Selecting Diversified Investment Funds -- Mutual Funds and ETFs

Rational selection of bond mutual funds and equity mutual funds -- overview

Given the extremely large variety and number of available fixed income and equity investment funds, investors need a rational basis to select among them. Without scientific selection criteria and a good understanding of which factors are more or less likely to increase risk-adjusted returns, investors will make erroneous decisions based on false assumptions.

The most effective strategy to increase your mutual fund and ETF investment returns

Just reduce your investment fees to rock bottom and buy directly to eliminate all sales loads. This strategy is both simple and entirely within your control. You do not have to be smarter than all those other smart investors out there. You do not have to take on the Herculean and very time consuming task of trying to "beat the market." With this smart, low cost investment strategy, you only have to be a better bargain shopper, when you buy your investments. If you cut your costs, your investments could be worth 40% more after 30 years, using reasonable investment expense savings assumptions.

Evaluate historical investment performance, but only after using other investment screening criteria

Choosing only from among mutual funds and ETFs that have performed very well in the past can lead to significant selection mistakes and inferior personal portfolio returns. Previous superior or average fund performance simply does not predict similar fund performance in the future. However, there is modest evidence that substantially inferior past fund performance is more likely to lead to continued inferior performance in the future, which is probably due to the excess costs of substantially inferior funds.

Choose mutual funds and ETFs with lower investment management expenses

Investment fund management fees can only be justified, if they lead to higher returns that more than compensate for the fees. Sadly, this is most often not the case with actively managed equity and bond mutual funds. In addition, you have no reliable way to tell beforehand which active fund will return more than its costs, when compared to a passively managed index fund.

Avoid mutual funds and ETFs with sales loads, commissions and 12b-1 fees

There is no convincing evidence that sales loads and other sales fees charged to investors result in higher performance. The opposite has repeatedly been proven true. Paying a load just means that you are throwing your hard-earned money down a hole.

Avoid mutual funds with higher investment portfolio turnover

The problem with high turnover is that higher fund trading adds substantial hidden expenses that drag down returns. Because short-term trading is a zero sum game (before costs) played against other well informed traders, greater turnover is far more likely on average to result in lower fund returns instead of superior risk-adjusted performance. When trading is greater, then even higher returns are required just to break-even on the higher associated trading costs.

Avoid very large actively managed mutual funds

Big fund portfolio positions and higher percentage ownership of any company's bonds or common stock are not good things for actively managed funds. Nor, are these big positions and high percentages good for you. Large size constrains how a fund can trade and how efficiently it can do so. When an actively managed fund becomes very large, it must manage its trading exceptionally well or it will suffer significantly higher transactions costs, which tend to cause lower net performance.

Choose sufficiently mature mutual funds and ETFs

Investing in more mature equity and bond mutual funds and ETFs allows you to evaluate the historical consistency of a fund's record. On average, the future portfolio returns of more mature funds are probably no more predictable than for very young funds with a similar style or strategy. However, the record of accomplishment of a more mature fund can provide more confidence in its commitment to its strategy and in its ability to remain in business. While there is no guarantee that an older fund will not fail, you have a better chance to avoid involuntary participation in the frenetic birth and death process of many infant funds.

Choose mutual funds with a minimum economical portfolio size

If you are going to invest in mutual funds and ETFs, then you should want them to have a sufficiently large asset base to fund adequately their administrative and research expenses. If an investment fund is too small, then fund management quality can suffer or fees could grow. While index funds have lower personnel overhead that active funds do, all mutual funds and ETFs have administrative costs that must be covered. Because of their lower costs, the minimum economical size of passively managed index funds is lower than that of an actively managed fund.