Selecting Mutual Funds for Your Portfolio

“Selecting Mutual Funds for Your Portfolio”

9/24/06

Last week, I discussed how you could develop a balanced portfolio using an Investment Policy Statement (see article at www.welchgroup.com; In the News; Articles).  Once you have decided on your asset allocation, you have to decide the best way to choose mutual funds for your portfolio. 

Active verses passive funds.  Some people simply cull leading magazines such as Kiplinger’s Personal Finance, Money or Forbes for their recommendations.  While you can certainly get some good ideas from these and other publications, I recommend you take one step back and first consider whether you want to buy actively managed funds or passively managed funds.  In an actively managed fund, a manager or group of managers actively reviews and analyzes the securities markets and selects securities that they believe will outperform their relevant benchmark over time.  For example, if you choose an actively managed fund that invests primarily in large U.S. companies, the manager’s goal–and your expectation– might be that the fund will outperform the S&P 500 Index, which is a recognized benchmark for large company stocks.  As an alternative, you might choose a passively managed fund such as the Vanguard S&P 500 fund, where Vanguard simply hires a computer programmer to buy stocks that replicate the S&P 500 Index.  As a result, Vanguard can keep fund management expenses low (0.18% annually versus 0.95 for the average large cap fund).  Using passive funds has the added advantage of minimizing the need for detailed research on your part.  You simply buy an index fund for each category you need. 

Past performance.  If you do choose to use active fund managers, I recommend your research include comparison of the fund’s year-by-year performance versus the year-by-year returns of its appropriate index benchmark.  What you are looking for is consistency of performance versus the index.  Simply looking at 3, 5 and 10 year total returns can hide the fact that the fund hit a couple of home runs that has skewed its performance over a period of time.  Also, remember that you are investing with a particular manager so reviewing past returns for a fund whose current manager did not produce those returns should be viewed with a skeptical eye.  The same holds true if a manger leaves a fund you are invested in. 

When researching fund managers, ask yourself this question, “Does their security selection process make sense to me?”  If the manager cannot articulate a well-defined process, performance is likely to be inconsistent at best.  You should be able to find this information in the fund’s prospectus.

Research tools.  To help in your quest for long-term top performing mutual funds, a good research source is Morningstar (www.morningstar.com).  The ‘Funds’ section allows you to sort top fund performers by categories over varying time periods.  Also, as I mentioned in my September 10^th column, be sure to pay close attention to fund expenses.  You want them to be low unless there is a compelling reason to pay more than average.