Choosing A Mutual Fund

Scott Leonard, CFP (President, Leonard Wealth Management, Inc.) gives expert video advice on: What should I look for in a mutual fund manager?; What factors should I consider in choosing a balance of mutual funds? and more.

What is the most important factor in choosing a mutual fund?

When it comes to selecting mutual funds, expense ratio is really important. Thats just the cost associated with running that mutual fund, and academic research has shown us that the lower the expense ratio the higher the probability that youre going to have a top performing fund over time.

What is a funds performance history, and is it important?

Performance history as it relates to mutual funds is just the past performance a fund; what its historical performance has been over time. A lot of people look at that as the sole reason to invest in a certain mutual fund or the number one category the number one determinant of whether we should invest in a mutual fund, and really it needs to be the last decision factor of why were going to invest in a mutual fund, and theres a few reason for that; one of the problems of looking at past performance is its not telling us what the fund is doing. Is it possible that the money manager made a really big bet on a single stock and got really lucky, and so their performance looks really good but theres really not good explanation that that performance is going to continue to happen. Another potential problem about looking at past performance might relate to its individual year by year performance. If youre looking at a five year history, you might not be picking up lets say two really really bad years; if has two really good years and so you might be missing some of the volatility, which is really going to affect you year by year. Its also possible that past performance has nothing to do with this being a good fund but the fund happens to be in a really good category and that category, whether its large growth or large value; whatever it might be a certain sector might have just gone through a really good investment cycle, and so it might be about to go into a bad investment cycle. So past performance alone can be very misleading into the really what we expect to happen going forward with a mutual fund.

Why is the funds manager important?

If were buying an actively managed mutual fund, it means that were going to find a manager whose job is to predict which stocks and bonds we should own to beat the market, which is really what were doing with that active management. The manager becomes very, very important to the mutual fund. Its that individual that were relying upon to make those predictions, to buy the really good stocks for us, to try to beat the market.

What should I look for in a mutual fund manager?

If youre going to go after an actively managed fund, youre really relying upon the fund managers ability to pick stocks, not the fund itself. You want to try to find out how that fund manager has done through their career. That might be at other funds, other fund families, or maybe even other investment strategies. If this fund manager has done very well with small cap stocks, but now theyre running a large cap stock fund, you want to be a little concerned that this fund manager hasnt necessarily shown their experience or their ability with a different class of funds. What you really are looking out with a fund manager is their history, how well theyve done with stocks or bonds — particularly with securities of the same type that theyre investing now for you.

What is mutual fund portfolio balancing?

Portfolio balancing or rebalancing is the process of bringing your portfolio back to its original asset allocation. If you have a good asset allocation strategy, you should expect, over short periods of time, some investments to be doing well and some to be doing poorly. The process of portfolio balancing is really going back to your original allocation. Youre going to sell whats doing well and buy whats doing poor. Youre selling high and buying low, which makes a lot of sense, and fundamentally that makes sense to us. Psychologically it can be difficult: Well, this investments doing so well. Why do I want to sell it and buy whats doing poorly? The reasoning is that were assuming that all of your investments are going to do really well over time, they just cycle through different up and down markets. What rebalancing is doing is allowing us not to have to call the timing aspect of when something is going to do well and when something is going to do poorly. Its just allowing us overall a broad, diversified portfolio to succeed over time.

When should I rebalance my portfolio?

When it comes to the timing of rebalancing, theres been a lot of research on this and it doesnt seem to be a specific answer to when you should rebalance whether thats monthly, quarterly, annually. And, so rebalancing should really, I think, be a function of other aspects as it relates to the portfolio. A taxable portfolio, you probably wouldnt want to rebalance, maybe, more than annually cause remember when were rebalancing, were selling whats gone up and so if we wait a year to sell that, its going to be a long-term capital gain versus a short-term capital gain. So, the taxes might be driving when we rebalance other than picking a certain calendar time to rebalance.

What factors should I consider in choosing a balance of mutual funds?

When choosing a balance of mututal funds the factor that you really want to consider is how each individual mutual fund plays out as part of the overall portfolio. So its always Why do I have this fund? and How is this fund going to complement all my other funds in my portfolio? Thats very different than saying: I want to pick these five really good funds. Usually when youre looking at a group of funds that are doing very well over a period of time, whether thats five years or something like that, what youre doing is youre probably picking funds that are very similar. So what you really want to do is pick funds that have dissimilar price movements, funds that are going to react to different economic events around the globe in different ways. So US versus non-US funds, large versus small, value versus growth, all these different factors of funds respond to different economic factors differently. Together theyre going to help decrease the volatility of your portfolio and as a result increase your returns.