Wednesday, March 10, 2010

The Mutual Fund Funnel

The primary task your financial advisor should perform is to provide you with a comprehensive financial plan. The plan should include an investment management section which outlines your strategy for managing your investment portfolio. First and foremost, this section should identify an appropriate asset allocation mix between stocks, bonds, and cash. This mix should coincide with the investors' risk tolerance. Next, the plan should determine a diversification strategy that outlines how much of the portfolio will be invested in certain asset classes, such as large cap stocks, international bonds, and money markets. Some of the more common asset categories include:
  • large cap growth and value stocks
  • mid-cap growth and value stocks
  • small cap growth and value stocks
  • international growth and value stocks
  • emerging market stocks
  • government bonds - short, intermediate, and long term
  • corporate bonds - short, intermediate, and long term
  • international bonds - short, intermediate, and long term
However, after we determine how much of our portfolio is going to be invested in each of these asset categories, we still need to identify high quality investments. This is where the mutual fund funnel can be of use. There are currently over 26,000 mutual funds. How do we know which ones to trust?

Start by only considering funds that invest in the asset category you are looking for. In our example, we'll assume we are looking for a large cap value fund. Of the 26,000 funds available, only 1,076 invest solely in large cap value stocks.

Of course, we want a mutual fund that is going to achieve superior investment performance. As we all know by now, past performance is not an indicator of future success. However, if you were looking for a coach for your basketball team, would you want a new coach with an unproven track record, or would you jump at the chance to hire Phil Jackson? We can further narrow our search by looking for a fund that has achieved above average performance over 3, 5, and 10-year investment horizons. This reduces the number of funds under consideration to only 143.

What are the other qualities we typically look for in a mutual fund? Ideally, we'd like to have a no-load (no-commission) fund, and we'd like the fund's annual management fees (or expense ratio) to be below average. After applying these filters, we are now down to just 45 funds.

The next filter is one that investors often forget about: manager tenure. Of course, we'd prefer a manager with two decades of experience to one who is straight out of training. Additionally, if a manager has only been with a fund for three years, he isn't the person solely responsible for the funds 5 and 10-year performance. Let's further narrow our search to funds who have had the same manager for at least 10 years, and we are now down to just 11 funds.

Lastly, trading costs can decimate a funds return. In fact, according to a recent Wall Street Journal article, the average mutual fund incurs trading cost of 1.44% in addition to its expense ratio (unfortunately, this expense is not required to be reported). Let's wrap up our search by focusing on funds with a below average turnover. We are now down to 9 funds.

Using this funnel, we have now narrowed our search from over 26,000 funds to just 9, and I would suggest that any of these nine funds are likely to be productive members of a portfolio.

This article was written by Lon Jefferies of Net Worth Advisory Group. Learn more about Net Worth Advisory Group at, or visit Lon's blog at

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