The importance of a mutual fund portfolio

There are three things to consider when building a mutual fund portfolio. First, the most respected investors in history believe in what a mutual fund portfolio provides the small investor. Second, the most respected investors in history may never advocate for a mutual fund only portfolio. And lastly... You can read the full article here.

Hope for the Best: Picking Mutual Fund Winners

Picking winners is an exercise in hope. Picking winners amongst the thousands of mutual funds available in the actively traded world requires more than just hope. Mutual funds, for those of you who may not be well-versed in the subject, offer investors an opportunity to ride with a fund manager to investment success. To determine this success, the fund manager must beat the benchmark that the fund is best judged. These benchmarks are index funds.

Now I have mentioned here before, this is a less than perfect way to determine success. But it is all we have. No actively managed mutual fund owns, in the same proportion, the underlying portfolio of the index fund. Index fund advocates suggest that index funds offer the wide diversification needed to get investors from point A to point B and do so in a passive manner.

Actively managed mutual funds do something quite different. And investors who use them know this. Investors looking for just a little more from their investment dollar believe that there is always the chance that the fund they pick will outperform the index fund benchmark. Few do. But the effort is worth the gamble. So why is it that we look backwards in order to move forward? Is what happened important to what might happen?

When an investor buys an actively managed fund, they have two choices to help enable their decision. The first is what the focus of the fund is. Understanding the underlying investments, how the manager approaches the fund's individual charter, how often the fund needs to readjust to complete that task and whether the fund manager can accomplish this in a cost-effective manner all play into the decision of whether or not to buy in. These are forward looking mechanisms designed to give us some level of expectation.

The second tool we use in the decision making process uses the exact opposite methodology: where has the fund been. By no means is this a necessary tool. Yet it is often employed by index fund advocates to point out the error of the actively managed mutual funds. Based on where these funds have been, indexers point out that had these same investors used an index fund, they would have been better off.

But this is not why people invest in actively managed funds. They do so to fulfill some inner need to do better than average. So why if that is this case, do these same investors, who see themselves as better than average and more savvy than the rest, look in their rearview mirror to get some indication of what the road ahead holds for them?

What was will never be again. None of the fund screeners offered around the web, from CNBC's to Forbes to the brokerages to the Persistence Scorecard offered by the Standard and Poors give you any idea whether the fund you are considering will do good in the next quarter, the next year or even the next ten-years. In fact, all of these screeners suggesting who won in the previous time periods would be useless in picking the next benchmark beating fund.

There are several things to consider when looking to invest in an actively managed fund. At the moment right before purchase, every one is on equal footing. This is referred to as the initial opportunity set. Every fund manager is equally skilled and/or prone to the same luck. The differences lie in the cost of the fund in terms of administrative costs. This is somewhat similar to suggesting that every horse in the race has four legs.

Yet unlike a horse race, where lineage, training and numerous other factors come into play, at the beginning of the race, all mutual funds are essentially equal. Once the new quarter begins, the race is on to beat not only what the benchmark might achieve but what other funds might do as well. At the end of the race, unlike horse racing, the gamblers place their bets. Sounds odd when considered like that, but it is essentially what happens. When the quarter is complete, new investors look for the winners, something that has already occurred and buy in.

The S&P Persistence Scorecard suggests that you will be right about 25% of the time employing a method of picking past winners over the previous five years (a period that seems to be quite a long time). You would have done slightly worse trying to pick a long-term winner amongst the mid-cap sector; slightly better with a small-cap fund. What the Scorecard does not suggest is the shifts among the stocks in the small cap to mid cap to large cap arenas during that period depending on capitalization (a shift that can change with each bull or bear market, mergers and acquisitions or simply with bankruptcies).

In fact, the Persistence Scorecard suggest that the middle of the pack might be a better indicator of what might come. If the top quartile is predicted to not repeat and the bottom quartile should be not considered as potential winners in the future (most at the bottom of the scorecard will probably merge or be liquidated in the future because of this underperformance), that leaves the second and third tier funds as the next winners.

