How To Select The Right Fund To Invest In?

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One of the most frequently asked questions that I have seen and received is the question: “why did you choose to invest in fund A and not fund B?”

In this video, I am going to share with you how I analyze, compare and select the handful of funds to invest in among the thousands of other selections in the market.

Without further ado, let’s get started

1. Alignment to the overarching investment strategy

The first filter that I have is that the fund must be aligned to the overarching investment strategy both in terms of the underlying exposure and the fund management style itself.

Take me as an example, my strategy is to design a portfolio that enables me to capture Asia’s regional growth in the next 10-15 years while diversifying across the world.

Having said that, the funds that I will be including in the selection process would naturally be the regional funds and in particular the funds with Asia and Global market exposure.

This automatically excludes your country and sectoral funds as they are not aligned with the strategy.

From there, the next thing that I will look at is the alignment between the fund manager’s investment style and my style.

Obviously, you do not select a fund that has a completely different investment style from you as it will result in a very unpleasant experience as you try to ride through the ups and downs of the market.

Depending on your investment style, beliefs and methodology, the type of funds that would fall under your consideration will be vastly different.

While the market likes to generalize things to be either passive or active. I prefer to see things on a scale rather than in extremes.

On the left-hand side, you have your indexed funds that provide exposure to a specific sector, country or region. These are suitable for people who subscribe to the efficient market hypothesis.

On the right-hand side, you have your actively managed funds who pretty much invest in anything that they deem profitable. These are suitable for people who believe that the market is inefficient.

Somewhere in middle, you will have your passively managed funds that invest in a way that closely resembles the index but takes certain actions to improve its performances. This allows them to generate higher returns without deviating too much from the index itself.

As someone who does not subscribe to the efficient market hypothesis, I tend to seek out passively managed funds that can deliver slightly higher returns than the index without deviating too much from the index’s underlying exposure.

If there are no good passively managed funds, I will then fall back to the index fund itself just for the market exposure.

2. Operating history of the fund

After you had decided the categories of funds that are suitable to be included in your portfolio, the next step is to filter the funds within the category itself.

The goal of this exercise is to identify the “best” fund within each category and the challenge here is to separate the funds that performed well as a result of skill from the funds that performed well as a result of luck.

To do so, the first thing that I look out for is the operating history of the fund itself. You can find this information in the Fund Fact Sheet.

If a fund does not have an operating history of more than 10 years, it is quite difficult to decern whether its past performances are a result of the proper skill of the fund manager or just dumb luck.

In addition, it will be good if the fund had a long enough operating history such that they had experienced periods of recession or financial crisis.

The reason for this is because it shows that the fund can survive and come out of a difficult environment and that alone is an indication that they are doing something right.

To give you an example of what I mean, look at ARKK.

Even with an operating history of 8 years, the fund itself underperformed the benchmark despite having periods of significant outperformance.

Given such a situation, can you be confident to say that the short-term outperformance is a result of skill and not luck?

I can’t and that brings me to my next point.

3. Past performance

Now that we’ve filtered out the funds that are not in the category that is suitable to be included in your portfolio as well as the funds that do not have more than 10 years of operating history.

The last thing I will look at is the past performances across the last 10 years.

With a long enough operating history, you can tell a lot about the fund manager’s skill by looking at how the fund had performed against the index as well as its peers.

Typically, fund managers who are skilful at what they do would generate a return that looks like this:

Minor outperformance that accumulates and compounds over time instead of what we’ve seen from the case of ARKK which is the case of a short term outperformance that is not sustainable in the long run.

Apart from just returns, we will also look at the risk-adjusted performance across the sectorial average

Ideally, a fund manager who is good at what he does will provide a higher return given a unit of risk which is measured by standard deviation. As such, at any given standard deviation, the best fund is the fund that provides the highest return over a long duration of time.

Summary

So, there you have it, these are the three things that I will run through before determining whether a Fund is worth being included in the portfolio.

To recap, the first criteria is that the fund’s underlying exposure and management style must be aligned to your investment strategy.

The second criteria are that the fund must have a minimum operating history of more than 10 years.

The third criteria are that the fund must performance must be consistently better as compared to its sectorial average for both total returns and risk-adjusted return.

Daniel is a Licensed Independent Financial Consultant with MAS and a certified Associate Wealth Planner that provides: