BM410 Investments
Selecting Mutual Funds
Objectives
 A. Understand why you shouldn’t be picking
stocks initially until later when your assets
have grown
 B. Understand where to find important
information on mutual funds and stocks
 C. Understand what makes a good mutual
fund
 D. Understand index funds
Applications #1
 Bill and Suzie, both 30, are married with one child.
They can answer affirmatively to all the questions
from the top of the investment hourglass. They have
determined they need $15,000 in an emergency fund,
will save 10% of their gross salary, and their asset
allocations are 75% equities and 25% bonds and cash
with targets:
• 25% bonds/cash (Lehman Aggregate) 25% T 0% R
• 55% U.S. (S&P 500 Index)
35% T, 20% R
• 10% small cap (Russell 5000 Index) 4% T 6% R
• 10% international (MSCI EAFE Index) 4% T 6% R
 How do they select the mutual funds to obtain
exposure to their chosen asset classes?
A. Understand why you shouldn’t be
picking stocks until later
 While we have talked about many things thus far, we
have not talked about picking stocks. Why?
• There are five major reasons why we don’t
recommend picking stocks when you are just
starting out investing. Picking individual stocks
violates the following principles:
 1. Principle 3: Stay Diversified
• Picking single stocks violates the principle of
diversification, especially when you are just
beginning to build your portfolio
• With a small portfolio, it is difficult to achieve
acceptable diversification with limited numbers
of stocks
Stock Selection Strategies (continued)
 2. Principle 4: Invest Low Cost
• Investing in stocks when you have a small portfolio
is very expensive.
• Transactions costs for purchasing stocks are the
highest of any major asset class
 3. Principle 6: Know What You Invest In
• Picking stocks when you have not developed the
knowledge base necessary to evaluate stocks is
risky
• Most have not as yet put in the time to learn to
evaluate stocks nor have developed the tools to
make good stock selection decisions
Stock Selection Strategies (continued)
 4. Principle 8: Don’t spend too much time,
money, and energy trying to “Beat the Market”
• Picking stocks is very difficult and challenging
• There is so much more to be learned about
valuation that can’t be taught in a single class.
 5. Stock selection is not required to have a
successful investment portfolio
• While it is intellectually challenging to select
stocks, you can generally improve returns and
reduce risk more by properly selecting asset classes.
• You may never need to buy an individual stock
Stock Selection Strategies (continued)
 Remember, since analyzing companies is not likely
going to be many of your jobs, it will be in your best
interest to develop a “Sleep Well Portfolio”. This is
done by:
• Writing and following your Investment Plan
• Write it well and follow it
• Maintaining a generally passive strategy
• But buying individual stocks to add value to
your portfolio
• Enjoying your family and friends
• Make memories, not investment reports
• Doing well in your day jobs
• Make a difference where you work
Questions
 Any questions on why you shouldn't be
picking stocks until later?
B. Understand where to find information
on Mutual Funds
 Where do you find mutual fund and stock
information?
• Stockbrokers
• Mutual Fund Supermarkets
• Schwab, Fidelity, TD Waterhouse
• Mutual Fund Monitoring companies
• Morningstar, Lipper
• Financial Websites and the Financial Press
• Yahoo, MSN Money
• Kiplinger’s, Smart Money
• BYU Libraries
Mutual Fund Information (continued)
 What is the best format for the information?
• In a database of consistent, pertinent information
that is updated on a regular basis
• The database must be directly searchable with a
consistent framework and structure
 Our example:
• Morningstar
• Note that this is just one of the many available
databases. By choosing this database, I am
neither implying or endorsing Morningstar
(although I think they are pretty good). It is just
that it is available free in the library
Mutual Fund Information (continued)
 What is the process to pick mutual funds?
• 1. Determine the asset class needed for your Plan
• 2. Determine the appropriate benchmark
• 3. Determine the key parameters for that asset
class, i.e., principles, such as costs, fees,
diversification, etc. to identify potential funds
• 4. Using a database program, set those parameters,
and evaluate each of the potential candidates
• 5. Evaluate each candidate and select the best funds
• 6. Purchase the funds (but not in December before
distributions are made) and monitor performance
carefully
C. Understand What Makes A Good
Mutual Fund
What makes a good mutual fund?
• Good diversification
• Low costs
• Low turnover
• Low un-invested Cash
• No manager style drift
• Small tracking error
Diversification
 Diversification is your key defense against
market risk
• Stay diversified at all times. Pick a fund with many
companies in their portfolios within your asset class
• Diversification your primary defense against things
that might go wrong in investing
• Remember where you are in the hourglass.
• Avoid sector (industry) funds, individual
stocks or concentrated portfolios of any kind
until you have sufficient education,
experience, and assets
• And even then, keep that percentage of these
assets small in relation to your overall assets.
