Education

How to Build a Profitable Mutual Fund Portfolio

When Is the Right Time to Sell a No-Load Fund?

The Role of the Fund Manager (and How to Pick One)

How to Build a Profitable
Mutual Fund Portfolio

If you agree that mutual funds offer opportunities for profit and safety, where and how should you allocate your assets? First, it's a good idea to own several funds. For investors with a $100,000 portfolio whose primary goal is growth, we recommend as many as nine funds diversified in various segments of the market. Owning more than one no-load doesn't cost any more. When your funds are properly selected, you gain the benefits of diversification and management expertise, with significantly less risk.

Know what you own.

If you currently own funds, begin by grouping them according to their objectives. For this task, a pad and pencil are all you need. Lists the riskiest funds in the aggressive equities section, growth-income funds in the conservative equities section, bond funds (corporate or municipal) in the fixed-income category, and money market funds in a section of their own.

The categories are not hard and fast. For example, if you are primarily interested in income, and have that orientation in your portfolio, you may want to put growth-income and income funds, which contain high-dividend stocks, in the income category. Growth funds could be placed in the aggressive growth category.

The financial pyramid.

Once you know exactly what you own, you should evaluate your portfolio, and make changes whenever necessary to ensure that your assets conform to your objectives. For example, even if your primary goal is aggressive growth, that doesn't mean that all your assets belong in aggressive growth funds. You should have the majority of your assets in more conservative investments and even a bit in cash so that your portfolio will never suffer catastrophic losses. Similarly, even if your objective is current income, don't put everything into fixed-income funds. Some of your money should be in income-producing stock funds to provide protection against inflation.

Lower-risk investors should apply the principle of the financial pyramid. (See above.) First, put the largest part of your assets in safe investments that provide a decent return. Next, invest in securities that provide for long-term growth of capital. Then put a smaller portion of your capital in more speculative vehicles. A small amount can go into high-risk vehicles that promise a high return if successful--but could result in a substantial loss.

18 model fund portfolios.

We divide investment objectives into categories oriented to the investor's lifestyle goals, ranging from growth to retirement income. Then The No-Load Fund Investor provides sample fund portfolios for each category. Each portfolio contains between seven and 10 funds. None of the portfolios are speculative or high-risk.

Here are the three lifestyle orientations that guide the selection of funds:

• The Wealth Builder approach is designed for working investors whose goal is capital accumulation. This is our riskiest approach, though even here we may stress low-risk funds. Current income is not a factor in this portfolio, so bond funds are often excluded. This portfolio has achieved outstanding results while investing conservatively.

• The Pre-Retirement strategy is more conservative. Designed for investors who are within 10 years of retirement, it generally avoids big positions in the aggressive growth funds that can suffer the greatest short-term losses. This portfolio normally invests in fixed-income, equity income, growth-income, and lower volatility growth funds.

• The Retirement orientation emphasizes income and capital preservation. A portion of the portfolio is generally invested in equity income and growth-income funds as an inflation hedge.

A word of explanation is necessary here. Our three "Master Portfolios" contain our top recommendations drawn from all funds and fund families. These recommendations are replicated in 15 additional portfolios, which invest via single fund families and "no-transaction-fee" brokerage programs. (See our Model Portfolios page.) That's a total of 18 portfolios you may choose from, depending on your goals and preferred source for transactions.

We also offer three "Best Buys" ETF-only portfolios on a subscriber protected portion of our website.

Remember: these are only models. They can be followed to the letter, but each investor can make adjustments for his or her own risk preferences and lifestyle. With no-load mutual funds and ETFs, you can build a portfolio that's profitable and safe--to achieve wealth and guarantee your financial security. Our goal is to keep you in the best-performing funds and ETFs, in both good times and bad.

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When Is the Right Time
to Sell a No-Load Fund

One of the most frequently asked questions we hear, from both the press and individuals, is when to sell. The questioners almost always want a simplistic answer. The question is usually phrased as "How many months of underperformance before I sell? Six months, twelve months? Tell me exactly."

We’re sorry, but it’s just not that simple, and there is no reliable rule of thumb. In order to know when to sell, you need to know the reasons for disappointing performance. Basically they fall into three categories.

