What Is the Biggest Mistake Investors Make When Evaluating a Fund?

August 13, 2013, 9:36 a.m. ET

What Is the Biggest Mistake Investors Make When Evaluating a Fund?

Avoiding errors when selecting a fund is no simple task, especially when there’s more than meets the performance data.

So we asked The Experts: What is the biggest mistake investors make when evaluating a fund?

This discussion relates to a recent Journal Report article on mutual-fund performance figures that don’t tell the whole story and formed the basis of a discussion on The Experts blog on Aug. 8.

Mike Piper: Don’t Judge a Fund By Its Cover

Two mistakes I see frequently when it comes to mutual-fund selection are picking funds based on their past performance and ignoring funds’ expense ratios. But I think an even bigger mistake (one that I’m seeing more and more often as target-date funds grow in popularity) is to invest in a mutual fund without having the slightest idea what’s inside it. It’s all too common these days for people to invest in a target-date fund based solely on the fact that the date in the fund’s name is close to the date at which they plan to retire. For some investors, this will lead to a nasty surprise during the next bear market when they find out that their target-date fund’s asset allocation is far too aggressive for their personal risk tolerance. (Of course, the opposite can happen, too. Upon taking the time to check, some investors might find that the target-date funds generally intended for people their age are too conservative for their tastes.)When evaluating a mutual fund (target-date or otherwise), the very first step should be to look at what’s actually in the fund—what is its asset allocation? By taking the time to do this, you can avoid finding yourself in a position in which you learn (too late, as many investors did in 2008 and early 2009) that your portfolio has a much larger allocation to risky assets than you thought it had.

Fortunately, it’s quite easy to look up a mutual fund’s asset allocation. For most retail mutual funds, in less than 60 seconds you can find the fund on Morningstar’s website(hint: put the fund’s ticker symbol in the “quote” search box), click over to the “portfolio” tab, and look at the handy pie chart and accompanying figures explaining what the fund holds.

Mike Piper (@michaelrpiper) is a Missouri-licensed CPA and the author of the blogObliviousInvestor.com. He is also the author of several personal finance books, including his latest, “Social Security Made Simple.”

Eleanor Blayney: It’s More Than Just a Ratings Game

They get stars in their eyes, and can’t see much else. If the fund rates five stars, they will buy or keep; if just one or two, they sell.

I am talking about the Morningstar “stars,” used by the investment research and data company to rank funds in similar style categories on their past risk-adjusted performance.

I happen to think that Morningstar is a great company, which transformed the mutual-fund industry through the “democratization of data,” to use a term coined by head of research Don Phillips. What Mr. Phillips and his team did, back in the 1980s, was to open the black box of mutual funds, and enable the investing public to see and analyze what the funds were investing in, how the funds were governed and performing, and what they cost in terms of fees and risk. They also adopted the star-rating system to give investors a way to evaluate the fund’s track record relative to other similar funds, in terms of return and risk.

This star-rating system has been explained and refined over the years, and Morningstar has always been the first to qualify its limitations in predicting future performance.

Many investors, however, fail to consider all the other data that Morningstar publishes on funds, and make their decisions entirely based on the stars. This, to my mind, is pure astrology and not prudent investing.

Eleanor Blayney (@EleanorBlayney) is consumer advocate of the Certified Financial Planner Board of Standards.

Charles Rotblut: Know When You’re Better Off Playing Roulette

I’m going to put a few numbers behind what I’m assuming several of my fellow experts will be saying: Investors too often focus on recent performance when selecting funds. Funds with good recent performance are viewed in a favorable light, and funds with lousy recent performance are frowned upon.

S&P Dow Jones Indices maintains a scorecard of how often top-performing funds remain top-performing funds. According to the latest Persistence Scorecard, which was released just a few weeks ago, only 4.69% of all domestic funds kept their top-quartile rankings for the three consecutive 12-month periods ended March 2013. Put another away, there was a 95% chance the top performing fund you picked three years ago didn’t keep on being a top-performing fund. Hardly favorable odds.

Let’s go out even further. Less than half of the large-cap funds tracked by AAII’s annual mutual fund guide had higher 10-year annualized rates of return than the S&P 500. Plus, many of those that did beat the large-cap index only did so by a small margin—a sign investors weren’t adequately compensated for incurring the risk of active management.