Where do you find Diversification?
 Diversification by:
• Numbers (Portfolio: Top 25 Holdings)
• Total Number of Holdings (Portfolio: Top 25
Holdings)
• Concentration of Holdings (Portfolio or
Snapshot: % in top 10 holdings)
• Type (Portfolio: Asset Allocation)
• Type of holdings (stocks, bonds, cash)
• Location (Portfolio: International Exposure)
• Location of companies invested in (geographic
area)
Diversification Pages
Low Cost
 Invest low cost
• In a world where investment returns are limited,
investment costs of all kinds reduce your return
 Invest in no-load mutual funds
• You should rarely (if ever) pay a sales load of any
kind (front end, level load, 12-b1, etc.).
• Rear-end loads, since you are long-term
investor, may be OK as long as they are less
than 180 days.
• Keep management fees to the lowest possible
within the sector.
 Remember: A dollar saved is a dollar you can earn
Where do you find costs?
 Costs (Fees & Mgmt: Fees and Expenses)
•
•
•
•
•
Administrative costs
Management fees
12b-1 Fees
Other Fees
Most important ratio: Total Expense Ratio
• Compare that to your category average
 Taxes
• Tax Cost Ratio (Tax Analysis)
Fees Pages
Low Turnover
 Keep turnover low, as it’s a proxy for fund
expenses and taxes
• The costs associated with turnover are hard to
quantify and may not be disclosed in the
prospectus. These costs include commissions, bidask spreads, and market impact.
 Each transaction generates a taxable event for
you, and these cumulative costs can be very
expensive.
• Stick to funds with the low turnover (and low
management fees), as they generally have lower
costs and are more tax efficient as well
Where do you find Turnover?
 Turnover
• Annual Turnover (Snapshot: Portfolio Analysis Turnover)
• Potential Capital Gains Exposure (Returns: Tax
Analysis)
Turnover Pages
Low Un-invested Cash
 High cash levels are drags on performance.
Keep cash low
• Many funds hold cash to fund potential
redemptions, or as part of their investment policy,
which are drags on performance.
 Choose funds that are fully invested (95%99% depending on the asset class and fund
size) in the market segment that you are
targeting
• Do not pay them to manage cash
• Some frictional cash is OK though for open-end
mutual funds
Where do you find Un-invested Cash?
Un-invested Cash
• Percent of cash in the fund (Snapshot:
Portfolio Analysis – Asset Allocation)
Cash Pages
No Manager Style Drift
 Make sure the managers investment style remains
constant
• Investment fund managers have no authority to change
the asset class
• If you purchase a small cap fund, you don't want
the manager to purchase international shares.
 The fund's prospectus should clearly define the market,
size company, and growth or value tilt for the portfolio.
• If you are looking for a domestic small value fund,
screen for funds with the all of their assets invested in
the U.S., the smallest average company size, and the
highest book-to-market (or lowest price-book) ratios.
Where do you find
Manager Style drift?
 Managers Style
• Managers Style Box (Portfolio: Style Box Details)
• The style box should not change over time
Style Drift Pages
Small Tracking Error
 Tracking error should be small
• Tracking error is the historical difference between
the return of a fund (i.e. a mutual fund) and its
specific market/sector benchmark or index.
• The smaller the tracking error, the better the
performance of the Index fund.
• However, you won’t complain if the tracking
error is positive (i.e., your fund had higher
returns than the index)
Where do you find Tracking Error?
 Tracking Error (Returns: Performance
History)
• Tracking Error versus the Index (+/- Index)
• Tracking Error versus the Category (+/- Category)
• % Rank in Category (Number is in top %--the
lower the number the better)
Tracking Error Pages
Mutual Fund Information (continued)
• Lets look up some information
• www.byu.edu
• See Teaching Tools:
7A Using Morningstar to Select
Mutual Funds using the HBL Library
7B Using Morningstar to Select
Mutual Funds using the Internet
Questions:
Any questions on what makes a good
mutual fund?
• Websites to review:
• www.morningstar.com
• www.Indexfunds.com
• www.cnnmoney.com
• http://finance.yahoo.com
• www.fool.com
D. Understand Index Funds / ETFs
 What are index funds?
• Mutual Funds or Exchange Traded Funds which hold
specific shares in proportion to those held by an index
• Their goal is to match the benchmark performance
• Why have they come about?
• Investors have become concerned that most actively
managed funds have not been able to beat their
benchmarks after all fees, taxes and costs.
• So instead of trying to beat an index, investors
accept the index return and risk.
• Interestingly, in the process, index funds have
tended to outperform most actively managed funds
Index Funds (continued)
 Why the big deal about index funds?
