Narrowing the selection of mutual funds
Joel Dresang: Kyle, you build investment portfolios mostly using mutual funds. But there are like 8,000 – more than 8,000 – mutual funds, hundreds more every year. How do you pick which fund to use?
Kyle Tetting: Yeah, it can be very difficult, Joel, to get an idea of where to start. And part of the problem for the everyday investor is that it is such a vast universe. But I think it’s really important to remember that every particular investment within a portfolio serves a very particular purpose. So, kind of the first step is to figure out what we’re trying to accomplish with a particular fund or a particular investment.
Joel: Generally, though, are there certain attributes that you look for in a mutual fund?
Kyle: There absolutely are. You know, American Funds, Morningstar, a number of other firms have done studies that suggest that there are a few key pieces that can contribute to long-term success.
- Fund expense is kind of the big one. Obviously, the more expensive a fund is, the bigger a drag that is on returns.
- And then over and above that, managers who invest in their own funds also is a very big indicator of long-term success. You want to invest with someone who’s investing along with you.
- The final piece of this is to make sure that the investment process is what management says it is. And that can kind of key you in to whether or not that long-term success is repeatable.
Joel: So, how do you sort through all those 8,000 funds with those three attributes in mind?
Kyle: We pay for a software platform that allows us to kind of narrow down that list. It’s pretty common in the industry to be able to aggregate that data, dissect it. It’s more difficult for the average investor to get through all of that information.
But ultimately, what we’re looking for is the ability to screen down based on what a fund does. Are they value or growth? Are they stock or bond? International or domestic?
And then start to narrow funds down that tick off those boxes. Low expenses, positive risk and reward over time, particularly looking at funds that have somewhat high upside capture while doing well in down markets. So, those are kind of the key things that we can screen on to make sure that we get from that big list of 8,000-plus funds down to maybe a handful or so of funds.
Joel: And you can also measure to see which funds have high investment from the managers?
Kyle: Yeah. So that is another criterion that we can look at. Even that gets a little bit more difficult to dive in to. It’s not necessarily a simple screen, but it is available from a number of resources. So you can get that as well.
Joel: How about the goals and objectives of the funds? How do you sort that out?
Kyle: So, once we’ve got that list down to a more manageable number, you know, down from that 8,000-plus, down to maybe a handful or two of funds, then it’s really about getting much more qualitative in the review process.
Is management really sticking to what they say they’re doing? Is performance indicative of that process, or is it a factor of something else? Luck can be a big piece of the investment world. And if you don’t know that returns aren’t a result of something else, it’s difficult to know whether or not that’s going to be repeatable.
Joel: How much of this can individual investors do on their own?
Kyle: You know, I think it’s possible for the individual investor to get the information they need. Often, it can be difficult for them to digest such a massive quantity of data. I think one of the pitfalls is that a lot of investors rely on those financial publications putting together a list of maybe the top ten, or top twenty funds.
I think there is a bit of a hiccup there in that those lists are historical in nature – looking back at how a fund did. They aren’t always digesting the process of the fund. But, I think ultimately, for most investors, there’ll be one or two in that list that are appropriate.
It’s just very important to remember that the list itself isn’t the final step. You really want to dig a little deeper into what each of those funds is.
Joel: And it probably is important for investors to remember those three attributes, right?
Kyle: Absolutely. You want to focus on the expense ratio of the fund, relative to its peers. Is it cheap, or expensive? You want to focus on managers who invest in their own fund. And then if you need to be able to get that information, it’s available within the fund documents themselves. And then that last piece, understanding the process of the fund itself, which you can get from the prospectus and from other, other fund documents as well.
Kyle Tetting is director of research and an investment advisor at Landaas & Company.
Joel Dresang is vice president-communications at Landaas & Company.
(initially posted Jan. 20, 2016)