Simply put, your odds of correctly determining whether a roulette ball will land on a red or a black number are better than your odds of picking an actively managed fund that will outperform over the next five or 10 years.

So what is an investor to do? Stop looking at performance first. Rather, figure out what asset classes you need exposure to and then seek out the lowest cost funds that target those assets. Only after doing this should you consider a fund’s long-term performance (at least five years, preferably 10 years). And once you buy a fund, compare its performance with that of its peers; a fund’s performance will primarily be determined by the rules governing what the manager can and cannot invest in.

Charles Rotblut (@charlesrotblut) is a vice president with the American Association of Individual Investors.

Christian Magoon: Don’t Put Too Much Focus on Expenses

Investors are often too focused on a fund’s cost rather than the performance of the fund. While a fund’s cost is an important detail, ultimately the purpose of investing is to make money, not to save it. Investors should incorporate the cost of a fund into their selection process by reviewing performance net of all fees and expenses. Only then will investors avoid the premature elimination of funds that may have a higher expense ratio but ultimately produce superior performance.

Christian Magoon (@ChristianMagoon) is founder and chief executive of YieldShares, an income-focused ETF sponsor.

Larry Zimpleman: Today’s Allocation May Not Be Tomorrow’s

First of all, I always encourage even experienced investors to seek opinions on funds from advisers before you make a final decision to invest. I think the mistake that investors often make when evaluating a fund is not understanding how much latitude the fund’s portfolio manager has to change the fund’s asset allocation. For example, an investor might look at a fund today and see that it’s invested 60% in U.S. equities and 40% in U.S. fixed income. But—can the fund go to 100% equities? Or 100% fixed income? Can it be fixed income or equities outside the U.S.? Don’t make the mistake of thinking that the investment portfolio will always look like it looks today—understand how much discretion the portfolio manager has to make asset allocation changes.

Larry D. Zimpleman is chairman, president and chief executive of Principal Financial Group.

Terrance Odean: Think About Today’s Fees, Not Yesterday’s Results

Focusing on past performance rather than fees.

Terrance Odean is the Rudd Family Foundation professor and chair of the finance group at the Haas School of Business at the University of California, Berkeley.

Michelle Perry Higgins: Follow My ABCs

While there are many ways to evaluate funds, the biggest mistake I see is that most people tend to overcomplicate things. My advice is to keep it simple and follow Michelle’s ABCs of evaluating funds to avoid costly mistakes.

A—Always check the fund’s expense ratios. Your goal should be to keep your costs as low as possible. Expense ratios are an important component and a simple measurement to keep costs in check. Although it sounds like a no-brainer, many investors often fail to review this figure.

B—Be clear on the fund’s objectives. The prospectus is an often-underused reference tool that contains valuable information. If you read nothing else in it, be sure to find out what the fund’s objectives are. This gives you a clear path to track its performance relative to the appropriate peer group and benchmark.

C—Chasing returns is a losing game. This is an easy trap to fall into for the investor without a solid game plan in place. You’ve got to look at the big picture. Don’t jump into a fund only because of past performance. You run the risk of buying high with the rest of the herd.

Disclosure: This is just the ABCs. Every investor should have a thorough plan when evaluating funds.

Michelle Perry Higgins (@RetirementMPH) is a financial planner and principal at California Financial Advisors.

George Papadopoulos: Stop Chasing Performance!

Investors make many mistakes when evaluating funds. These include

• Only considering funds that make it to “Top 10 Funds to buy now” lists that regularly appear in the media

• Judging the funds only based on past performance and/or Morningstar star ratings

• Selling the funds too fast when a manager hits a rough spot (it should be expected)

• Not giving high enough importance to the fund’s expenses

• Not looking into how a particular manager fared in both bull and bear markets

• Not looking to see if the current manager was at the helm for the entire 10-year stellar record

But by far the biggest mistake investors make when evaluating a fund, in my humble opinion, is performance chasing!

George Papadopoulos (@feeonlyplanner) is a fee-only wealth manager in Novi, Mich., serving affluent individuals and families.

