Mutual Funds and Exchange Traded Funds are a great way to establish a balanced asset allocation and get plenty of diversification. One fund might be all you need, or you might decide you want to have a different mix that suits your investment goals.

Investors once needed to comb through prospectuses and annual reports. The Globe and Mail used to have a monthly section detailing mutual fund returns, and I remember clients coming into my office waving Gordon Pape’s latest Buyers’ Guide to Mutual Funds and telling me “Gordon Pape says…”

Now, all the up-to-the-minute on-line resources available make it a lot easier to do your research, but it can also be harder because there are so many hundreds more funds to choose from.

How do you choose which funds are right for your portfolio?

Evaluating a fund

Once you’ve decided on the asset classes that fit your investment objectives, you need to pick funds to stock your portfolio.

Rather than spending my time trying to study thousands of funds, what I like to do is look at sample portfolios and articles like “The Best ETFs for 2017” by respected financial writers and analysts. I figure that the broad research has already been done by them, and I can then narrow it down to what’s suitable for me.

Both mutual fund and ETF companies have “fund facts” detailing relevant information about all their funds and some will also help you determine an asset allocation based on your requirements.

Morningstar.com has also become the go-to source for most information.

Morningstar uses two types of ratings for mutual funds:

  • The traditional one- to five-star ratings are backward looking. This is a pretty good assessment of what the fund has done in the past, and how its performance compares to its peers, but it is not a prediction of how well the fund might do in the future. And, as every tiny-print disclaimer will tell you, past performance is not a predictor of future performance. The manager of the specific fund may be replaced, the fund itself may alter its direction, market conditions may change, and so on.

The stars might help you screen out really poor performers, but if you’re primarily searching for index funds or ETFs that mirror a particular index, a three-star rating indicates that the fund is doing about as well as its peers, which is probably good enough – you want an index fund to replicate the index as nearly as possible.

  • The newer gold/silver/bronze/neutral/negative classification was introduced to provide an analyst’s forward-looking judgement. The analyst reports are full narrative discussions by an analyst who specifically follows that company or fund. Sometimes, you can also read several archived reports to see whether predictions have come true, and how much back-pedaling the analyst has had to do. Like all analyst judgements, including yours and mine, these ratings may be grounded in numbers, but they also depend on a person’s assessment of the future. You can’t rely on it completely.

What’s in the portfolio?

Don’t assume funds are the same just because they have a similar name. Some funds aim to simply track a broad market while others attempt to outperform the market.

  • Take a look at the holdings and composition. See if the holdings, sector and country breakdowns match the asset allocation you have in mind. Pay particular attention to how they are weighted. Some ETFs will only have a “sampling” of an index, meaning it buys some, but not all of the stocks or bonds in an index. It may under- or over-perform slightly based on the securities it holds.

Index funds will simply hold the companies in the benchmark index. If you’re looking at an actively managed mutual fund, are the top holdings similar to the index or a different composition?

  • Look at the fund’s stated objective to see if it’s consistent with your own. One that focuses on monthly income may be fine for a retiree, but a young investor may want more emphasis on growth. What is the investing style and strategy – passively managed, leveraged, inverse, currency hedging? What is the risk potential?
  • What does the index track? Funds that track a long-standing index such as the S&P 500 have stood the test of time, but many ETFs have cooked up new indexes that track obscure segments of the market.
  • How big is the fund? You want funds with high daily trading volumes and more assets under management rather than a small sampling sector fund. A smaller fund could be in danger of closing or being merged with another, possibly changing the style. It may also have low liquidity or a large bid/ask spread (costly for investors).

Is it fairly priced?

Consider your costs. Management and expense fees are what the fund company charges investors to run the fund: salaries, advertising, regulatory fees, and so on. You won’t be paying these fees out of pocket; they reduce the returns paid to you by the funds. Even though some managed funds might have better returns with a higher management fee, studies suggest that going forward, low management fees are a good indicator of future high performance. And, if the content and strategy of the funds are essentially the same, there’s no reason to choose one with a higher management fee.

Fee percentages might look tiny, but consider the impact they will have on your long-term returns.

So, make sure the fund is reasonably priced. Generally, the lower the better, but that’s not all. Look at the funds “tracking difference.” ETFs are designed to track indexes. Expenses will drag down returns. Some issuers do a better job tracking indexes than others.  A fund with lots of turnover will have high transaction costs.

A low fee fund that trails its index by a large percentage doesn’t do you much good.

Consider tax consequences in non-registered accounts. Most ETFs and index mutual funds are pretty tax efficient because of the way they’re constructed. However, some funds tend to trade more often, triggering more capital gains.

Analyzing the return

Okay, you’ve noted what analysts think of the fund, how it’s performed in the past compared to peers, and what it’s going to cost to invest. But how is it doing? You want to examine the “annualized return” of the fund over all available time periods.

First, look at the 1-month, 3-month, 6-month, and year-to-date returns. These figures will tell you what the fund has been doing recently and how it has reacted to any relevant news events. Next look at mid-term record: the 3- and 5- year annualized returns. If you are considering the fund for your medium-term goals, you want to look at the year-by-year returns for 5 years. For example, if it has an annualized return of 8%, does that mean it returned 7%, 8% or 9%. Or does it have a record of -1%, 16%, 3%, 8%, and 14%? In that case the fund may be too volatile for you.

If you’re judging a fund for long-term investment potential, look at the 10-year return, or longer if available. See how the fund did in a horrible market such as 2008 and 2009. Be wary of funds with very short track records.

The next thing to look at is the trailing 12-month yield. This is what the fund has paid in dividends, interest, and any profit from currency transactions. Not all funds have a yield. However, over long periods, most of the growth of a fund will come from reinvested dividends. If you’re retired and need income, you can have those dividends paid to you.

Final thoughts on choosing the right fund

It takes some work initially to find the right fund(s), but it does pay off in the long run when you’re not spending a whole lot of time managing your portfolio in the future.

Get all the information you need to make confident investment decisions.

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