningstar and a useful tool for screening and filtering can be found at Yahoo! Finance. Some of these criteria include:

  • Category – This defines the asset class such as small-cap, mid-cap, international, etc.
  • Rank – This will give you a good feel for how this fund’s performance ranks among its peers.
  • Tenure – This is how long the manager has been with this fund. You don’t want someone still green behind the ears nor do you want someone learning with your money!
  • Morningstar Rating – This is not the number one stat to look at! It is one company’s opinion on the fund. However, it can provide a good starting point for you to go further into your research.
  • 3, 5, and 10 year annualized returns – In the grand scheme, it doesn’t matter how good a fund performed last year. You are in for the long haul so you want to know how this fund has performed over an extended time period.
  • Minimum initial investment – Some institutional funds require a minimum purchase of at least $5 million. You may want to look at this first so you aren’t spending a lot of time researching a fund you may not have access to.
  • Front-end load – Go ahead and set the filter to no-load. This will prevent you from picking a fund that is going to take 5 percent of your money right off the top.
  • Expense ratio – This is how the fund pays for its managers, advertising, and any other expenses. Think what it means to pay 2% each year on a fund that might only be returning 6-8% — a quarter to a third of your total potential return lost! The lower the better … 🙂

Also, Liz Weston taught me something I didn’t know last week about Purchase Security Protection from most major credit card companies. I did some research for you guys on this topic, and in the show I’ll share with you what I found.

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Thanks for listening! If you enjoyed the show, please visit the Apple iTunes website and leave positive feedback. They often feature shows like this one that have consistently good feedback and a growing listenership. If we can do a better job, drop me a personal email. See you next week 😉

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