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How to Pick Better Mutual Funds?
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How to Pick Better Mutual Funds?
Bourbon Financial Management, LLC
Dec 13, 2011
Economy & Finance
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How to Pick Better Mutual Funds?
1. How to Pick Better Mutual Funds?* PEOPLE + PROCESS + PHILOSOPHY = PERFORMANCE * October, 2011Dear friends, You should decide to be either patient with active managers or seek a passively managedIf you have the time, desire, experience and approach. The vast majority of long-term topknowledge of building your own investment and performing managers will endure periods of lousyretirement portfolios, this newsletter is for you! performance.At BFM, we are very analytical and we believe · 85 percent of all ten-year top quartile fundsthat asset allocation is more important than spent at least one three-year stretch in the bottomstocks or mutual fund selection… but many of half of their peer group (they spent about 23you have asked us to share our disciplined due percent of all their three-year periods in thediligence process to selecting investment bottom half of their peer groups).managers and mutual funds. · 62 percent of ten-year top quartile fundsSelecting a good mutual fund is extremely spent at least one five-year stretch in the bottomdifficult. Only 20% of funds may outperform half (19 percent of rolling five-year periods in thetheir benchmark over the long run. 40% of funds bottom half of their peer groups). Source DiMeo.that were in business 10 years ago are now gone.A fund can be at the top one period and be at the Short-term greed and impatience will leadbottom the next one. investors to fail. Before investing you should develop confidence in the fund and theAs you can see, mutual fund returns can be very patience required for long-term success.different (international fund category). Otherwise, you should invest in index and passive funds (low costs). 10-year Value ofName Return $10,000 “Do not wish for quick results, nor look for small advantages. If you seek quick results, you will notOld Mutual Copper Intl Sm Cap 50% $14,988 attain the ultimate goal.” Confucius.Invesco International Sm Cap 417% $51,716 Human emotions are the biggest obstacle to investor success. Proper research goes well beyond the numbers. It also requires regular The debate between active and passive meetings or calls with the managers. Naturalmanagement (investing in index, passive funds human behavioral tendencies during the managerand ETFs) is a constant discussion among selection and termination process generally leadsindividuals in the financial world. There are to failure so we recommend a rigorous process.qualitative and quantitative factors that need to be We believe that qualitative metrics for selectingunderstood and analyzed correctly before picking mutual funds are as important as quantitativea good fund. metrics. © 2011 Bourbon Financial Management, LLC ~ All Rights Reserved ~ Info@bourbonfm.com ~ (+1) 312 909 6539 1
What traits and factors do we look for, review Such data may not available by directly lookingcarefully, and monitor constantly? into sources like Bloomberg, Morningstar, and Lipper. This requires contacting every fund andQualitative factors: requesting them to provide the data.1. People: education, qualifications, experience, depth, stability, diversity, quality and diligence of the investment team (portfolio managers, Quantitative factors: analysts, traders, auditors…) 1. Fees*/ Expense ratio: Funds in the cheapest2. Investment philosophy that is consistent, quintile were more than twice as likely to beat clearly articulated and understandable the average for their categories than the most expensive quintile3. Investment process and style based on meritocracy that are transparent, repeatable, 2. Tenure / Experience / Track Record of the consistent, and definable with good buy and Portfolio Managers and Analysts. The average sell discipline and risk management tenure maybe close to 6 years only… procedures 3. Fund ownership** by the portfolio4. Stewardship: a corporate culture of management team excellence, with clean regulatory history, board integrity, independence, ownership and 4. 5 and 10-year Information Ratio (IR) and compensation who will put your interests first peer ranking. The IR measures the risk- adjusted return for assessing the performance5. Firm ownership structure of active portfolio managers6. Manager compensation and incentives 5. Long-term after tax return / performance: structure (salary, bonus, stocks, shares…) that GMO Emerging Country Debt had a 10-year reward individual contributions annual return was 14.54% ($10,000 became $38,880) but after tax, the post-tax return was7. High conviction approach that is distinct and 9.80% ($10,000 became $25,468 or 35% less) with potential to outperform. “Worldly wisdom teaches that it is better for reputations 6. Consistency of portfolio returns with the to fail conventionally than succeed investment process (attribution reports) unconventionally.” J. M. Keynes. 7. Funds concentration8. What percentage of research is generated internally (vs. sell-side research from Wall 8. Tracking Error and Active Share: these Street)? numbers represent how much the fund returns deviate from the benchmarkWe also review the portfolio composition, size 9. Beta and Correlation with the fund’s true(small or large cap) and style of the funds, Benchmark (R square)manager concentration, and if a manager hasclosed a fund to new investors in the past and ask 10. Inflows/Outflows and total assets in the fundhow they decide to close it in the future. today and 5 years ago © 2011 Bourbon Financial Management, LLC ~ All Rights Reserved ~ Info@bourbonfm.com ~ (+1) 312 909 6539 2
