How to Create and Manage Your Own Personal Mutual Fund 0 comments

Oct 21, 2010 4:32 PM

How to Build Your Own Mutual Fund

I firmly believe that individual investors should be in complete control of their investing. In that vein I wanted to present some concrete ideas on how to create a flexible portfolio structure which allows for active involvement and keeps fees under control. In essence we will find out how to create our own personal, customizable mutual fund.

The traditional mutual fund we are all familiar with is essentially a device whereby pooled capital can be invested in a variety of securities. It typically retains professional management (although in recent times some might question exactly how professional they have been) to plan and execute the funds market strategy. The reason to use a mutual fund of course is to leverage the expertise of the fund manager and in addition to be able to own a diversified portfolio of securities which otherwise might be prohibitive from a commission cost perspective.

I guess the first question that comes to mind is why should we invest the time and effort to create our own fund when so many choices already exist? There are a several good reasons to do so and I have listed them below:

1) To gain a greater degree of control over what we invest in.

Typically a mutual fund for competitive reasons will not publish its current holdings so any public disclosure of what they hold will be out of date. The SEC only requires them to disclose holdings quarterly, so you may not know what you think you own or what you are considering purchasing.

2) To customize our investment strategy and minimize fees.

No matter how hard you look, you may find that you need to own several funds to get close to your desired strategy and then you are paying multiple management fees, which will undercut long term returns.

There are of course other viable options for building a diversified portfolio without using mutual funds. One method would be to use ETFs (Exchange Traded Funds) and I encourage their use, as well see later. But ETFs typically are designed to track a stock index or a sector and may not allow you the customization you want unless you buy as many as it takes to get you close to your ideal portfolio mix. The other issue with most ETFs is that typically there is no active management, so you are in effect creating your own mutual fund when you aggregate several in your portfolio. I prefer a mix of ETFs and individual equities simply because it allows me a maximum of customization and in addition allows me to actively manage stocks that I want to own.

Basic Requirements for Building Your Own Mutual Fund

There are several basic requirements we need to meet first to successfully create our own customizable mutual fund. We will need the following:

1) Flexible Portfolio Design

2) Validated Investment Selection Methodology

3) Low Cost Method of Implementing Trades

Now that we know what we need lets discuss how we can implement our mutual fund.

Flexible Portfolio Structure

I favor a portfolio structure that contains a core set of holdings that define our overall investment strategy and an actively managed portion that can be used to take advantage of market opportunities wherever they may arise. An example of what the Core portfolio for a long-term moderate risk investor might look like is detailed below:

60 % of Portfolio Assets (Core)40% of Portfolio Assets (Active)

30% Large Cap Blend ETF25% Individual Stock Selections

5% Mid-Cap Blend ETF15% Fixed Income ETFs

5% Small Cap Blend ETF

20% Broad Market Fixed Income ETF

The example structure shown above would allow for flexibility to take advantage of market opportunities and also allow participation in the systematic movement of the market with the Core portfolio. You would determine your asset mix for the portfolio as a whole based upon your risk tolerance. You also should use some reasonable controls such as not investing more than 5% of total portfolio in any individual stock.

Once we have determined our Core portfolio we need to implement a functional, validated method of selecting investments for our Active portfolio. This is harder than it seems so if you have any doubts about your ability to pick stocks successfully, then you shouldnt be doing it until you have dispelled those fears. I will however give you a start with a method that I use successfully that does away with much of the grunt work of reading financial statements and trying to assess a companys prospects from the numbers in their numerous financial disclosures.

Validated Investment Selection Method

The starting point of any good investment is a sound fundamental picture. The problem is that for most non-professional investors and many professional analysts, the road from interpretation of financial statements to successful investing is a rocky one. It takes much training and effort to interpret financial disclosures and even if you manage to decipher the accounting jargon in most annual reports, you have successfully placed yourself in the company of millions of other investors who have the same publicly available information. This is certainly not the edge we are looking for as investors. What I propose is that you leverage the wealth of analysis already out there, much of it at no cost. Note that I have purposefully used the word Validated in the header for this paragraph. My Validated method for investment selection is to use what I call Pre-Qualified watch lists when selecting investments for our Active portfolio.