If past indicators tell us anything, it might be to look the other way. Or, they might suggest that last quarter's average will be the next quarter's winner. Whatever it is, some skill and a lot of luck keep the current winners at the top of the rankings. Which is why few do with any success. If you are picking your next opportunity based on what happened, you would be better off with an index fund. I say this because average in the actively managed mutual fund world is a bit more expensive than simply buying the index.

But if you think you know the future, your ability to pick the next winner will make the envy of your fellow investors. And considering the odds, you have about a one-in-four chance of doing so.

Does Tenure Matter: Mutual Fund Managers for the Long-Term

One of the single toughest problems facing any investor is research. The information we seek is mostly conflicting, mostly difficult to understand and worse, readily available for the taking. The trouble is, access doesn't make the choices we need to make about where to put our money any easier.

You might consider the grocery store analogy. You may want to cook a whole chicken for dinner tonight but when standing at the meat counter you find three perhaps four different types of whole birds to chose from ranging from the very pricey organic variety to the very cheap store brand. They look alike, perhaps even clucked alike at one time. But what they are, besides all being chickens, different somehow.

Now mutual fund managers can hardly be compared to chickens. But in some ways, we have the same sort of conundrum facing us when it comes to a mutual fund selection. How much is the fund the manager and does it matter?

Mutual fund managers do have some appeal to certain investors. The longer the term some managers have, the more likely they will remain with the same investment style. Consider the long-term managers at these funds: Parnassus Fund (PARNX) which has had  Jerome Dodson as the fund's lead for 26 years,  Richard Aster Jr. of Meridian Growth (MERDX) has also put in just as many years and the grandfathers of the industry are people like Albert Nicholas who created his namesake Nicholas Fund (NICSX) and has managed it since its 1969 inception and perhaps the oldest fund manager Bernard Klawans who at 89 years old still runs the small Valley Forge Fund (VAFGX).

But is the same investment style still in style? Yes and no. Markets have remained essentially the same since they were conceived. And although we often consider them as impersonal entities, much like a Watson, they are not. Instead they are made up of people who, for want of a better term, want you to lose. There are two sides to every transaction and good will doesn't enter into the equation. Hiring a professional such as a mutual fund manager - and this is what you are doing - offers you box seats in the battle of who will win and who will lose in the marketplace.

Understanding the nuances of the markets is a timeless venture that involves understanding the players involved. Sure, computers have made the world smaller and faster and more efficient. Companies have broaden their customer bases and in the process made the oceans that separate the world seem like nothing more than a small pond. The world is at our doorstep.  But the people at the heart of every investment haven't evolved one iota since the markets were conceived.

It is still not about chasing the next new thing; it is about finding the things that no one really sees as bright and shiny, old investment ideas that have never changed. This is what older managers bring to the conversation. So that would be yes.

On the other hand, the reason these fund managers have remained at the helm for so long has more than a lot to do with who owns the fund family., The four above mentioned fund managers can't be fired from the positions they created. They can only step aside. So too long is perhaps too long.

Each fund manager must do three things. One they must create a portfolio that is sustainable and worth holding. Fund managers generally have ideas about how this is done and new fund managers will come on board and switch things around, selling one security in favor of another. So they initial year is generally a wash in terms of comparisons. By the five year mark, they should have settled in with their strategies in place. So five years is a good judge of turnover - a term that references how much of the portfolio has changed in the previous year. Less is better.

The second thing they must do is create returns that are better than an index and enough to pay the bills. If the expenses are low, this shouldn't be too much of problem provided the markets cooperate a little bit during those initial years in the lead position. Returns are tricky though. Weighed against fees, risk and a host of other obstacles, the number the fund posts can mean the difference in whether investors stay invested or turn a look for something more suitable.

Each exiting investor, aside from a no-confidence vote is a sale which forces a sale which in turn, creates some disruption to the investment plan. Get a lot of investors headed toward the door and no matter how good you think you are, you will not be able to sell enough to make ends meet for the remaining investors. This cascade effect was seen best in late 2008 when numerous investors ran rather than staying put and allowing the fund managers to keep the level head they were hired to have. So they must contend with investors and the markets.

The last thing a fund manager needs to contend with is the shareholders in the fund company. Many mutual fund companies are publicly traded entities which puts the manager in the middle of two sets of shareholders. One demands returns and the other demands returns and both consider themselves the most important part of the equation.

