Although there are likely as many mutual fund selection approaches as there are investors, for this discussion, we have divided the most common approaches into two categories:
At the end of this section, we will review the methodology used by MutualFundAlliance.com in selecting our mode portfolios and how they relate to the above two approaches.
Fund screening is by far the most popular means of mutual fund selection. Fund screening was made popular by Morningstar when they first created tools that enabled mutual fund investors and financial professionals to use a computer to search through the universe of all funds looking for funds that met certain characteristics. Now through the use of the internet, and portals such as Yahoo! Finance, fund screening tools are available to everyone. Here is how it works:
In the Sections below, we describe these steps in more detail.
In developing your initial set of screening criteria, you need to take into account all that you have learned thus far in this book, including:
To help you get started, Morningstar provides through Yahoo! Finance a set of pre-determined mutual fund screens that take some of the above factors into account. These include:
The problem that we find with these typical types of fund screens is that they don’t overtly take into consideration the factor that we feel is the most important in fund selection: Your outlook for the economy and the stock market. Although we feel that patients is the golden rule of investing and that we should be investing for the long-run, it would be foolhardy to ignore current economic conditions. Let’s take a look at what we mean.
At the end of 2003, the economy is in a rapidly growing state, interest rates are low, and the unemployment rate is declining. Most economists feel that it is likely that the economy will continue to expand in 2004 and unemployment will decline. As we learned in Chapter 2, and the economy expands and unemployment declines, interest rates are likely to increase. As a result, bonds yields are likely to increase as the price of bonds decline. Therefore, a prudent investor will want to lower their holdings in bond mutual funds and balanced mutual funds and increase the portion of their portfolio in growth mutual funds.
Therefore, you will want to make sure that your mutual fund screen takes these factors into account. In addition, you may want to further refine your screen to fund types. For example, you may want less exposure to value funds and higher exposure to aggressive growth funds.
Once you have customized your fund screen for your market outlook, you can further refine your fund selections by analyzing how your funds have performed in the past in similar markets. For example, if you feel that the market’s performance in 2004 will be similar to the market in 1994 (the year following the last economic downturn) you may want to analyze how your selections performed in 1994. But you can’t always count on a fund performing similarly to the way it performed 10 years ago, with management turnover and different economic conditions. Therefore, you may also want to take a look at its asset class weightings and its industry weightings. You can then make a determination as to how you anticipate those asset classes and industry sectors will perform over the next 12 to 18 months.
There are many fee-based and free fund screening tools available on the internet. These include:
To illustrate the mutual fund screening process, we will use Yahoo! Finance.
For this particular illustration, we’ll begin by using the following criteria:
Using the above criteria, we can log onto http://finance.yahoo.com and navigate our way to the Mutual Fund Screen Tool. A short cut to the tool is at the following address: http://screen.yahoo.com/funds.html.
When we enter the criteria from the previous Section, one fund makes its way through the screen: Vanguard Windsor. Although in the past, we have liked this fund, for our illustration here, let’s say that we want to widen our search for the following reasons:
For this example, since the screen didn’t give us much to choose from, let’s modify our criteria to broaden our search.
Let’s modify “Rank in Category” from “Top 10% to “Top 20%. By making this modification to the screen, we get the following funds:
In analyzing the funds that made it through the final screen, for this example, we chose Vanguard Morgan Growth. It is an aggressive growth, large cap stock fund. Based on our assessment of the economy, as outlined above, we are looking for a fund that does well at the beginning of bull markets. When we analyze the fund more closely, we see that this fund has a beta of 1.15, meaning that it experiences 15 percent more volatility than the overall market. That is good when you are expecting the market to expand. The other funds that made it through the screen didn’t have profiles that were consistent with our outlook for the markets.
Mutual fund forecasting models is a technique that has been used with varying degrees of success. Mutual fund forecasting was an approach first developed by those in academia and implemented by a few practitioners. This approach typically correlates the monthly performance of mutual funds with stock indexes. The result is a formula such as the following:
f = a + b*s
The above equation is derived with linear regression using standard software packages as Excel or SAS. But alpha and beta are readily available from most sources of mutual fund data, such as MutualFundAlliance.com, Morningstar, or finance.yahoo.com. You can then export the alpha and beta data to Excel and derive your own forecasts.
As you can see from analyzing the above equation, by using alpha and beta, you can input your own estimate of the return of the S&P 500 over a period of time and derive your own forecast for any given mutual fund’s return over that period of time.
Of course the only catch with this approach is having an accurate enough sense of the stock market’s overall return to have a meaningfully accurate mutual fund return forecast. Nonetheless, if you have an idea of the relative return of the stock market for a given year, you may feel that that may be enough data for you to make a relatively accurate mutual fund selection.
For example, if you feel that it will be a “strong” year for the stock market, then you may feel comfortable selecting mutual funds with a high beta relative to alpha. This will tend to be aggressive growth mutual funds. On the other hand, if you feel that the market will be declining you may want to choose funds with very low betas and high alphas, such as bond funds. Go ahead and take a look at the alphas and betas for funds using MutualFundAlliance.com or finance.yahoo.com and see how the types of funds relate to alpha and beta.
To add a little more science to this approach, the MutualFundAlliance.com has created and uses a model that analyzes each fund’s historical performance relative to various economic and financial statistics, such as corporate earnings by sector and the various stock indexes. Then based on our forecast for the economy and financial markets, we select funds for our mode portfolios that we anticipate will perform the best in those forecasted economic scenarios. This approach is a hybrid between a forecasting model and a stock screener, as described above.
Although we have created some pretty complex models to help us in our fund selection decision-making process, we make the results available to our members. In addition, you can always use the data we provide and calibrate our recommendations relative to your own assessment of the market.