Pre-Qualified Watch Lists

To make the job of financial analysis easier, why not let someone else do the analysis? Professional analysts and managers routinely purchase outside research to supplement their internal work and give them a perspective they may not have in house. You can do the same by using sources that have been proven over time (or validated) to use sound fundamental methods. Here are my favorite sources to build a watch list from:

1) Investors Business Daily

IBD publishes weekly what it deems are the 100 best investment opportunities currently available. They call the list the IBD 100. It is oriented toward fast growing, generally smaller companies.

2) Barrons Weekly

Barrons maintains a list of 400 companies that in their opinion are the 400 top investment prospects. The list is unsurprisingly called the Barrons 400. This list has typically more of a value orientation.

3) Value Line Investment Survey

The Value Line Investment Survey maintains 4 portfolios: (Year Ahead Performance, Growth and Income, Long Term Appreciation, and Dividends). These portfolios are an excellent source of investment ideas from a long standing and respected firm providing independent analysis.

4) Zacks Investment Research

Zacks is an independent firm providing securities analysis and web based tools for investors. They rank firms on a numerical scale of 1 to 5 with #1 ranked firms being the most attractive for current investment. Their #1 Rank list is a great place to find opportunity. Zacks uses a method that tracks analyst earnings revisions along with fundamentals and has a great long-term track record.

I prefer to use all of these sources combined as my base watch list because each respected source uses their own independent and sometimes very different method of analysis. By doing so, I am assured of getting a spread of investment candidates that will most likely allow me to find some great investments in any market orientation.

Once I have built my watch list(s), I apply my own proprietary technical analysis methods to the list(s), which allows me to narrow down my candidates. I then use a current assessment of what the broad market is doing to help me decide which candidates I want to buy (or sell). You of course can devise your own final screening methodology but once you start with some great fundamental candidates much of the hard work is done.

So far, we have designed a flexible portfolio structure, selected our active portfolio investments, but we need a cost-effective way to implement our investing strategy. You could use any one of the many available discount brokers, such as E-Trade or TD Ameritrade, but there are drawbacks to the commission per trade model. Even with commissions as low as $9.99 a trade, depending on how many trades you execute annually you might incur costs higher than you would like. The alternatives are a couple of innovative brokerage platforms that allow you to purchase shares in dollar amounts as opposed to whole share amounts only and charge a set monthly or annual fee for as many trades as you need (or want). My favorite among these innovative brokerages is Folio Investing (https://www.folioinvesting.com /). We use the institutional version of their platform for certain client accounts and are very happy with both their technology and level of service so I have no qualms about recommending them for readers of this article.

What Folio Investing allows you to do in short, is create what it calls Folios, which are simply collections of stocks, ETFs, and Mutual Funds in dollar amounts vs. share amounts. It allows you to specify your orders in term of percentages of portfolio. For example, I may say I want to take $100,000 and allocate it just like we laid out our sample portfolio structure earlier in the article. For the active portion of the portfolio we could allocate $25,000 to individual stocks by saying we want to buy 25 stocks (regardless of share price) by allocating 1% to each stock. Should you want to trade these every day or every week, you can do so all inclusive of the fee you pay. With a commission per trade model you would quickly run up excessive costs that would eventually eat too far into returns.

To summarize, I think everybody can and should take control of their own investments and using a flexible portfolio design, a strong investment selection methodology, and an innovative low cost brokerage, you can do so successfully.

For more detailed information about the portfolio design you can read our white paper on what we call The Portfolio Navigator system here:

portfolionavigator.com/index.html

Thanks for Reading.

Disclosure: Disclosure: No Positions

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