• Index funds have become the standard against
which other mutual funds are judged
• If a mutual fund cannot perform better (after
taxes and fees) than an index fund (index funds
are very tax efficient), then investors should lean
toward index funds
• There are nearly 1,000 different index and exchange
traded funds which follow different geographical,
maturity, capitalization, and style indices
Index Funds (continued)
Index Funds (continued)
 Why have index funds and ETFs grown so
quickly?
• There is no correlation between last years winners
and this year’s winners for actively managed funds
• Actively managed funds tend to hurt performance
through excessive trading, which also generates
taxes
• Actively managed funds generally have higher
management fees which must be overcome through
higher returns (18 basis points for an index fund
versus 80-250 basis points for an actively managed
fund)
• It is very difficult to beat these funds on a
consistent basis after fees and taxes
Do Winners Rotate?
Do World Regions Rotate?
Do Sectors Rotate?
Does Style Rotate?
Ten-Year Annualized Return on the 30 Largest Mutual Funds
Investor return for calendar years 1993 to 2002; largest funds as of year-end 1992
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
Fidelity Magellan
Investment Comp of America
Washington Mutual Investors
Vanguard Windsor
Janus
AIM Weingarten
Vanguard Windsor II
American Cent Ultra
MSDW Dividend Growth
Fidelity Equity-Income
American Cent Growth
Fidelity Growth & Income
American Mutual
American Cent Select
Growth Fund of America
9.16
10.63
11.33
9.86
6.85
2.69
10.18
8.53
7.23
10.01
5.62
10.30
10.00
6.91
11.82
Average mutual fund return:
Vanguard 500 Index fund return:
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
Pioneer II
Lord Abbett Affiliated
Putnam Fund for Grth & Inc
Dreyfus
Janus Twenty
Amcap
INVESCO Equity Income
AXP New Dimensions
Nicholas
Fidelity Destiny I
Waddell & Reed Adv Core
Van Kampen Pace
Phoenix-Engemann Cap
Fidelity Independence
Fidelity Equity-Income II
8.14%
9.27%
Funds outperforming the index: 12 out of 30 (40%)
Correlation to prior decade return:
-.181
6.70
10.38
8.43
3.50
8.52
10.82
7.18
9.03
6.07
6.57
9.02
5.40
2.56
9.28
9.75
Figure 1a: Distribution of Simulated Portfolio Returns for 1996
Before Costs
1000
Index Fund Return
900
Portfolio Count
800
700
600
500
400
300
200
100
0
-20 -15 -10
-5
0
5
10
15
20
Percent Return
25
30
35
40
45
50
Figure 1b: Distribution of Simulated Portfolio Returns for 1996
After Costs
1000
Index Fund Return
900
Portfolio Count
800
700
600
500
400
300
200
100
0
-20 -15 -10
-5
0
5
10
15
20
Percent Return
25
30
35
40
45
50
Benjamin Graham
Benjamin Graham on security analysis, 1976:
This was a rewarding activity, say forty years ago, when our
textbook “Graham and Dodd ” was first published; but the
situation has changed a good deal since then. In light of the
enormous amount of research now being carried on, I doubt
whether in most cases such extensive efforts will generate
sufficiently superior selections to justify their cost.
Indexing and Mutual Funds?
Reasons to not index
Passive investing is boring
Picking stocks can be intellectually challenging
Investment war stories are fun to share with friends
Doing nothing about your investments is unnerving
Reasons to index
Immediate diversification
Superior long-run performance
Tax efficient
Takes very little time
Insights on Indexing?
1. Most actively managed funds and brokerage accounts will
generally under-perform index funds in the long run after
all taxes, costs and fees
2. The competition in stock-market research is intense and
will get more competitive going forward, making markets
more efficient and indexing even more attractive
3. Market indexing or “passive investing” is a free-ride on
the competition and it takes very little time
Suggestion: For broader diversification, choose an index
fund that has more members or a “total market” index
fund
Index Funds on a $50 a Month
 Transamerica Premier Index Fund (tpiix)
• Type: S&P 500 Index, Expense ratio: .25%
• Min. Investment: $50 month, $1,000 initial AIP
 TIAA-CREF Equity Index (tceix)
• Type: Russell 3000 Index, Expense ratio: .26%
• Min. Investment: $50 month, $50 initial AIP
 MassMutual Select Index Equity Z (miezx)
• Type: S&P 500 Index, Expense ratio: .21%
• Min. Investment: $0 month, $0 initial AIP
 There are many others which fall under this same
Automatic Investment Program criteria and that are
even cheaper!
Questions?
Any questions on indexing and why it is
important?
Review of Objectives
 A. Do you understand why you shouldn’t be
picking stocks initially until later when your
assets have grown?
 B. Do you understand where to find important
information on mutual funds and stocks?
 C. Do you understand what makes a good
mutual fund?
 D. Do you understand index funds?