For most people, researching individual stocks is a very complex and involved process that requires time and knowledge of the market. Even those who earn a living doing market research have difficulty selecting the best stocks for themselves or prospective clients. In most American households, where there often is limited time to conduct market research and where funds to invest often are limited, it is difficult to establish and maintain a properly allocated and diversified portfolio on your own. It is easy for portfolio managers with $500 million in capital to set rules to limit the total percentage value of each stock to between 5 percent and 10 percent of the total value of the portfolio. But what about the individual investor who has only $1,000 to $5,000 in cash to invest? After paying commissions to an investment firm, one might be able to buy only 4 or 5 shares of each stock.
Purchasing shares in a “mutual fund” is an easy way for you to achieve the desired portfolio diversification. A mutual fund is a security that gives small investors access to a well-diversified portfolio of equities, bonds and other securities. Each shareholder participates in the gain or loss of the fund. Shares are issued and can be redeemed as needed.
Each mutual fund is managed by a qualified portfolio manager whose sole job, ideally, is to obtain a solid return for those who invest in the fund. There are thousands of mutual funds with thousands of managers whose styles and strategies vary widely. It is your job as an investor to make sure that you select the fund that is most appropriate for your needs and preferences.
With such a variety of funds, however, how do you select the best one for you? Here are a few key areas to consider when selecting a fund.
No-load mutual funds. These are sold directly to customers at net asset value without a sales commission. Because commissions can erode the long-term return of a portfolio, I select “no-load” funds for my clients. Many investment advisors will suggest “loaded” funds, which generate a commission when bought and sold. For each loaded fund, however, you can find five no-load funds that can give you an equivalent or better return.
The following table shows the impact of commissions on your investment portfolio. Both scenarios reflect an investment of $500 per month, at a 10 percent yield, for a period of 40 years. The commission scenario assumes monthly commission charges of $50 per month.
Management tenure. The manager of the mutual fund should have significant experience in directing the fund’s investments. Be sure to determine the success a particular manager has had in managing the mutual fund. If you see that a mutual fund has a five-year history of averaging a 20 percent return per year, find out if that performance was generated by a previous manager or by the current manager. You get a better sense of how well the fund is managed when the management in place has directed the fund for at least five years.
Morningstar rating. Morningstar is a well known and respected analyst service in the securities industry that rates funds based on their performance against that of their peers. One star is the lowest rating, with five being the highest. Generally, it is best to select funds with a minimum rating of four stars.
Risk rating. If you want to sleep well at night, select funds that do not carry excessive risk. High-risk funds show that the manager’s investment strategies, or the investments he or she selects, are often very volatile. I usually suggest that the risk rating of a fund be from low to average risk compared with its peers.
Performance measurement. Per-formance measurement is the calculation of return a money manager is able to achieve over a stated time interval. It is common practice to measure a fund’s return over the past three, five and 10 years of the life of the fund. The return normally is assessed by comparing it to a benchmark over the same interval. One commonly used benchmark is Standard & Poor’s index of 500 “large-cap” (market capitalization of more than $10 billion) corporations, or the S&P 500. A mutual fund that has outperformed the benchmark during all three time intervals under the same manager is a good indication of a quality investment strategy.
In the example below, a hypothetical mutual fund, VWXYZ, outperforms the S&P 500 in every time interval measured, indicating a good choice for an investment.
Exchange-traded funds. In order to receive ultimate diversification, one would have to purchase every stock in the entire market. This sounds farfetched, but it isn’t entirely impossible. Some funds are designed to trade according to how an entire index trades. It would be as if you purchased every stock in the stated index.
If you are just starting out and don’t have much money to invest, it may be prudent to simplify your portfolio even further, beyond mutual funds. An “exchange traded fund,” or ETF, is one of the best portfolios for beginning investors. This kind of fund tracks a specific index and represents a basket of stocks in that index, like an index fund. However, it trades like a stock on an exchange and therefore experiences price changes throughout the day as it is bought and sold. The two main advantages of owning an ETF over a mutual fund or a stock are:
• You receive the diversification of an entire index;
• The expense ratios are lower than those of the average mutual fund because ETF trades are computer-generated.
The investor who is looking to start a portfolio from scratch, with less than $4,000 per year to invest, should allocate 80 percent of the portfolio to ETFs and 20 percent to a no-load foreign mutual fund.
Ryan C. Mack is founder and CEO of Optimum Capital Management L.L.C., a wealth management firm in New York City. He can be reached at email@example.com.