5 pitfalls to avoid when selecting funds

By Larissa Fernand |  22-11-19 | 
 

We have been getting a number of emails from investors asking us what they should do about their poor performing value funds. Their apprehension stems from the mistake in not comprehending what these funds offer in the first place.

When investors assemble lineups for their portfolio, they must be cognizant of potential pitfalls that could trip them up down the road. Setting up things in a way that minimizes behavioural errors as well as exogenous investment risks can be just as important as, say, picking the right funds.

JOSH CHARLSON, director, manager selection, for Morningstar Research Services covers some of those potential traps and errors that can arise.

1. Getting blinded by the light of recent performance.

When selecting funds, it’s easy to get seduced by recent outperformance, but chasing short-term returns--even 3-year results--is a sucker’s game. There’s too much noise, with the potential for style bias or pure luck to be the swing factors in the results.

In addition, mutual fund returns are notoriously mean-reverting, so that outperforming funds during one period may be equally likely to underperform in the next.

Ideally, focus on strategies that have seen at least one full market cycle, and examine the fund’s full record under the manager responsible for it. Rolling return periods are also a useful lens, as well as discrete periods of both market duress (such as the 2008 bear market) and success (the last bull run).

2. Overemphasizing high active-share managers.

There’s an understandable tendency when picking actively run funds to emphasize managers with high active share, which is to say those who run funds that don’t look like the benchmark. The basic reasoning is that if you are going to pay the fees for active management, you might as well find managers whose portfolios look nothing like the benchmark. That is sound wisdom, as far as it goes.

Where it falls short is in the recognition that many investors lack the patience and discipline to stick with a strategy when it has a pronounced slump or performs at odds with the broader market, as often occurs with higher active-share funds.

That doesn’t mean you should avoid such funds in constructing your own portfolio, but you should make an honest appraisal of your ability to tolerate significant variance in performance, both on an absolute and relative basis.

Even if you have a bias toward active managers in your portfolio, don’t overlook passive options. Not only will they lower the overall cost of running your portfolio, they can help smooth out the performance bumps that the more active managers may cause and perhaps help you stick with your investment plan.

3. Gravitating to trendy strategies.

The fund industry is always coming up new products, such as sector or thematic funds. In many cases, the expense ratios could be high, the product is higher-risk, or lacking in benefits over traditional, well-established categories. Moreover, they often focus on a sector that has had recently strong performance.

You’d be well-advised to avoid the latest trends or buzzy funds when constructing your own fund portfolio.

4. Creating unintentional overlap.

How many funds should you own in a given account in your investment portfolio? The bottom line is that there's no single number that's right for everyone.

But accumulating too many funds can lead to unintentional overlap. It’s important to look beneath the hood, viewing funds at the underlying portfolio holdings level, to ensure that one fund isn’t replicating the work of another.

Some overlap is inevitable, but aim for distinctiveness in diversification.

Try to identify strategies that offer different substyles or that exhibit differentiated performance patterns from one another.

Your diversification may be adding no value or very limited value, and additionally introducing potential overlaps to your portfolio as well as the headaches of excessive recordkeeping.

For instance, banking and financial services is a sector well represented in many funds. Taking a separate sector fund in this space won’t really help. What may help is a pharma sector fund. On an average, mid-cap funds have an 8% exposure to pharma, while large-cap funds have a 3% exposure. (This is not a recommendation, it is purely for illustrative purposes).

5. Forgetting about risk.

It’s easy to fall into the trap of focusing solely on a fund’s returns. Even taking pains to measure a fund against an appropriate benchmark or evaluate its returns over very long periods doesn’t lessen the limitations of such an approach. Instead, consider integrating two other elements as you build your portfolio: your ability to handle risk and your goals. A fund’s long-term annualized returns tend to smooth out the ups and downs over that time. A fund’s volatility and downside performance, however, can have a significant effect on your comfort level as well as your ability to stay with an investment.

Moreover, your specific investment goals can guide how much risk you can or should take. Folks investing for retirement with a very long time horizon can afford to take more risk across the portfolio, with time to ride out even large declines. If your time frame is shorter, or you expect you’ll need to draw on assets for a short-term need, that argues for taking less risk both in your overall stock/bond mix and in the specific investments you choose.

Do Note: Investment involves risk of loss

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