Three Types of Poor Performance

Market confidence. If you think the overall market is going down, this may be a reason to sell. Down markets obviously create poor performance. In this case the number of months of sub-par performance is irrelevant. If you decide to liquidate part of your equity holdings due to lack of market confidence, you would most likely sell the most volatile positions, because they would typically decline the most in any downturn. Most of our selling down in Best Buy portfolios during 2000 was because of weakening market conditions.

Changes in market leadership. This is the most common reason for underperformance in a given asset class or sector. It is, unfortunately, commonplace for investors to buy toward the end of a cycle of leadership. For example, if growth funds outperform value funds for two to three years, most investors will then shovel money into growth funds. Almost invariably, that is when the cycle ends. Value becomes ascendant, and the new growth fund holders find their funds lagging. Leadership can shift from value to growth, as in the early to mid 90s, or from growth to value, as in 2000. Similarly, small cap and large cap funds rotate leadership. Sector leadership also shifts, as we saw with technology’s rise and fall. This type of underperformance can be identified by checking performance of a fund’s peers in the same category. If the whole category is down, an adverse change in market leadership is the cause.

What are the rules for selling when leadership changes? That’s a tough one. The cycles between growth and value and large and small caps are erratic and extremely difficult to forecast. Also, keep in mind that these cycles don’t mean fund managers are making bad decisions. Brian Rogers, a classic value manager, had several years of underperformance in the late 90s, when growth led. This didn’t mean Rogers had lost his ability to pick stocks. He was simply staying true to his discipline. When the growth bubble was pricked in 2000, Rogers returned to above-average performance, and T. Rowe Price Equity Income has ranked highly now for years.

Our recommendation is to adopt a policy of modestly over or under weighting asset classes or sectors as leadership shifts. For example, if value is leading, we might allocate around 60% to value and the remaining 40% to growth. If growth then pulls ahead, we might reverse the percentages—60% to growth, 40% to value.

One problem that can be related to leadership changes is called "style drift." This happens most commonly when small cap stocks are out of favor, and some small-cap managers slide up to mid-cap stocks. In theory, this shouldn’t result in poor performance. But it can if leadership reverts to the fund’s original mandate and the manager is slow to fall back in step.

Individual fund problems. Sometimes a fund’s performance falters while other similar funds are doing well. While there could be many reasons, most fall into three categories: 1) The manager has changed; 2) the fund has grown too large; or 3) the manager has lost his or her "touch."

A manager responsible for strong performance in a prior period may have left the fund. Or, if still with the fund, he may have become too rich, tired, inattentive or unlucky to remain successful. Some fund managers run into a string of bad buys, just like baseball players fall into hitting slumps. We don’t want to name names here, but there are a few iconic managers from the 80s and 90s whose funds aren’t world-beaters anymore. In some cases, these managers have grown fabulously rich after selling their management companies to large fund complexes. No longer do they put in the hours needed to excel in the stock-picking business. There was a case years ago of a fund that had been number one in America for several years, and then collapsed to near last place for another several years. After making discrete inquiries, we came to the conclusion that a major reason for the fund’s declines was the manager had four girlfriends in four cities. He had been distracted from his principal task.

Growth in assets can become a problem, particularly for small-cap funds. However, it’s hard to tell when a fund gets too large. Small-cap funds have closed with less than $150 million in assets, while others have done reasonably well with far greater amounts.

Good Reasons to Sell

There are circumstances that require an immediate fund sale, such as suspicion of fraud or a sharp decline in the fund’s NAV due to revaluation of portfolio holdings.

Selling funds that are in net redemptions, for whatever reason, is almost always a good idea. It is harder to manage these funds, and when they sell off stocks to meet redemptions, larger capital gains distributions may follow. Exceptions might be a quarter in which a large capital gains distribution is made or modest redemptions because of a bear market.

In cases where the problem is with the individual fund, it is wise to allow the fund a set number of months of underperformance. If the fund’s underperformance exceeds perhaps six months to a year, sell.

Selling for non-performance reasons. The article basically discusses selling because of poor performance. You, of course, may find non-performance reasons to sell, such as a need for more liquidity or money to fund a large purchase. This is a very different situation and can be done at any time.

