Selecting A Mutual Fund

Portfolio Management
July 16, 2023

When choosing a mutual fund or ETF to invest in, the large majority of investors rely on a fund's past performance and/or their Morningstar ratings. First, let’s look at a couple research studies regarding Morningstar’s Ratings.

There’s a link to Vanguard’s study below. Excerpt from conclusion: “in fact, our analysis reveals that higher-rated funds are no more likely to outperform a given benchmark than lower-rated funds.”

The Wall Street Journal also did a study. The title of this article is “Morningstar Mirage”, that should give you some clue as to their conclusion. The link to the article is below.

You should read the studies and draw your own conclusions. There are other research studies you can find online, and we strongly encourage you to read them prior to choosing a fund based on Morningstar’s ratings.

Another common method used by investors evaluating funds is to examine the performance of these funds over the past 1, 3, and 5 years, then choose the ones with the best track records. . This can be misleading. Here’s an example of how the selection of one stock can overly influence past performance.

Consider the share price of Tesla. In September 2019, each share was worth $16. Fast forward to June 2023, and the price had soared to $214 per shareAs of the beginning of June 2023, it was $214. If fund manager A had 5% of his portfolio in Tesla and fund manager B had the exact same portfolio without Tesla, fund manager A would have outperformed fund manager by 3.7% annually over that 4-year period based on a compounded return.

Does that mean fund manager A is a genius and you can expect them to outperform manager B over the next 4 years based on this one stock selection? Sometime in 2018-2019, Elon Musk said Tesla was about a month away from bankruptcy. According to Musk, that wasn’t the first time Tesla was on the verge of going under.

Looking at past performance doesn’t inform you as to the risk level that the manager employed in their portfolio or if most of their outperformance was generated by one or two stocks.

A sophisticated institutional investor would likely ask the manager of an investment vehicle (Mutual Fund or Hedge Fund) the following:

  1. What is your source of Alpha?
  2. How has it been employed in the past, how sustainable is it?
  3. How will it evolve in the future?
  4. Detail how much of your outperformance can be attributed to increased risk.
  5. How has your fund performed in the down market?
  6. Some other stats to consider: maximum drawdown/calmar ratio,, upside/downside beta, return-style attribution with risk model factors, tracking error, etc.
  7. Selection of the appropriate benchmark for relative performance

These are questions you should consider.

If you don’t contact the fund manager, you could watch, listen to, or read interviews they’ve given about their strategy. Cathie Wood manages the ARK funds. She did an in-depth interview on the halftime report (CNBC) on 2/17/22. Below is a link to a podcast of the full interview.

As of 2/17/22, Wood’s flagship fund, ARKK, had outperformed the Nasdaq over a 5 year period. ARKK had a 26% annualized return vs 19% for the NASDAQ. Listen to the interview and see if you would select Wood as one of your fund managers. It’s a useful exercise. ARKK was down 6-1/2% on the day of her interview. That might give you an insight as to what others thought of her interview and ideas. Over the next year, NASDAQ was down 14% while ARKK was down over 38%.

Selecting managers takes work. You have to analyze their portfolios, learn about their strategies and judge whether you think they’re people who you’d trust to manage your family’s wealth. If you’re not either willing or able to put in the work, you’ll be better off in an index fund.

If you’re going to invest with an active manager, it’s probably a good idea to find one that fishes in a pond that few others do. Apple has 37 analysts following their every move. It’s difficult for a manager to find useful information about Apple that the 37 analysts don’t already know.

If you find a great manager who invests only in Emerging Market Small Cap, you might be able to outperform the index. Many of the companies in that market have little or no analyst coverage. If I were 20 years old and starting out, I’d only invest in companies with no analyst coverage. Since I’m not, finding a young, brilliant, hard-working manager who does, might be another option.