Greg McBride: Keep the Past Where It Belongs

As every fund prospectus says, “Past performance is no guarantee of future results.” Yet investors routinely look to past performance as a harbinger of what returns they can expect going forward. This mistake can manifest itself in a couple of ways: chasing performance and buying into sectors or asset classes that are overvalued; and disrupting a proper allocation by overweighting hot sectors and asset classes at the expense of those that have been underperforming, but may well be poised to rebound. When looking at past performance, focus instead on how the fund has performed relative to its benchmark index and peers. But even then, this is no guarantee of future results.

Greg McBride (@BankrateGreg) is a senior financial analyst and vice president for Bankrate.com, providing analysis and advice on personal finance.

Manisha Thakor: Find the Hard-to-Find Fees

The biggest mistake I routinely see is not paying attention to fees. The difference between a low-cost index-oriented fund with a 0.25% expense ratio and an actively managed fund with a 1.25% ratio may not seem such a big deal on the surface. Yet assuming 7% returns, over a 25-year time period, that incremental 1% in fees will eat up over 25% of your return.

Think about that for a minute. Two funds. Both generate returns of 7% a year on average for 25 years. Yet investors in the fund that has the 1.25% fee only have $3 to spend for every $4 the investor in the .25% fund has to spend.

It’s understandable that investors often don’t focus on fees as the financial-services industry doesn’t exactly make it easy to see what you are paying. Between management fees, 12b-1 fees, other expenses, and my least favorite fee of all—”the load”—it can be hard to get the full picture. While not exactly scintillating reading, the fund prospectus is the best place to look as all fees are required to be disclosed here.

Manisha Thakor (@ManishaThakor) is founder and chief executive of Santa Fe, N.M.-based MoneyZen Wealth Management LLC.

Tom Brakke: Stop Looking in the Rearview mirror

Chasing performance.

Investors tend to invest in what has done well, without regard to the inherent risks that may have built up during the run of historical performance that catches the eye.

That goes for asset classes, specific strategies fund families, and individual funds. They become popular when performance has been good and unpopular when it hasn’t been good.

But you can’t buy historical performance. You get what is coming down the road, not what is in the rearview mirror, so the numbers you see there are mostly distractions.

Tom Brakke (@researchpuzzler) is a consultant, writer and investment adviser who specializes in the analysis of investment decision making and the communication of investment ideas.

Rick Ferri: Low Fees Beat Star Ratings

Investors put too much emphasis on past performance and that can hurt. A better selection method is to find low-fee funds, preferably index funds, that track the markets.

Morningstar has been tracking and rating mutual-fund performance for over two decades. Funds are ranked from five-star to one-star based on past three-, five- and 10-year performance.

According to the Morningstar 2012: Annual Global Flows Report, only 10% of funds receive the coveted five-star rating, yet investors flocked to these funds. Net new assets into five-star funds overwhelmed the other four categories. There was some asset flow into four-star funds and net outflows from three-star, two-star and one-star funds.

Are investors setting themselves up for a fall by chasing top funds? They may well be, according to the newly released S&P Persistence Scorecard. Published twice per year, S&P tracks the performance consistency of mutual funds over consecutive 3- and 5-year periods.

The Scorecard released in July shows that a U.S. equity fund in the top quartile of performance three years ago had only a 24% chance of staying there over the next three years. Funds in the top half for five years ending in March 2008 had only a 46% chance of being in the top half for the five year period ending in March 2013. Past performance is not a good predictor of future return.

If past performance doesn’t work, what does? Morningstar analyst Russel Kinnal wrote in How Expense Ratios and Star Ratings Predict Success, “If there’s anything in the whole world of mutual funds that you can take to the bank, it’s that expense ratios help you make a better decision.” Fees beat star ratings as a predictor of returns. And which funds have the lowest fee? Index funds.

Rick Ferri is founder of Portfolio Solutions LLC and the author of six books on low-cost index fund and ETF investing. His blog is RickFerri.com.