Selling funds you never should have bought in the first place. Examples: high expense funds including 12b-1 funds, inappropriate funds that are either too aggressive or too conservative, and certain sector funds that don’t meet your objectives. These funds can be sold immediately, and the money reallocated to more appropriate funds.

In sum, there are a number of times when you should sell. In only one case—problems at the individual fund level—is the months of underperformance relevant.

How We Make Sell Decisions in Best Buys

If a fund in Best Buys is doing at least average, we will not delete it simply because another fund may be doing somewhat better over the short term. Ultimately, longer holding periods mean better after-tax returns. If a fund is deleted for performance reasons, its replacement will be one of its peers. However, if it is dropped for reallocation reasons, another type of fund will replace it.

Because of these practices, it is quite possible a fund can be dropped from Best Buys and yet retain its boldface listing in the tables. Occasionally, the reverse is true in the single-family portfolios. This happens when we need a fund for diversification purposes, but see no ideal choices available in a particular family.

The Role of the Fund Manager
(and How to Pick One)

The consensus view in the fund field holds that manager selection is a major key to achieving superior performance. This thinking has produced the cult of the manager, who is the public face of most funds. Although many talented people contribute to a successful fund, the manager is usually the one quoted in newspapers, interviewed on TV, or invited to speak at financial conferences.

Interestingly, this wasn't always true. When we published the 1983 edition of our Handbook for No-Load Fund Investors, we decided to list managers in our individual fund profiles. No publication had ever done that before, so we encountered plenty of opposition from the funds. About a fourth of them wouldn't cooperate with our request that first year. They wanted their investors' allegiances to be to the whole company, not just the manager.

This started to change when Peter Lynch began managing Fidelity Magellan. By 1983, Lynch was compiling an outstanding record, and Fidelity saw the value of promoting his persona. When the press and public responded enthusiastically, Magellan's assets zoomed. Within a couple of years, we had no trouble obtaining managers' names for our Handbook.

On July 1, 1993, the SEC made this practice official, adopting a rule requiring mutual funds to identify their portfolio managers. In a nutshell, the rule mandates that mutual funds disclose in their prospectuses the name, title and background of persons who are primarily responsible for the day-to-day management of the funds' portfolios. Money market funds and index funds are excluded from this requirement.

However, the SEC offered one out. If all investment decisions for a fund are made by a committee, and no one person is primarily responsible for making recommendations to that committee, the fund may state that fact in lieu of identifying committee members.

Of course, in an age of marketing, most groups are not content to use the term "committee," which implies lack of individual responsibility. Many prefer to use "management team." Years ago, American Century funds clarified the difference by explaining that any member of their team could make decisions alone. Some alternative phrases now in use include: multiple portfolio counselor system, equity value research team, investment advisory council, and board of trustees. Some funds refer to teams (or the equivalent) when their managers actually are sub-advisors or when there are multiple managers for a single fund. That's something completely different. In the latter case, two or more investment advisory groups each manage discrete segments of the fund. For example, a balanced fund may have one advisor for stocks and another for bonds. A team works together, but sub-advisors or multiple managers don't have to.

A few decades ago when most funds had far fewer assets than they do today, funds were generally run by a single manager. As the funds and the industry grew in size, more and more funds found that multiple managers worked better.

Which is more important--the manager or the management company?

It is generally assumed that the manager is the most important, but a recent academic study says otherwise. The study, conducted by Klass P. Baks, an assistant professor of finance at Emory University, looked at the performance of funds with different managers and managers at different funds from 1992 to 1999. He found that, on average, about 70% of the difference in performance between various funds can be attributed to the fund companies and just 30% to the managers.

Let us be clear. This doesn't mean the manager is unimportant. Only that the group, on average, is more important.

This study confirms what we have long believed, although we take the analysis one step further. We have always differentiated between large and small groups. Clearly, when you invest in a large group, the group organization itself is more important than the individual managers. With small stand-alone funds, the reverse is usually true.