11. Up/Down capture ratio and maximum drawdown *: Of domestic stock funds, 47% in the cheapest12. Sortino Ratio which measures the risk- quintile beat the average over a 10-year period, adjusted return while just 19 percent of the most expensive quintile beat the category average. The cheapest13. Volatility quintile of domestic-stock funds survived and beat the cheapest index fund 29% of the time, compared with just 17% of the most expensive14. Turnover which measures the number of quintile. There is a high correlation between times securities/shares are replaced/traded costs and survivorship, as high-cost funds have a large attrition rate. Looking at rolling 5 and 10- year periods for US stock funds, the cheapest group had an attrition rate of 13% over 5-yrThe quantitative data is available from a variety of periods and 25% over 10-year periods. Thesources like Morningstar, Lipper, Bloomberg, attrition rate for the most expensive group wasfund prospectus, fund statement of additional double that: over 5-year periods, 29% of the high-information, shareholder reports, fund cost funds had merged or liquidated and 49% hadcompanies… merged or liquidated over 10-year rolling periods.You can see that these lists could include manymore factors. Also important is that these factors **: We like managers to have skin in the game.are not available easily. You need time and a Does your Manager eat his own cooking? Wouldgood network to obtain all the necessary you invest in a fund when its portfolio managerinformation. does not even invest in it? 46% of the US stock funds managers report no ownership! 59% forIt does not end there. You may want to look at a international foreign funds managers. Thisfunds correlation with other assets/funds in your information can easily be found atportfolio to optimize your portfolio risk level and www.morningstar.com/goto/fundspy or in thedecide what capital allocation would be best to fund prospectus (statement of additionalminimize your downside risk. Short-term information. Higher investment levels aren’t aperformance is not important. guarantee of success or an ethical manager, but it shows that managers believe in the funds. © 2011 Bourbon Financial Management, LLC ~ All Rights Reserved ~ Info@bourbonfm.com ~ (+1) 312 909 6539 3
DETAILS Investment knowledge is imparted by investment and finance professionals. These professionalsThe world is a mix of different professionals. include individuals with professional degrees likeEvery professional has his or her own duty to an MBA, Masters, CFA, CFP, CPA...perform well, be it as a teacher, mechanic orbartender. Many times individuals try to But in spite of the experience and educationexperiment with ideas outside their expertise. professional investors possess it is difficult toThere is nothing wrong in learning new ideas; attain the highest skills in all the differentthey rejuvenate you and can bring a fresh investment arenas. So, being a common personperspective to your daily routine. But what is who does not work intensively in the world ofimportant is that you should not be over finance, you can see the complexities in makingconfident in pursuing activities beyond your investment decisions.expertise. For example, practicing skydivingwithout a professional skydiver or dancing Balletwithout a ballerina’s guidance can harm yourbody. What Are Mutual Funds? A mutual fund is a company that pools moneyInvesting your wealth, just like skydiving and from many investors and invests the money in aballet dancing, is an art. Investing without combination of stocks, bonds, and other securitiesknowledge is like jumping into a valley or assets. The combined holdings that the mutualwithout a parachute. fund owns are known as its portfolio. Each share represents an investors proportionate ownership of the funds holdings and the income thoseThere are two main categories of investments: holdings generate. Equity Fixed Income © 2011 Bourbon Financial Management, LLC ~ All Rights Reserved ~ Info@bourbonfm.com ~ (+1) 312 909 6539 4
