How to choose funds that will make money is a primary goal for many investors, but how should one go about selecting funds?
This article shares three steps for selecting fund investments, which I believe are fundamental principles when starting the fund selection process. These steps aim to provide some criteria for consideration, helping you make judgments that suit your needs when choosing funds.
Step 1: Decide asset allocation ratio.
Before choosing which fund to invest in, the primary step isn’t about looking at metrics like Sharpe ratio, Beta, or standard deviation, or immediately diving into monthly fund reports. It’s about first “deciding asset allocation ratios.”
I’ve mentioned before, while each asset category covers various investments, assets within the same category tend to have similar risk-return characteristics. Some assets move in tandem, while others have low or even opposite correlations. Asset allocation aims to invest funds across different types of assets (like stocks, bonds) to significantly reduce volatility without compromising returns too much.
Rather than concentrating investments in one asset type, effective asset allocation helps mitigate significant damage from market ‘black swan’ events.
In essence, determining the proportion of each asset based on one’s risk tolerance is a crucial consideration to mitigate investment risks arising from market uncertainties.
Step 2: Decide fund diversification level
Concentrating investments in a single asset isn’t a problem, but excessive concentration in an industry category might pose cyclical risks.
This means that when an entire industry experiences a prolonged period of decline, even if you hold a diversified portfolio, it might still be concentrated within a specific range.
For example, if you buy stocks from multiple companies in the technology sector, you may have diversified into 10-20 different stocks. However, if there’s a global pandemic like the recent one or a black swan event that impacts the entire tech industry, all stocks within the same industry will fall, including bonds and REITs (such as data centers) that are highly related to the tech industry. Under systemic risk, you may still need to endure significant volatility.
A common misconception about diversified investing is that diversifying the targets is sufficient. However, true diversified investment logic should include three levels of diversification:
Asset Diversification: Holding different types of assets, such as stocks, government bonds, investment-grade corporate bonds, gold, cash, etc.
Industry Diversification: To avoid the impact of a single specific industry cycle, invest in national or regional ETFs or funds, typically diversifying across various industries of that country/region.
Stock Diversification: Investing in 1-2 different ETFs or funds with different characteristics, or assembling a diversified investment portfolio yourself.
Diversified investing is just one of the investment options. Everyone’s situation and risk tolerance differ. If you have enough time to research and are confident in your judgment, you might also consider concentrated investments.
For most people, diversified investing may not always be better, but it is certainly not a worse option.
Step 3: Screening Fund Composition, Fees and Performance
The essence of a fund lies in pooling together funds from a group of individuals, managed collectively by fund managers to seek higher investment returns. It’s one of many investment tools, much like ETFs.
If you opt to use funds as an investment tool, the following sequence introduces indicators such as fund composition, fees, performance, and more. These aid in selecting a suitable fund for your needs.
Step 1: Observing Fund Components
Each fund usually lists its top 10 or top 5 holdings, which can be found on the fund’s official website or in its monthly reports. When you invest in a particular fund, its holdings represent your investment portfolio. Hence, it’s crucial to observe whether the manager’s stock selection aligns with your expectations. Unless we’re very familiar with a fund manager, it’s unlikely we’ll know their team’s investment strategy. However, we can gain insights through their stock selections.
When screening funds, consider these three questions to assess if a fund matches your investment style:
Are there any holdings in the top 10 that you don’t agree with?
What are the respective weightings of the top 10 holdings? Do they match your expectations?
Where does the recent performance come from in terms of stock selection? Do you agree with this performance?
Remember, whether it’s an ETF or mutual fund, you’re essentially paying someone to manage your assets. Therefore, it’s crucial to understand their management style and decision-making process. Reviewing fund components helps us understand their decision-making logic.
Step 2: Understanding Fund Fees
When buying or selling funds, you may encounter several main fees, which can be found on the fund’s official website or in monthly reports. While assessing a fund, besides examining if its performance meets expectations, pay attention to the associated fees. High fund fees might impact the fund’s returns. Don’t assume that earning more than the fees is sufficient; even small percentage differences can have a significant impact as the amount grows.
Especially for products with lower investment returns, high fees can proportionally increase the total cost, making fee levels crucial to consider.
It’s important to note that these are not the only fees; there are also internal expenses like the fund’s trading costs. Funds intended for long-term investment usually follow the guideline of holding for extended periods and avoiding frequent trading. Funds with high turnover rates and frequent stock turnover might significantly elevate costs. While short-term gains might seem promising, it’s essential to question if it’s beneficial in the long run.
Step 3: Screening Fund Performance
Many people tend to assess a fund’s performance as the first step, but I believe performance should be the final consideration. After agreeing on investment style and understanding fee structures, then delve into performance assessment.
After all, a fund with stellar performance might be chasing the trend with various hot stocks at the moment, which might not align with your long-term investment strategy.
Observing a fund’s long-term performance entails two key aspects:
1. Assess whether the fund’s annual performance has consistently outperformed the corresponding index.
For instance, a tech stock fund should be compared to growth stock indices to gauge relevance. A high-yield bond fund should be compared to high-yield bond indices to derive meaningful insights. While it’s challenging for even exceptional funds to outperform indices annually, observing annual performance provides insights into its strategy’s quality.
2. Observe performance during both bullish and bearish periods, particularly in bear markets.
For instance, in the stock market, during major downturns like 2008, 2018, 2022, observe the fund’s performance during these years. Pay attention to years with significantly high profits or losses, especially when there’s a substantial deviation from the index.
This observation helps in understanding the fund’s risk and strategy, aiding in determining its suitability for you.
Of course, funds need to have a sufficiently long track record for substantial data. For funds with less than a year of establishment, it’s advisable to observe for a longer period.
When assessing performance, focus not on net asset value but on performance or cumulative fund-level returns.