Fidelity Investments' managers are supported by more than twice as many analysts, traders and other management professionals. While Fidelity says that the degree to which individual managers rely on analysts varies from fund to fund, it is quite obvious that the company's overall team depth is the most important factor in the performance of the Fidelity funds. Also, manager turnover is another factor minimizing the importance of managers. The average Fidelity manager shepherds any particular fund for only about three years. Few of its managers have been with a fund for 10 years or more.

In the smaller fund groups, where managers often are owners, the manager is the key figure. Some have been there for decades. Chuck Royce has 30-plus years at Pennsylvania Mutual. The team at Dodge & Cox has been there for decades. If you own the fund, you don't quit to start another one.

In the mid-sized groups, it's a bit of both. For example, Ron Baron is listed as the portfolio manager on three Baron funds, and he most certainly dominates the investing process. Mario Gabelli is listed as solo or team manager for many Gabelli funds. However, these groups have deep talent, too, with many excellent analysts and traders.

While there is no doubt that a fund needs competent management to be successful, many other factors influence performance beyond the professional staff. These include the sector of the market in which the fund invests (large-cap, small-cap, tech, health, etc.); investing style (growth, value, growth at a reasonable price, etc.); fund size; and costs. So, when you hear a manager pontificating on TV, put his role into proper perspective.

How to pick a manager

It seems to us there are three ways to evaluate a manager: 1) Listen to the manager talk, either in person or on TV; 2) Ask the manager questions; 3) Check the performance record.

We stress the third alternative, checking the performance record. All too many managers talk a great game but don't deliver performance. We don't believe there is much correlation between the ability to pick stocks and the ability to be a great guest on TV. Some good stock pickers are good guests, but others are not. Conversely, and unfortunately, some terrible stock pickers are good guests. Since the media look for engaging personalities, those are the people who get the airtime. Just remember that it's easier to talk the talk than walk the walk.

The next time some publication touts a "great" manager, consider the basis for the claim. Chances are they are relying on the manager's record as the reason. So, why not just ignore the personality and look at the record?

There are other more indirect factors we think are important, but we must confess they are hard to nail down, and nearly impossible for the layman to do so. Nevertheless, they are worth discussing.

Investing is a vast endeavor. There are thousands of stocks to consider, and culling through them properly takes a lot of work. So, it's not hard to understand why we believe there is a distinct correlation between how hard a manager works and his results. Accordingly, we put a premium on energy and motivation.

The restrictions on a fund's objective or style can trump the skills of even the most competent managers. In the last bear market, managers who were overweighted in growth or tech stocks lost more than more conservative managers, and their knowledge or experience didn't matter a whit.

We also prefer managers who put their investors' interests first. That means keeping costs and portfolio turnover down, as well as not doing things that will get them in trouble with the SEC. It also means managing on an after-tax basis when possible, and in the case of small-cap funds, closing the fund to new investors before it becomes too unwieldy to manage. Managing on an after-tax basis may be a conflict of interest for some if their bonuses are based on pre-tax performance. Similarly, closing a fund restricts asset growth, often a very important variable in compensation.

If the manager has his own money in the fund, that's a good sign. This is hard to track, but many managers who do invest in their funds will readily tell you they "eat their own cooking." On the other hand, don't consider it a negative if the manager doesn't invest in the fund. There are many legitimate reasons why they wouldn't, such as the fund's objectives not matching the manager's personal needs.

Then, there is the matter of discipline. Generally speaking, we prefer managers who hew to their discipline, particularly in this age of market segmentation. If they don't, it makes it very difficult for the investor to make his own allocation decisions, because he can't be sure the manager is covering the segment the investor needs filled. However, it can also be argued that flexibility is more important than strict discipline. What does a small-cap manager do when large-caps are in favor? What does a value manager do when growth is in favor?

There is the interesting example of Bob Sanborn, who managed Oakmark fund from 1991 to early 2000. He turned in fabulous returns when value was in favor, but when growth became ascendant in the late 90s, the fund became a laggard because Sanborn stayed with the value discipline. In March 2000 he was fired. That was severe punishment because it was only a few months later that growth began to bomb and suddenly all the beaten down value managers, including his successor, began to look very good.

Finally, we like managers who are not afraid to be different. Managers who follow the herd will never produce more than average results.

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