What was once a process only used by an exclusive group of institutional consulting firms became a stand-alone industry with the creation of the 401:* in the late 1970s, making it necessary for every individual investor to know how to select a winning fund and fund manager. Let’s examine the key components of mutual fund managers that can easily be analyzed, so average investors just like you can make informed and profitable investment decisions.

Take a Look at the Person Behind the Fund

Funds are run by portfolio managers that tend to have similar credentials. Although some may have a graduate or doctoral degree, many fund managers hold undergraduate degrees in business, leveling the academic playing field. However, there are industry credentials that need to be examined as well.

The standard industry credential for fund managers is the Chartered Financial Analyst designation. In order to become a CFA, candidates must pass a rigorous examination process that covers all aspects of economics, accounting, portfolio management, and securities analysis. While many fund managers are satisfied with this designation, others choose to further their credentials by becoming a Certified Financial Planner as well. CFPs primarily work with individual investors, so the curriculum covers topics like estate planning and insurance, which are neglected in the CFA program. While neither designation is a requirement, both are well-respected throughout the investment world.

Prior to his or her current role, a fund manager may have held the title of a securities analyst, making them responsible for analyzing and selecting securities for portfolio managers. In fact, some fund managers still play a dual role as an analysts and portfolio manager. Although there is no specific experience requirement, any respected fund manager should have at least five years of experience in the industry.

Examine the Investment Strategy

When selecting a fund manager and the fund they control, you should analyze your level of understanding regarding the fund, the definability of the fund, and the soundness and consistency of the fund manager’s performance. Most importantly, you should be able to easily understand the investment process. Warren Buffett and other famous investors often say that investors should not invest in something they do not understand. It may sound simple, but it is a critical starting point.

After determining your level of understanding, trace the history of the fund’s investment process to determine if the fund manager employs a consistent investment strategy. For example, a manager that amends his or her investment philosophy according to the changing tastes of investors may indicate that the manager often chases trends. While fund managers who chase trends may witness short-term successes, calling the peaks and valleys of these trends takes quite a bit of foresight and luck.

It is also important that a fund manager uses a definable and sound strategy. For instance, if you cannot identify the specific role of the fund or fund manager, they may be too autonomous for your liking. To determine the soundness of the investment strategy utilized, thoroughly read and evaluate the strategy. If the strategy is fairly new and primarily theoretical, you should be aware of this beforehand in order to determine if the risk and reward is suitable for you.

Evaluate the Performance

There may be a plethora of information available for evaluating mutual funds and the people that manage them, but investors tend to only pick funds based upon their most recent performance. This is a major mistake, because a top performing fund one month can easily become one of the worst performing funds the next month. When this occurs, most investors overreact and sell the fund, leading to the predictable buy high and sell low investment trap.

To avoid this trap, you should evaluate the consistency of the fund manager’s performance, the relative and absolute performance of the fund, historical performance over various cycles, and any personal investment they have in the fund.

The consistency of a fund manager can be determined simply by comparing their performance to other managers. This is a measure of absolute performance and a solid foundation for performance analysis.

Relative performance compares the absolute returns of a fund to indexes, which are widely available as benchmarks for every type of asset class. For example, large cap domestic stocks are typically compared to the S&P 500 benchmark.

When comparing the performance of a fund, you should also evaluate the performance of a manager throughout different market cycles. This will help you determine if the manager only performs well in bad markets, good markets, or both.

Lastly, you should try to determine if the fund manager personally invests in the fund. If the fund manager is confident in the fund, ideally he or she will have some of their own money invested in the fund as well.

The Bottom Line

In today’s modern investment arena, a vast amount of information is available at the click of a mouse or a simple swipe of the screen. The key to becoming a successful investor is to use this information and not solely rely on a ratings agency. After all, if you have invested in penny stocks for any amount of time, you may be surprised at how much you actually know.

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