Which Strategy to Choose: Active vs. Passive Management?Passive Management is an investment strategy Active Management, on the other hand believesthat attempts to replicate the returns of an index the market can be inefficient sometimes.or benchmark by owning the same assets, in the Managers attempt to add value over the returns ofsame proportions, as the underlying index. Passive an index by picking assets based on models,investing does not seek to capture any excess insights, and analytical research. Managers aim toreturns, but rather tries to match the performance achieve a higher return then the benchmark byof the index. Indexed Mutual Funds and ETFs are selecting a superior stock, currency, market, orcommon vehicles used for passive investing. sector, etc. Active managers will try to exploit pricing inefficiencies to obtain excess return. (Source: SPDR University). Percentage of Active Funds are Underperforming the BenchmarkEfficient wealth management is a tedious and large-cap value and large-cap growth, all the othertime-consuming activity. It requires a categories have more than 75% of the fundspsychological self-understanding along with underperforming the benchmark.excellent analytical and technical skills. Here welook at how actively managed mutual funds have By looking at the numbers we can say thatperformed across the years compared to their selecting a good mutual fund is extremelyrespective benchmarks and the numbers are very difficult. Thus, effective organized financialsurprising. planning is important. The finance professional cannot guarantee above average returns but someThe figures below are Equity and Fixed Income of them will be more adept and skillful inmutual funds style boxes after adjusting for managing investments than a layman.survivorship bias. We see that all the categorieshave more than half of the fundsunderperforming the benchmark. Also, except forEQUITY FIXED % below Value Blend Growth INCOMEbenchmark % below Government Corporate GNMA benchmark Large 56% 83% 73% Short 94% 99% 100% Mid 99% 96% 98% Intermediate 80% 91% N/A Small 84% 93% 76%Sources: Vanguard calculations, using data from Morningstar, Inc., MSCI, Standard & Poor’s, and Barclays Capital © 2011 Bourbon Financial Management, LLC ~ All Rights Reserved ~ Info@bourbonfm.com ~ (+1) 312 909 6539 5
Why do active managements underperform active managers outperformed the relative indexesbenchmarks so poorly? An indexing investment only in three asset classes—small cap blend, smallstrategy performs favorably in relation to actively cap growth, and international as shown in themanaged investment strategies because of figure below.indexing’s low costs, broad diversification,minimal cash drag, and, for taxable investors, the Research conducted in the 1960s by Jensenpotential for tax efficiency. Combined, these (1968), Sharpe (1966) and Treynor (1965) foundfactors represent a significant hurdle that an active that, on average, active funds underperform theirmanager must overcome just to break even with a benchmarks on a risk-adjusted basis and that thelow-cost index strategy over time. magnitude of underperformance directly relates to the level of expenses.Some studies support the notion that active fundscan sometimes outperform passive funds in less This debate about Active and Passiveefficient markets over certain down market Management is of constant discussion amongperiods and sustained time horizons. individuals in the financial world. Thus, instead of trying to find the winner the fundamentalA research report by State Street Global Advisors approach should be to ask: “How can I make theand SPDR® ETFs for the 15-year period ended best decisions with respect to my goals andDecember 31, 2010 found that more than 50% of objectives?”Percent of Active Managers Outperforming Indices ~ 15-Year Annualized Fixed Income 15% Emerging Markets 42% International 65% Small Cap Blend 54% Small Cap Growth 59% Large Cap Blend 35% Large Cap Growth 43% 0% 10% 20% 30% 40% 50% 60% 70% Source: Morningstar Direct, SSgA Global ETF Strategy & Research as of 12/31/2010. © 2011 Bourbon Financial Management, LLC ~ All Rights Reserved ~ Info@bourbonfm.com ~ (+1) 312 909 6539 6
The decision to pursue passive or active management strategy should be decided based on understandingyour objectives by asking certain questions as shown in the figure below. Do you believe Do you believe that there are that markets are some managers generally who can inefficient? consistently beat the benchmark? How comfortable Do you believe are you with that you can find taking on active these skillfull risk? managers? YES ACTIVE MANAGEMENT © 2011 Bourbon Financial Management, LLC ~ All Rights Reserved ~ Info@bourbonfm.com ~ (+1) 312 909 6539 7
