Choosing a Mutual Fund

Mutual funds make sense for beginning investors who want exposure to the stock market, especially when their account size is small. They also have a place in the portfolio of an investor who wants to delegate stock selection to a professional. In the past week, we’ve invited two mutual fund companies into our office for a conversation. This is a rare occasion, so it got me thinking about the signs of success for a mutual fund.

The first requirement is a clear strategy. Closet indexing, or owning so many stocks that investors will receive index-like returns, is a real problem. Why pay management fees when a manager isn’t using their professional judgment? A strategy might be value, income, growth or something else, but the manager should have an approach that they believe in whole-heartedly and stick with through thick and thin. There are multiple ways to make money in the stock market, but a fail-proof way to lose money is to switch strategies depending on your mood.

Following from the clear strategy should be a focused portfolio. Ideally, a fund would hold the manager’s best ideas, limited to something around 30. Anything from 20-40 stocks would be appropriate, but any more becomes very difficult for a manager to research and maintain. If a manager is using his or her professional judgment, the outcome will likely vary from the index. Sometimes performance will lag and sometimes it will be better. The manager should not be distracted by having requirements with respect to index weights.

Professional judgment and research have the greatest impact in small to mid-cap stocks. These are less likely to be followed and researched by a large number of investors. In this case, the market is less efficient and it becomes more likely to be able to choose stocks that will outperform. When investing in a limited number of smaller companies, the fund size should remain small in order to avoid illiquidity or moving the market.

Finally, a fund should have reasonable fees. Most mutual funds carry a management fee of 1% or of 2% with a 1% trailer. A management fee higher than this, unless there’s a performance bonus, would warrant further questioning. And if a manager truly believes in his or her fund and the fees are reasonable, he or she should be a large investor in the fund. There is no reporting on this aspect, but it never hurts to ask.

There is no guarantee that a mutual fund will outperform the market. Due to problems with fund flows and mistakes that might be made, around 70% of mutual fund managers underperform their benchmark. Choosing mutual funds with the characteristics outlined above gives a greater probability of success. And eventually, an investor may prefer to own individual stocks in their account.