Michael Kitces: Don’t Confuse an Asset Class With an Active Manager

Asset allocation and effective diversification have been long-standing tenets of portfolio construction. In fact, while long credited as a key outcome of modern portfolio theory, the truth is that the benefits of diversification extend back even further. In his seminal paper “Portfolio Selection” from 1952, Harry Markowitz stated, “Diversification is both observed and sensible; a rule of behavior which does not imply the superiority of diversification must be rejected both as a hypothesis and as a maxim.” In other words, diversification wasn’t actually an outcome of modern portfolio theory, it was a fundamental assumption used in creating it in the first place.

What modern portfolio theory did show, however, was that the benefits of diversification and their impact on reducing portfolio volatility and enhancing risk-adjusted return could be quantified, through the measure of correlation. The caveat, however, is that determining the benefits required an accurate estimate of what correlation would be in the first place. Though many assumed that correlation would be stable, it has been revealed otherwise, especially in the 2008-2009 financial crisis (and in fact, many other high volatility periods in history) when correlations rose together at the worst possible time.

In the search for new alternatives to low correlation, though, investors have begun to move down a dangerous path—one that fails to recognize the underlying factors that lead to a low correlation in the first place. After all, there are many different ways to generate a low or negative correlation, and still much debate about what constitutes an alternative asset class in the first place. Adding an investment with low correlation can be done by investing in a completely new, different asset class. It can be done by investing in something very illiquid (though in truth what is perceived as “low correlation” may actually be little more than a lack of price transparency). It can be done by buying a well-diversified portfolio (as almost by definition, buying a well-diversified basket of investments will show a reduced correlation to any one of them in particular). And it can be done by buying an active manager whose investments will continually be changing, such that the correlation to anything else will be low and/or won’t sustain for long.

The reason why these distinctions matter, though, is because they are all present to varying degrees in mutual funds, and while the first represents true diversification, and arguably the second might as well, the last two do not. The third option actually is diversification, not an alternative to be added to create diversification. And the fourth is perhaps the most concerning option. Because the reality is that while an active manager may or may not deliver value, the outcome is not dependent upon what the low-correlation diversification benefits of the asset class(es) that the active manager invests in (especially if they change over time), but the effectiveness of that manager to make the trades at the right time. Which means, for better or for worse, the opportunity of an active manager is not about having more diversification, but simply about picking a good manager that makes good active decisions, and the manager should be scrutinized accordingly.

So the next time you’re considering a mutual fund to add, be certain that you’ve really considered whether you’re investing in an asset class or an active manager; one of those relies on being a low-correlation diversifier, while the other relies on the effectiveness of the manager to make good decisions, and it’s crucial to evaluate the investment accordingly!

About bambooinnovator
Kee Koon Boon (“KB”) is the co-founder and director of HERO Investment Management which provides specialized fund management and investment advisory services to the ARCHEA Asia HERO Innovators Fund (www.heroinnovator.com), the only Asian SMID-cap tech-focused fund in the industry. KB is an internationally featured investor rooted in the principles of value investing for over a decade as a fund manager and analyst in the Asian capital markets who started his career at a boutique hedge fund in Singapore where he was with the firm since 2002 and was also part of the core investment committee in significantly outperforming the index in the 10-year-plus-old flagship Asian fund. He was also the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. Prior to setting up the H.E.R.O. Innovators Fund, KB was the Chief Investment Officer & CEO of a Singapore Registered Fund Management Company (RFMC) where he is responsible for listed Asian equity investments. KB had taught accounting at the Singapore Management University (SMU) as a faculty member and also pioneered the 15-week course on Accounting Fraud in Asia as an official module at SMU. KB remains grateful and honored to be invited by Singapore’s financial regulator Monetary Authority of Singapore (MAS) to present to their top management team about implementing a world’s first fact-based forward-looking fraud detection framework to bring about benefits for the capital markets in Singapore and for the public and investment community. KB also served the community in sharing his insights in writing articles about value investing and corporate governance in the media that include Business Times, Straits Times, Jakarta Post, Manual of Ideas, Investopedia, TedXWallStreet. He had also presented in top investment, banking and finance conferences in America, Italy, Sydney, Cape Town, HK, China. He has trained CEOs, entrepreneurs, CFOs, management executives in business strategy & business model innovation in Singapore, HK and China.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s

%d bloggers like this: