Book of Wise Investors

Although there are more causes for investing in a passively managed index fund/exchanged-traded funds, in certain specific circumstances, such as shorter holding periods, or identify that a certain sector is going to become hot in three years time, or simply believe in the advices of bank relationships managers and financial advisers, decides to allocate some investment dollars in actively managed mutual funds, then what are some basic rules to follow when deciding on this type of mutual funds, given that there are even more actively managed mutual funds than index fund/exchanged-traded funds and all the stocks listed on stock exchanges combined.

The following seven rules are crystallized from various opinions and sources found online and offline, which I think are correct to a great extent

Principle One – Index investing still returns better than active funds over the long run, at least in a statistical sense

In my opinion, or least the conclusion that I reached, is that in the long run of more than 10 years, passive index investing is still highly likely to do better than actively managed funds by so called professional fund managers. As a consequence, it is wise to place more of your investment dollars in index funds/ETFs instead of active managed funds.

A general rule of thumb is no more than 30% of your portfolio for stocks and bonds. In addition, it will be wise also to set a limit of not more than 0.50% for the total overall average expense ratio that is average of all passively managed and active mutual funds.

Principle Two – Funds costs are important, every percentage on fees counts

Consider all the actively managed funds to choose one that is the lowest cost among all for similar active mutual funds. This is like choosing the lowest expense ratio for an index fund.

Any actively managed funds that require up-front commissions, known as load fees, please don’t even consider buying. Simply because, there will be similar active funds in terms of fund objective, investing strategy of fund managers, sectors or regional, that have no load, also known as no-load funds.

Then from the short listed no-load funds, choose one with lower net expense ratio and management fees than the rest for the same fund objective, investing strategy, sectors, regional etc. In other words, same or similar funds for lower costs.

Principle Three – Avoid “active” funds that behaves like index funds

Actually, there is a little known secret in the wealth management industry. That is, the fund and money managers actually do not aim to beat the market; they are aiming to beat fellow fund managers in the mutual fund industry. In other words, there is no need to beat the markets when almost every expert is unable to, just need to be the top among the “experts.”

As a result, what is the best way to achieve the top fund more than 8 years later, simple, no need to hire first class honors as fund managers, just market a passive index fund as “active” managed fund and achieve market return, which most probably achieve better returns than more than 50% of the actively managed funds. Remember, not only do past historical data shows that stocks return the most than other asset classes, past historical data also shows that the longer the holding period, the better index funds returns, relative to actively managed funds, on average of all index and active funds. What a good way to improve profit margins of mutual fund companies!

Then how do you recognize an “active” fund being market as index fund?

To do so, you will need access to some mutual funds analysis programs and aware of a statistical concept called R-squared which measure the correlation of the active fund to the index that the prospectus claim it is trying to beat.

For example, for a large cap United States fund that invests in large market capitalization companies, a so called actively managed by a professional fund manager, if it got a R-squared of more than 80%, meaning to say 80% of the fund’s assets are identical to S&P 500, or that the value of the fund is almost 80% positively correlated to S&P 500, isn’t it better to invest in an index fund that tracks S&P 500 with much lower management fees?

A much easier approach is to go to Yahoo Finance or any other similar financial websites, search for the fund you are interested in, then find the graphical chart for past one to five years performance and superimposed it with the index that most of the stocks that the fund holds is in. If they superimposed almost perfectly, I think you may as well invest in the index and achieve better returns due to lower fund expense and management fees.

Image Credits: oskay

Principle Four – How does the active fund performs in a prolong bear market?

In a bull market lasting more than one year, I think even a monkey throwing darts can also achieve positive returns. The real test of a fund quality does not come from a finance magazine naming it as the top mutual fund of the year but from how it performs during a bear market, especially a long bear market.

As a result, checking the fund performance during recent bear markets of 2000 to 2002 (after the dot com bubble burst together with 911 attacks) and end 2008 to early 2009 (after the full brown effects of subprime mortgage crisis show its ugly head), if it does not do too badly compared to other similar others and even the index, then it will most probably also not do too badly in the next bear market in future.

Principle Five – Small cap for funds, blue chips for index and direct stocks ownership

In a statistical sense, small cap is more risky as only some but not all will become tomorrow Microsoft. On the other hand, today Microsoft is unlikely to achieve the same rate of growth like yesterday but safer in suffering from large price changes or collapsed, though there are exceptions like Bear Sterns, Lehman Brothers, Enron and Worldcom.

Investing in an active fund of small caps stand a higher chance of achieving greater returns than an active fund of large cap or blue chips, the logical explanations for this follows from larger and well known corporations like MacDonald, Coca Cola, Intel and Microsoft tend to stick in the minds of masses and analysts as well and they will follow their news and prices closely.

This is in stark contrast to Microsoft more than 20 years ago when almost everyone don’t know what it is. As a result, the professional fund manager has a higher odd of discovering a hidden treasure that will become tomorrow MacDonald and Google.

Research has also shown that stock prices are more efficient for large cap blue chips than small caps.

Principle Six – Long term performance matters, not short term performance of one year or less

We have been told repeated that past performance does not equal to future results. But how long is that past, if past performance of 10 years or more does not equal to future results, wouldn’t it be even worse for past short term performance?

The past return of a fund is often the only factor that most people consider when investing in mutual funds but it should not be the only factor. Many finance magazines regularly feature the best fund of the year for a fund that do the best during the past year but the best fund of the year usually keep changing every year, suggesting that the fund manager is most probably get lucky during that year.

You do need to consider past performance for actively managed funds, in addition to others as described here. But the past had better be 10 years or more, not the recent 12 months.

Principle seven – Choose a well known mutual fund company

Unlike index funds and exchange-traded funds, there are many scandals surrounding active funds such as the infamous Bernard Madoff. The last thing you want is losing money unnecessarily given that equity exposure is already risky in the first place.

In this aspect, it will be wise to deal with well known fund company like Vanguard, T. Rowe Price and Dodge & Cox etc.

Related posts:

1. Deciding between actively managed mutual funds and passive index funds
2. Essential knowledge in choosing stocks mutual funds to invest
3. Neglected risk when invest in stocks and bonds through mutual funds and ETFs
4. Are you aware of what your mutual funds own?