Passive strategies should be relied upon when your objectives, and understanding the factors likethe potential to beat the market is relatively poor taxes, fees and risk tolerance. The best investorand to minimize tax liabilities related to capital would be the one who can identify marketgains. segments which are not efficient and employ active strategies among those segments. InActive Strategies should be pursued in those addition, one must identify superior activemarkets which are less efficient and when you managers in asset classes where the manager has ahave high confidence. greater chance of outperforming.You should make a decision as to which is the (Source: Passive and Active Management , A Balanced Perspectivecorrect and advisable strategy after accounting for Thomas Guarini, ETF Strategies, Global ETF Strategy & Research, State Street Global Advisor)We just saw the strenuous procedure involved Picking the right mutual funds is not an easyinto opting for passive or active management. task. There are qualitative and quantitative factorsNow the active investor needs to create a universe that need to be understood observed and moreof Mutual Funds to choose from. Creating this importantly analyzed correctly.universe of funds involves tremendous skills in allaspects. The active investor needs to have goodanalytical as well as technical skills. Alsoimportant are qualitative aspects like goodnetworking skills and having knowledge ofbehavioral finance. Manager Due DiligenceIt is very important to perform diligence on the team changes every year. We would want thecompany and its management, to know whether same management for at least 10 years. Wethe management is engaged in costly litigation or need to evaluate how a manager has done in theis involved in finding innovative ideas for the long-term. Why?firm. Short-term performance is of little use in pickingThe performance of a mutual fund is largely a fund that you’re going to hold for the long term.driven by the manager and his/her team. Funds with the top trailing one- and three-year returns may continue well over the next shortInvestment style, people, philosophy and term period, but may fare poorly over the longperformance are all carefully reviewed in the term.manager search and selection process. How big is the team? We prefer firms with aThe fund’s manager tenure period is looked at. strong team of analysts.You would not want a fund whose manager and © 2011 Bourbon Financial Management, LLC ~ All Rights Reserved ~ Info@bourbonfm.com ~ (+1) 312 909 6539 8
How is the management team compensated? We expensive 20% of equity funds. (Source: Fund Spy byare more interested in private firms, where Russell Kinnell)managers receive ownership stakes in the firm. We review how managers performed in the past,We want funds with at least enough assets under during bull markets and bear markets. We likemanagement because this will generate enough downside protection. Once a manager’s pastrevenue to pay the salaries of good analysts and performance is understood, expectations can bekeep them for many years. set for future performance. These performanceWe like for managers to have skin in the expectations and an investor’s tolerance for riskgame. We look at a manager’s ownership in his should be explicitly discussed and accepted whenor her own fund and like to see ownership valued selecting a manager.at $500,000 or more. You wouldn’t like to see a Even after a manager is selected, constantCEO who doesn’t own any stock in his own monitoring and reviewing is a difficult task.company and for that reason we demand it in Unfortunately, ongoing manager review oftenfund managers. becomes an afterthought or is not even discussed.With regard to the fund’s portfolio, we want a low We review if a manager has closed a fund to newturnover because it gives a low tax impact. investors in the past and ask how they decide to close it in the future. Closing a fund means a fundWe want funds to have concentrated company is passing up fee income and hurting itsportfolios with fewer stocks. If the mutual fund own short-term profits in order to avoid lettingowns so many stocks, it may be better to just buy asset growth harm performance of the fund.the index which is cheaper. We pay managers totake risks. The managers selected should remain true to the style and asset class for which they are beingWhat is the investment strategy? Funds that rely selected. A large-cap growth manager should noton momentum strategies to buy hot stocks incur deviate drastically from his/her intended strategy.greater trading costs than those more contrarian Any change to the investment team should bestrategies that involve buying the stocks that immediately reviewed. Changes to senioreveryone is desperate to sell. Like Warren management or to the structure or ownership ofBuffett, we believe in buying stocks and the firm should also be evaluated with a criticalholding it for the long-term. eye as to their impact on the investment team’sWe prefer no-load mutual funds with low time, resources and capabilities.expenses for several reasons. First, it shows that amanager keeps business costs under control.There is a high correlation between costs andsurvivorship, as high-cost funds have a largeattrition rate. Second, fees reduce investor * People + Process + Philosophy = Performance *return. When the cheapest 20% of equity funds iscompared to the cheap index fund, it is twice aslikely to beat the index as compared to the most © 2011 Bourbon Financial Management, LLC ~ All Rights Reserved ~ Info@bourbonfm.com ~ (+1) 312 909 6539 9
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