Are there other criteria I should consider when deciding which mutual fund to buy?

By committing to a well organized and consistent investment process, investing can go from overwhelming to very simple and straightforward. Once you have established your criteria, you should also consider a few additional criteria such as the following items listed below:

  • Your portfolio’s current holdings:  Again you should understand the required job for the selected investment within your overall portfolio. For example, if your portfolio already has a high proportion invested in common shares of Canadian banks and in the common shares of energy companies, then you should be aware of the mutual fund’s current investments in these two areas. Buying a mutual fund with 35% of its assets invested in Canadian banks and 33% invested in energy companies does not constructively add to your portfolio’s diversification and it would increase your portfolio’s exposure to the same industries. Ensure that the mutual fund selected meets all of the qualifications for the job it is to perform within the portfolio.
  • Past performance: Because investing involves making decisions while not knowing future outcomes, investors gravitate to history for their investment decisions. Past performance, as all mutual funds are required to state, should not be considered a projection of future performance, but it does give an investor important information for their investment decisions. Performance numbers are difficult to analyze because the majority of Canadian mutual funds have not been in existence beyond a complete business cycle. For example, in 1999 Canada had 1,200 mutual funds, and as at September, 2010 there were 12,931 mutual funds (Globe Fund). And we cannot assume that the 1,200 mutual funds alive and well in 1999 are still operating today. As a result, past performance should be used in the selection process, but not by itself.
  • Performance consistency: At any point in a stock market and economic cycle, certain asset categories will outperform other asset categories. In the late 1990s, assets in technology performed well while in the mid-2000s it was energy. Today the gold and precious metals sectors are outperforming other asset sectors. Individual sectors outperform because their popularity rises. Their popularity may increase because they benefit from the current economic/business cycles, or maybe their industry is undergoing a resurgence or innovation, or simply investor attitudes have changed. A sector will outperform because their popularity with investors increases and, as a result, the sector attracts greater and greater investment capital. So money flows can be an important consideration when looking at past performance. Was the fund well managed or was it simply at the right place, at the right time? No management skill was required.
  • Consistent management: An often overlooked consideration when selecting a mutual fund is the stability of the management team and the mutual fund’s corporate culture. How long has the current investment manager been overseeing the mutual fund’s investments? Has the fund’s investment manager turnover rate been consistently high? Is the manager changed every time the performance disappoints? How is the mutual fund company’s succession plan for the investment process structured? Some mutual fund companies have a very well established, successful and consistent succession process for their portfolio managers. This process has ensured that a consistent investment management philosophy and approach endures, even as investment mangers come and go from the firm. Other mutual fund companies have a much more Cowboy approach where they hire the latest and currently hottest investment managers. (Here today, gone tomorrow.) A profile / or explanation of a portfolio management should be available on each fund type.  You will want to review the turnover rate and ask yourself why.
  • Asset allocation within the fund: Does the mutual fund have a well-defined Investment Policy Statement (IPS) or investing mandate? Does the fund’s current investments fall within that mandate? Are the fund’s assets concentrated within a couple of sectors? What percentage of the fund’s money do the ten largest holdings represent? Has the fund invested 90% of its money in the top ten investments or do the ten largest companies only represent 5.0% of the holdings? If the top ten holdings represent 90%, then maybe the mutual fund is too concentrated in only a few holdings, thereby inviting a higher risk profile than you wish to have in your portfolio. And if the top ten fund holdings represent only 5.0% of the fund, then maybe the fund owns 600 companies and is too diversified, thereby muting fund performance. If it owns 600 companies and a couple double in value, does an investor really benefit? And is it possible to find 600 good quality companies to invest in? Most managers, if asked to recommend 20 companies to own, would have trouble rambling off 20 names. If they were asked to recommend 50 companies, they would struggle. And if they were asked for 100 recommendations, we suspect they would be throwing darts at the financial pages to come up with the last 25 recommendations.  This is even more important when selecting specialty or sector funds. A narrower investment focus can make investment selection with diversification in mind a difficult process without raising the risk profile and limiting the performance success.
  • Investment turnover ratio: A mutual fund’s investment turnover ratio is calculated as the value of all transactions (buying, selling) divided by two, then divided by a fund’s total holdings. In simpler terms, mutual fund turnover typically measures the replacement of holdings in a mutual fund, and is commonly presented to investors as a percentage over a one year period. If a fund has a 100% turnover ratio, the fund replaces all of its holdings over a 12-month period. A mutual fund’s turnover ratio is an important consideration. A high turnover ratio will lead to higher transaction costs for the fund. Most investors are told that they should select an investment and hang on to it for the long term (years, maybe decades). Investors are advised that no one can successfully trade or time the stock market consistently. So investors, to be successful, must adopt a Buy and Hold investment approach. But what is the point in an investor buying a mutual fund, holding it for five or ten years, if the mutual fund’s investment manager is buying and selling all of the investments each and every year. The portfolio manager and mutual fund company while preaching the Buy and Hold approach turn around and try to trade and time the stock market.
  • The fund’s management expense ratio (MER): Depending on the type of fund, operating expenses vary widely. The largest component of operating expenses is the fee paid to a fund’s investment manager/advisor. Other costs include record keeping, transaction costs, custodial services, taxes, legal, accounting and auditing fees, and marketing expenses. Costs associated with mutual fund purchases and sales by investors are not included in the MER. The MER is an important consideration for investors as these costs have a significant negative impact upon the investment’s performance. According to The Investment Funds Institute of Canada (May 12, 2010), the average MER in Canada is 2.31%, per year.  You as the investor pay this MER expense every year you own the fund. The MER expense is deducted directly on the calculated net asset value (NAV) of each mutual fund unit.  As an investor you do not see this expense.

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