There are more than a handful of mutual funds that circumvent this one manager stewardship by using teams or even people and computers, the former to take the blame should things go awry. But some rules do apply across all mutual funds. New anything is not worth buying. A new fund, a new fund manager and new investment strategy are all worth giving a little time and latitude to before you invest. Let the folks who don't know any better buy first.

Three years is barely enough time to make a performance call on a mutual fund manager; five is better but ten tends to be best. Remember, the three parts to a fund manager's skill: the markets, the investors and the shareholders. Mastery of those masters is never done in a short period of time.

Paul Petillo is the managing editor of Target2025.com/BlueCollarDollar.com

To Index or Not: Mutual Fund Investors still ask

It isn't like this would be a fair fight. But get two investors who believe in one or the other in the same room, and the index fund investor would declare their style the winner, based on low cost alone. While fees play an important role in the long-term objectives of any investor, particularly those using mutual funds for retirement, the idea of long-term has seen its day come and go. As Tom Lydon of ETFTrends suggested recently: "The notion of buy-and-hold investing shows signs of falling out of favor. Ten years ago, 80% of advisors’ portfolios were buy-and-hold. Today, that’s 30%."

Which leaves the actively managed mutual fund investor, often described as a resident of Lake Wobegon (where everyone is above average) as the beneficiary of this shift ininvestment style. The question that every index fund investor will ask every opportunity they get: how do you pick an actively managed mutual fund if so many underperform?

And it is a good question. But the problem is, how do you make that call if you are essentially comparing these sorts of funds to those that buy across a broad market? An index fund, for the sake of argument we'll use the S&P500 index as an example, buys the top 500 companies. These companies are in the top 500 due to market capitalization. But index funds don't buy all 500 equally, weighting their funds based on numerous criteria.

Among those are as I mentioned, market cap. To be eligible for this index, a company must have $5 billion of market worth (issued stock) with 50% of that stock available for the public to buy. They must be based in the US - it doesn't matter where they do business as long as the headquarters are on US soil, follow GAAP reporting practices and offer sector representation.

The weighting of an index like this, which many investors assume is done much more evenly, actually gives the top ten companies based on market cap, over 20% of the index, leaving the 490 remaining companies to fill out the rest of the index. How would this sort of style compare to a actively managed mutual fund that owns less than one hundred stocks in their fund? Talk to an indexer or as they often refer to their group as Bogleheads, after the man who brought the index fund into existence (there were attempts made earlier than Mr. Bogle's but the ability to do it correctly was dependent on the advent of the computer) and they would quip, there is no comparison.

Yet, this is the very comparison they make, time and again. Their argument does hold some merit. Index funds have lower fees because they trade only when the index changes. (This is an irony lost on many indexers as the these funds must divest any interest they might have in a stock taken from the index and purchase any security the index has added - a sort of counterintuitive move of selling losers and buying winners.) Many still charge 12b-1 fees even if they are in company sponsored plans and act as the default investment. Over five years, performance of the S&P500 index has been north of 15% and that was due to the large amount of value given those top stocks in the index and the dividends paid by many of these large businesses.

Actively managed funds do have more to contend with in terms of trading (more frequently but the best funds do so prudently without changing their whole portfolio in a given year) research (they aren't given a group of stocks to buy as the index publishers do) and their are management fees (the cost of hiring a professional to wade into the marketplace for you). Yes these do impact the overall returns of a fund and as investors focus more on these items, they have dropped significantly in recent years.

So what do you get with an actively managed fund that isn't there for indexers. Obviously, a bit more nimbleness, less buy-and-hold and if your fund manager is good, acceptable returns. Most investors do still look to the performance - and too often in the short-term, as in a year or even a quarter just past - as the tool most likely in their portfolio picks. Doing this at the exclusion of tenure - how long the manager has been at the helm - the fees - they should be low, under 1% with a portfolio turnover in any given year of less than 60% - and should be able to best their peers in both categories, if not the index they are often compared to, over five years or longer.

