Choosing Mutual Funds: Do It Like A Scientist

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How should we choose among the 8,000+ funds available to us as investors? It’s not an easy choice given that most of us don’t have the time, knowledge, and expertise to consider all these funds. Many investors end up choosing based on unreliable metrics, like the cost of a fund, a promising name, or emotions. Many of us are lured by the idea that somehow it is possible to control performance by picking winners or time market cycles. But none of these approaches work and can be very costly for investors. So what can investors do? We believe the best way to select funds is to rely on good guiding principles backed by empirical evidence. Here are some key principles.

The difference between investing and speculating

Investing means growing your savings while managing key risks to your goals. It’s a long term process. Trying to pick this year’s winners or if it is a good time to be in or out of the markets is not investing. It is speculating with the hope of a short term return. There is ample evidence that speculating does now work for most investors and leads to underperformance, fund liquidation, and anxiety. The upshot is that investors can avoid actively traded mutual funds, therefore substantially decreasing the number of funds to consider. How do you know if a fund is active? The name or the investment strategy description in the prospectus can indicate that. These funds typically hold fewer stocks (80 stocks is the median among US stock funds), have higher turnover (over 50%), and have higher expense ratios, about 1% or more. So if you see a fancy name and a high fee, you may want to stay away from the fund.

Risk and reward are related

The key principle in finance is that risk and return are related. The US stock market has rewarded investors over long periods of time, with a return of about 10%, annually, in the last 90 years or so for which we have data. That long term return has come with periods of decline. For example, we have experienced eight declines of 20% or more (bear markets) since 1980. It would be great if we could get the 10% return without the possibility of large declines, but the data show we can’t. Does this mean we should hold a market index? Not really. But we can use this insight to gain a better understanding of the relationship between risk and returns, and use it to select our investments.

Small, value, and quality stocks

Research shows that variables that can be related to the risk or return potential of a company can explain differences in returns across stocks. For example, smaller companies are generally riskier than large established companies and have yielded higher returns over time. So, the size of a company has information about differences in risk and returns across stocks. Distressed companies are generally riskier than non-distressed companies and tend to sell at lower prices — they are cheap or value companies. As a result, they have yielded higher returns relative to non-distressed, more expensive stocks. Other characteristics that have information about the risk and return of stocks are profitability and balance sheet strength, or quality, and recent performance, or momentum.  Academic research finds that the patterns in returns determined by size, value, quality, and momentum are persistent over time and have been found to hold globally across many countries.  This means that you can expect funds or portfolios that emphasize small stocks or value stocks, for example, to have potentially higher returns than a market index. This information can be used by fund managers to build portfolios, as we discuss below.

Some risks are not compensated

The reward that markets offer (risk premium) is earned on average and over time. Markets do not reward risks that can be averaged out. For example, the risk of picking a stock to beat the market is not rewarded. For every investor that is successful at picking an outperforming stock, there has to be an investor that failed to do so. Stock picking is a zero-sum game. This concept extends to picking just a few stocks (even if they are small, value, or quality stocks), individual industries, or individual countries. The more concentrated a portfolio, the more likely it is that you are taking a risk that is not compensated by the markets. So focus on highly diversified funds and invest globally. There are about 4,000 stocks in the US, and more than 12,000 across over 40 countries globally, so the opportunity set is large. You can avoid funds that only have a double-digit number of stocks.

The hidden costs of index investing

Many investors invest in index funds, which are funds that mimic one of the many available stock indices. An index is simply a way to summarize the value of a broad basket of stocks. Some indices hold large parts of the US or even the global stock markets. Index funds are relatively transparent, can be diversified, and have the lowest expense ratios, so they are a good starting point for some investors. Unfortunately, though, the expense ratio may not be the only cost index investors are paying. 

A lesson from Valentine’s day

Do you buy flowers on Valentine’s day? If you do, you are doing great, love is priceless. But flower prices are higher on Valentine’s day, you should know. In my own experience, the price of a bouquet can double between Feb 10 and Feb 14, only to return to normal on Feb 15. You can’t buy Valentine’s day flowers on Feb 10 or Feb 15, but we should have that flexibility when we buy stocks. Index funds, however, don’t allow themselves any flexibility; they simply have to track an index, day in and day out. Every time companies, or even countries, are added to an index, index-fund managers have to buy large quantities of those companies, en masse, regardless of the price they pay. It is estimated that index funds could save between 0.20% to 0.40% or more, annually if they allowed for some flexibility. This cost is reflected in the performance of the index, and can be higher for less liquid markets and indices that have more money tied to them. For example, the valentine’s day effect of an S&P 500 addition is quite visible.

If you decide to invest in index funds, start with broad market indices that have lower turnover, and avoid concentrated and sector indices.

A flexible portfolio that uses more information

Another drawback of most indices is that they simply average prices by using the market value of a company. That means that if company A is twice the size of company B it takes twice the weight in the index. As a result, large companies get a disproportionately high weight in the typical market index. For example, the S&P 500, which includes 500 of the largest companies out of the 4,000 or so companies in the US, is approximately 90% of the total market capitalization. So a broad market index would give approximately 10% weight to the remaining 3,500 companies. But because these smaller companies can have higher potential returns, it would make sense to increase the proportion of small companies relative to the index.

What if we could have the same benefits of an index fund in terms of diversification and low fees while using information about each company’s size, value, quality, and momentum, and allowing for some flexibility when buying and selling stocks? Such funds are available and sometimes go by the name of factor-based or strategic-beta funds. Dimensional Fund Advisors has been a pioneer of this approach, based on Nobel Prize-winning research that has studied the patterns of risk and return we described above. More recently, other managers have started offering funds that follow this approach. Talk to us if you want to learn more about this approach.

What to do

Ultimately, picking the right funds requires knowing your goals, priorities, and risk preferences. Like most things that are potentially rewarding, successful investing requires some work, and there is no easy prescription, but here is a general summary:

• Avoid high costs, high turnover, actively traded mutual funds. That should narrow down the field a lot already;
• Avoid non-diversified funds that have less than at least hundreds of stocks. This includes sector funds and some factor-based or strategic-beta funds;
• If you decide to use index funds, try to select funds that track very broad market indices. If you elect this route, you probably need just a couple of stock and bond funds that track the entire US market and international markets;
• Talk to us to learn more about a low cost, systematic approach to investing that uses more information about risk and return and is more flexible than an index. Or you can do some research on your own, starting here.

Until Next Time!

Massi De Santis is an Austin, TX fee-only financial planner.  DESMO Wealth Advisors, LLC provides objective financial planning and investment management to help clients organize, grow and protect their resources throughout their lives.  As a fee-only, fiduciary, and independent financial advisor, Massi De Santis is never paid a commission of any kind, and has a legal obligation to provide unbiased and trustworthy financial advice.