How to select funds - Part 1
June 16, 2007I recently mentioned that I wanted to change the fund allocation of my life insurance and a couple of days ago I finally sat down with a list of available funds to figure out which ones to include. Since the selection is limited by the life insurance company to about 50, this is a much easier task than starting from scratch and having to navigate through the vast amount of mutual funds available. Nevertheless, the same criteria apply and I have compiled a list of features that I’ve checked before making final decisions.
If you’re completely new to investing, I suggest you familiarise yourself with the Morningstar website, which I think is one of the best and most comprehensive websites available for fund comparison. And most importantly, the key features are completely free of charge.
Assuming you have a list of funds that - for one reason or the other - seem attractive to you, here’s what I look at to determine whether or not to include them in my portfolio (or life insurance in my case). The list is not meant to be in order of importance; it simply reflects the order I’ve looked at information. All of the following are (almost) equally important and should be considered in a bigger context to see whether you end up with a sound overall performance picture.
Morningstar Category. Each fund is classified by assigning it to a main category that most closely reflects its purpose, e.g. UK Large-Cap, India Equity or Sector Equity Biotechnology. Using the categories is also a good way to start looking for certain additions to your portfolio as you should have a good idea what sort of countries or sectors you’re after. If you don’t, I suggest you do some more reading and get yourself a model portfolio that can be used as an initial guideline. Mine is here. When selecting funds, make sure you are diversifying across different categories and don’t rely too heavily on a single selection. (This information can be found on the fund overview page)
Returns. We’re trying to earn some money, so surely the actual returns that a particular fund has achieved are important. I usually look at the 3-year mean return to see how the fund performed in the recent past. Some people look back even further than that (5 or 10 years), but if you do certain other considerations like the fund management should be researched as well. The key point is that you should avoid the “best fund picks” of the year, especially if they have only achieved mediocre performances before. We’re looking for stable long-term performance and many funds that outperform the market this year will underperform it subsequently. (This information can be found on the fund overview page and in the subsection “Risk and Rating”)
Volatility. Those of you, who have read my chapter reviews for Richard Ferri’s book “All About Asset Allocation” will know that we want to reduce volatility in order to maximise long-term returns. Volatility measures the degree to which you can expect your returns to deviate from the average. The lower the volatility, the more likely you are to achieve a certain return. There will often be a trade-off between return and volatility and it is essentially a personal decision how much risk you feel comfortable with. Regardless what you decide, you should always opt for funds with lower volatility given the same return. (This information can be found in the subsection “Risk and Rating”)
Costs. There is no such thing as a free lunch and you will have to pay your fund manager for his (or her) work by paying an annual administration fee. This fee varies considerably and also depends on whether your fund is actively or passively managed. You should only pay a higher admin fee if you are convinced (and the numbers prove it at least for the past) that the fund will severely outperform the index. Otherwise you might as well invest in an index fund. When you compare funds, make sure you always compare the net return, i.e. the annual return minus the annual management fee. Only then you have a true picture of how successful your investment strategy was / would be.
Another important cost factor to look out for is the initial charge some funds require. This is usually give as a percentage of the money you’re investing and can exceed 5% quite easily. Again, don’t forget that the fund has to earn back any money you paid before you can make any profits. Therefore, you should only pay this fee if you are convinced of your choice, or else opt for a no-load mutual fund which doesn’t charge the initial fee. On the other hand, many fund supermarkets (online websites you can use to buy funds) have special deals that significantly reduce these upfront charges. Make sure you shop around! (This information can be found in the subsection “Fees”)
There’s plenty of other things to consider before buying a particular fund, so make sure you check back for more evaluation criteria in part 2!
