In my last column, I described a series of steps in selecting mutual funds. I wrote about ways to think about investment performance, fees and risk in finding attractive funds. There’s a bit more work to do in trying to figure out whether the fund and the portfolio manager are suitable. In the institutional world, these steps would entail detailed analysis and an on-site visit with the manager. Obviously, you don’t have the time, and the mutual fund company wouldn’t take it kindly if you showed up for a visit. So what follows is a relatively quick way to kick the tires before you invest.
While you don’t have time to analyze every stock or bond in a mutual fund, you want the summary information to get some idea of how the portfolio is managed. The data are available in lots of places, including the fund’s website, Morningstar, or Yahoo Finance. First, you’ll want to know how many securities are in the portfolio. In stock portfolios, a manager usually needs no more than about 40 stocks to build a fairly diversified fund. Small cap managers might needs another 40 or 50 stocks. However, if the portfolio gets to be over 100 stocks, you may be paying a lot of money to someone who is not really trying to be an active manager. Bond portfolios are different and may contain a much larger number of issues.
Next you’ll want to examine the size of the biggest holdings. If the largest positions are over 7 percent or 8 percent, you’d better have a lot of confidence in the manager; you’ll be relying heavily on their prowess in picking just a few securities. You might be better off buying the securities yourself. Again, bond portfolios take a more nuanced approach, because a large position in U.S. Treasuries or agency securities doesn’t represent the same sort of risk as an outsized position in corporate or high yield bonds.
Let’s move quickly to a fund’s sector weights. Once again, you’ll want to shy away from extremes. If the portfolio is heavily concentrated in two or three sectors and largely void of most other sectors, you’re really looking at a sector fund in disguise. On the other hand, if the portfolio closely matches the sector weights for its index and holds 100 or more securities, you’ve probably found a “closet index fund.” A closet indexer is a fund that charges an active management fee but largely mimics an index.
Before discussing a portfolio manager, we’ll need to get a trading style sense. If you are investing using a taxable account, you’ll have to review the estimated difference between the pretax and after returns. The data are available on many websites and in the prospectus. If the gap is large, you might drop the fund from consideration, because you’re likely to lose too much of any gain to the tax authorities.
Even if you are investing through a tax-deferred 401(k) or IRA, turnover matters. The more a manager trades, the more it costs you in commissions, market spreads, and other transactions costs. While most websites show the amount of turnover in the portfolio for the past year, one year’s worth of data is insufficient. For example, all too many managers will slow their trading to an acceptable turnover rate of 50 percent, only to have it shoot up to 100 percent or 150 percent the next year. It’s time for you to get out an annual or semi-annual report. If you go to the bottom of the page entitled “financial highlights,” you’ll find the turnover for the past five years displayed across the page. You should look for consistently low turnover.
Stability is key
Since you are interested in active managers, you’ll need to know something about the people who are responsible for managing your money. I try to look for four characteristics in portfolio managers: stability, experience, commitment and focus.
Stability means that the manager or team has worked together for a while managing the fund. If the folks running the fund have only been working together for a year or two, I’d prefer if they learned their craft using someone else’s money. A manager can actually have too much experience. If I were still an active portfolio manager, you’d have to ask the same question of me. While it’s helpful to find managers who have been analysts and portfolio managers for a decade or more, you should dig more deeply. If one or more managers are nearing retirement, you might best look elsewhere, especially if the manager has an exemplary record. The next generation seldom perpetuates the record.
It’s time to dig into the “Statement of Additional Information” or SAI to find out about commitment and focus. The SAI is the document that is available for the asking, but is seldom requested because it is exceedingly long and deadly dull. Moreover, if you study it carefully, you might become angry because you’d discover that the trustees who oversee your mutual fund are making a nice fee for showing up for quarterly meetings. Admittedly, they have to read a lot of documents, but their job is mainly to bless the work of others. Moreover, you’d find out that most of them don’t have much of an investment in the funds they oversee.
Manager money at risk
We’re interested in a section of the SAI called “management of the fund.” It’s buried somewhere in the middle of the document. It will give you a rough indication of how much a manager has invested in the fund (commitment) and what other funds or accounts they manage (focus). Regrettably the SEC doesn’t require the fund to disclose precisely how much money the manager has at risk in their own fund, but the data will provide you some idea about whether they eat their own cooking.
By looking at the number and size of the other accounts the manager oversees, you might be able to judge whether the manager has enough time to truly pay attention to your fund and whether they have too much money to manage. For example, if the manager has dozens of mutual funds and institutional accounts, they may be spread too thin. If the total amount of money the manager is trying to invest across a single strategy (your fund plus all their other accounts) is too large, they simply might not have enough good ideas to add value for all their investors.
I know it’s a lot of work and I’ve covered a lot of ground in the past couple of weeks. The odds of successfully picking a group of value-added managers are long, but if you want to have a chance, you at least have to do the work.
Andrew Silton’s Meditations on Money columns can be found twice a month in The N&O’s Work&Money section. He is a retired money manager living in Chapel Hill. He was CIO for the North Carolina Retirement System from 2002-2005. He writes the blog http://meditationonmoneymanagement.blogspot.com/