Indexed funds have pluses that seem outsized compared to actively managed funds. But too often, a one size fits all approach to investing is not suited for everyone and this is where actively managed funds fill the void left by that sort of approach.

The Overvalued Emerging Market

It is easy to be attracted to emerging market mutual funds in your portfolio. If you are investing through a 401(k), you have noticed in your last statement how well they have been doing. Your US equity funds have done well over the same quarter or even perhaps YTD. But the contrast with the mutual funds that might be available to you that invest in other countries might have caught your eye.

Return envy is still one of the primary weakness that investors have. They see a fund that has done well, in this case, almost the entire sector, and we jump, feet first without knowing whether there is a shallow bottom or not. In the world of emerging market mutual funds, that bottom might be closer than you realize.
Emerging market mutual funds have a great deal of headwind to navigate as they get those returns. And just like the days of yore - only two years ago or so - risk is the reason why. Those risks are numerous.



First is the money issue. No country can be considered a viable investment unless they have a good banking system. That statement could be the reason why many stateside investors have looked to other countries for their investment needs. But in truth, the US does have a better banking system than most countries abroad. In its defense, it is able to survive a serious economic blow, put together a plan to recover from it and, although it can be criticized for many of its moves of late, it will still survive even if it is has already shown much of its financial hand. The simplest way to do this si compare a developed and mostly mature system such as that of the US and those in that outperforming emerging market fund.


The second issue is politics. We might have what seems to be a chaotic and disagreeable political system. But because of that robustness, we can be assured that even though we don't know what taxes will be, the discourse on how much we pay will be discussed at length and resolved with compromise. In addition to how the government operates, it is still a business-centric governing body that even when it falters in doing what it considers right, it does what it considers best for the creation of jobs. And even if the US seems to be burdened with regulations, many of which are direct and legislative reactions to abuses, countries overseas have placed these sorts of restrictions before the fact. This keeps investments and innovation under the control and purview of whomever is in charge at the time.


The third issue is economic freedom. While we take capitalism for granted, it si not the case in the largest emerging markets. It is often difficult to comprehend that a country the size of China or India could be considered emerging. But the definition of emerging suggests that while growth seems to be on pace and often well-beyond that of the US and Europe, it is done without the transparency that we enjoy. If China has the ability to drop a trillion dollars in cash into its economy - something a developed country would need to borrow to do - this offers a glimpse of instability.


The fourth issue is risk. By risk I mean your ability to predict and project how much you might make and how much you might lose. Most of us don't do this sort of metric exercise prior to shifting our money from one place to another. We look at all of the basics: return, tenure, return, cost, return, risk, return. And then we buy.

Understanding the risk in an emerging market mutual fund is much harder because of the reasons I have already discussed. But risk comes in numerous forms and the one most likely to derail you is diversity. You may, through your target date funds, your index funds, and even your bond funds, all of which may bill themselves as domestic, may have placed some of your money in markets your are currently looking at with envious eyes. Diversity in a portfolio simply suggests that of there is trouble in one place, not all of the investments you own will be impacted the same. Some will fair better than others.


The fifth issue is investor impatience. Most emerging markets are not near maturity and therefore have a period of time to traverse before they become more reliable. Political unrest needs to be quelled, businesses need to feel as though their investments are safe from political unrest, money needs to be available to be borrowed and infrastructures are solid enough to make it all possible. This is difficult feat in developed and relatively stable economies. Imagine a country on less solid footing, unable to embrace different political outcomes and survive them more or less intact. Which means, the investor who is willing to pay the higher-than-normal fees for such funds, need to wait a much longer time to get back what they have invested in portfolio risk and cost.

This is not to say you shouldn't have emerging market funds. Ten to even twenty percent of a portfolio would be acceptable in most instances. Just be prepared for cloudy days and they will come and you will want to sell. But the developed world needs emerging countries to buy their goods. In that sense, the investment becomes symbiotic and over the long term, you will probably be pleased. But be warned.

(One final note: the exchange traded fund - ETF - market for emerging market investments has grown substantially. In this author's opinion, the risk of selling too frequently and chasing minute returns, as ETF investors are more likely to do,  poses just as much a risk as you would face if you simple held this investment for a longer period of time.)