The Funds Selection Process

The investor who has decided to invest through a fund is now faced with the task of selecting an appropriate fund. It is at this stage that many new investors are overwhelmed with the vast variety of choices. The selection process is simplified when using a systematic approach as follows.

The first consideration is whether to select a mutual fund, a closed-end fund or even an exchange traded fund (ETF). The decision here is largely dependant on the investing ambitions of the investor.

Shares in mutual funds can be bought directly through the fund provider and there is no requirement for a stock brokerage account. Investors who do not wish to directly own any stocks tend to find mutual funds convenient as they do not need to open a brokerage account.

Stock investors who hold a portfolio of stocks tend to prefer buying shares in closed-end funds and/or ETFs since they can simply buy these from the stock exchange using their brokerage account. The process of buying from the stock market is already familiar to them and there is the convenience of holding the funds in the same account as their stocks. This means they have one portfolio which holds both stocks and funds. Also selling a closed-end fund or ETF is exactly the same as selling a stock.

Some stock brokers allow mutual funds to be held in their brokerage accounts, but usually there is a fee for this service. So the investor looking at holding mutual funds in their brokerage accounts needs to consider whether it’s worth paying for the convenience.

Another consideration is the costs of the three fund types. Generally the mutual funds tend to be the more expensive. Closed-end funds tend to be slightly cheaper than mutual funds and ETFs are generally cheaper again.

The next consideration is whether to buy an actively managed fund or a passively managed fund (which are usually an index tracking fund). Basically the active funds seek to provide returns greater than what the market offers and passive funds merely replicate the markets performance.

Generally the active funds are more expensive (and can be considerably more expensive) than passive funds. The better performance from active funds is often outweighed by the additional costs.

If the investor is satisfied with the returns obtained from the market, then it makes sense to buy a passive fund and save the extra costs. However if the investor is looking for better returns than that offered by the market, then they will need to select an active fund but the costs need to be carefully considered. The costs of active funds tend to vary considerably and the investor is probably better of selecting a lower cost active fund. A higher cost active fund needs to outperform the market by the amount of their additional costs and there is no guarantee that it will continue to provide those high returns.

If you are satisfied with the returns obtained from the

market, then consider passive funds and save on fees

The investor now needs to consider whether to buy a fund that specializes in stocks or whether to include a fund that specializes in bonds. Some funds will include stocks and bonds together in the one fund such as the target date retirement funds.

A general guideline for conservative investors is to have a percentage of their portfolio in bonds based on their age. For example, an investor who is 30 years old would have 30% of their portfolio in Bond funds and 70% in Stock funds. An investor who is 60 years old would have 60% of their portfolio in Bond funds and 40% in Stock funds. These general guidelines are based on long-term investing for retirement which can be used with individual retirement accounts such as an IRA, however they also tend to work quite well for general long-term investing.

The only downside to incorporating bonds into a portfolio is that in the long-term (meaning 20 to 30 years) the returns from stocks outperform that from bonds by a fair amount.

The idea of incorporating bonds into a portfolio is that it reduces the volatility of the year to year returns, but it also reduces the long-term returns. The more aggressive long-term investor who can handle the higher volatility from stocks is probably better of with only a small portion in bonds or even a stocks only portfolio. Bonds only reduce the volatility, they do not eliminate it. Even a bond only portfolio has some minor volatility in the year to year returns due to the value of the bonds fluctuating along with the interest rate cycles.

The general rule is that in the long-term stocks outperform bonds and for the short-term bonds are less volatile. The only way to totally eliminate the volatility is to invest in cash equivalents such as certificates of deposit or Treasury Bills but these also provide the lowest returns.

As a guide, the shorter the investment time frame is then the lower the percentage of stocks that should be included in the portfolio.

The next step is to determine which type of Stock fund and/or Bond fund to buy which is covered in the following articles.