How to select funds - Part 2
June 17, 2007Thanks for visiting! If you like what you're reading, you may want to subscribe to my RSS feed.
After I shared half of my wisdom about fund selection, I’ll continue today with the remaining features to look out for when deciding which fund(s) to include in your portfolio.
I discussed the Morningstar category, returns, volatility and costs yesterday.
Risk. Based on the category your fund belongs to, Morningstar makes a relative comparison for returns and risk. For example, this fund had consistently high returns (relative to the UK Large-Cap Blend Equity category) but is exposed to a higher than average risk as well. This essentially means that you could get the same category exposure at lower risk. Ideally one would find a fund that has higher than average returns for the category while maintaining average risk. (This information can be found in the subsection “Risk and Rating”)
Investment objectives. Every fund manager has some high-level objectives that (s)he tries to achieve with her security selection. Look out for buzzwords like growth, risk or income to get an idea whether the fund is more conservative or aggressive. I suggest you diversify across different objectives as well to be sure to include some defensive funds that will achieve moderate returns no matter what. (This information can be found on the fund overview page)
Morningstar Style Box. This mainly applies to equity funds and illustrates the area of concentration in terms of large-cap, mid-cap or small-cap as well as value, blend or growth where blend effectively describes an even mix between value and growth (refer back to my shares introduction if you don’t know what I’m talking about). Your portfolio should contain at least one representative for every “box” to make sure you have diversified well enough across different capitalisation sizes and equity types. The fund that I used as an example earlier has the following style box:
and has therefore a nearly even mix between large-cap growth and large-cap value stocks. (This information can be found in the subsection “Portfolio”)
Morningstar Rating. This rating is probably one of the more important numbers you should consider, and personally I would not invest in a fund that doesn’t achieve at least 4 (out of 5) stars. 5 stars are awarded to funds that belong to the top 10% of the category’s risk-adjusted returns, while 4 stars are awarded to funds that achieved a risk-adjusted return in line with the next 22.5%. Therefore, by investing only in 4- and 5-star rated funds you only include funds that belonged to the top third in their category (in the past). Bear in mind though that past performance is never a good indicator of future performance and we can only hope that the “good” funds will continue to be lucky. (This information can be found in the subsection “Portfolio”)
There are many many other things you can learn about the fund of your choice, including important facts about the world regions and economy sectors your fund invests in (Portfolio section). You can also learn about the top 10 holdings of each fund in terms of weighting (i.e. the shares that the fund has most heavily invested in) and get a more detailed break-down of the market-capitalisation represented within your fund. Unless you are very keen and good with Excel I suggest you make use of a very useful tool on the Morningstar website called “Instant X-Ray“.
This tool gives you an overview of your portfolio once you have decided which funds to include and what percentage of your portfolio those funds will assume. After running Instant X-Ray you will have a much better idea of how well you diversified across regions, sectors, styles, risk and so forth. Once I finish my fund allocation for the life insurance, I’ll post my X-Ray results so you get a better idea of what I’m talking about.
