The Funds Selection Process
The investor who has decided to invest through a fund is now faced with the task of selecting an appropriate fund. It is at this stage that many new investors are overwhelmed with the vast variety of choices. The selection process is simplified when using a systematic approach as follows.
The first consideration is whether to select a mutual fund, a closed-end fund or even an exchange traded fund (ETF). The decision here is largely dependant on the investing ambitions of the investor.
Shares in mutual funds can be bought directly through the fund provider and there is no requirement for a stock brokerage account. Investors who do not wish to directly own any stocks tend to find mutual funds convenient as they do not need to open a brokerage account.
Stock investors who hold a portfolio of stocks tend to prefer buying shares in closed-end funds and/or ETFs since they can simply buy these from the stock exchange using their brokerage account. The process of buying from the stock market is already familiar to them and there is the convenience of holding the funds in the same account as their stocks. This means they have one portfolio which holds both stocks and funds. Also selling a closed-end fund or ETF is exactly the same as selling a stock.
Some stock brokers allow mutual funds to be held in their brokerage accounts, but usually there is a fee for this service. So the investor looking at holding mutual funds in their brokerage accounts needs to consider whether it's worth paying for the convenience.
Another consideration is the costs of the three fund types. Generally the mutual funds tend to be the more expensive. Closed-end funds tend to be slightly cheaper than mutual funds and ETFs are generally cheaper again.
The next consideration is whether to buy an actively managed fund or a passively managed fund (which are usually an index tracking fund). Basically the active funds seek to provide returns greater than what the market offers and passive funds merely replicate the markets performance.
Generally the active funds are more expensive (and can be considerably more expensive) than passive funds. The better performance from active funds is often outweighed by the additional costs.
If the investor is satisfied with the returns obtained from the market, then it makes sense to buy a passive fund and save the extra costs. However if the investor is looking for better returns than that offered by the market, then they will need to select an active fund but the costs need to be carefully considered. The costs of active funds tend to vary considerably and the investor is probably better of selecting a lower cost active fund. A higher cost active fund needs to outperform the market by the amount of their additional costs and there is no guarantee that it will continue to provide those high returns.
If you are satisfied with the returns obtained from the
market, then consider passive funds and save on fees
The investor now needs to consider whether to buy a fund that specializes in stocks or whether to include a fund that specializes in bonds. Some funds will include stocks and bonds together in the one fund such as the target date retirement funds.
A general guideline for conservative investors is to have a percentage of their portfolio in bonds based on their age. For example, an investor who is 30 years old would have 30% of their portfolio in Bond funds and 70% in Stock funds. An investor who is 60 years old would have 60% of their portfolio in Bond funds and 40% in Stock funds. These general guidelines are based on long-term investing for retirement which can be used with individual retirement accounts such as an IRA, however they also tend to work quite well for general long-term investing.
The only downside to incorporating bonds into a portfolio is that in the long-term (meaning 20 to 30 years) the returns from stocks outperform that from bonds by a fair amount.
The idea of incorporating bonds into a portfolio is that it reduces the volatility of the year to year returns, but it also reduces the long-term returns. The more aggressive long-term investor who can handle the higher volatility from stocks is probably better of with only a small portion in bonds or even a stocks only portfolio. Bonds only reduce the volatility, they do not eliminate it. Even a bond only portfolio has some minor volatility in the year to year returns due to the value of the bonds fluctuating along with the interest rate cycles.
The general rule is that in the long-term stocks outperform bonds and for the short-term bonds are less volatile. The only way to totally eliminate the volatility is to invest in cash equivalents such as certificates of deposit or Treasury Bills but these also provide the lowest returns.
As a guide, the shorter the investment time frame is then the lower the percentage of stocks that should be included in the portfolio.
The next step is to determine which type of Stock fund and/or Bond fund to buy which is covered in the following articles.
Selecting a Stock Fund
There's a large range of stock funds available for the funds investor. Having a basic understanding of the various stock investing strategies will simplify the selection process. The first consideration for the funds investor is to determine their own objectives and align those with an appropriate investing strategy.
Funds also tend to specialize in certain market capitalizations such as blue-chips, large-caps, med-caps and small-caps.
There are funds that track an index with some funds specializing in certain sectors such as energy or even specialize in a particular industry group such as solar energy.
Index Tracking Funds
These are the simplest stock funds to invest in and they are also the simplest for new investors to understand. Basically the funds performance mirrors the performance of the index that it tracks.
Table 1. below shows the two most popular ETFs on the market that track a major index (data based on Oct 20, 2017).
Table 1. Stock Index ETF's
From Table 1. above, the SPY ETF tracks the popular S&P 500 index and the DIA ETF tracks the oldest index which is the widely followed Dow Industrials Average.
Mutual funds also have funds that track an index. Table 2. below shows several funds that track the S&P 500 index (data based on Oct 20, 2017).
Table 2. Stock Index Mutual Funds
Funds Investing Styles
Funds can use any of the common investing styles such as growth investing, value investing or dividend investing. Some funds will even combine several strategies together. These funds are generally actively managed and as such tend to charge higher fees.
The basic characteristics of these funds can be summed up as follows:
Funds Investing Styles:
- Growth Investing Funds: These funds seek out stocks that are displaying strong earnings growth and have the potential to continue grow their earnings. The basis for growth investing is that as the company's earnings increases then the fundamental valuation also increases and the stock price will generally increase. These are generally considered higher risk investments but in the long-term provide good returns. In the short-term they are high risk.
- Value Investing Funds: These funds invest in stocks that are fundamentally sound but are undervalued. The basis for value investing is that the stock price will sooner or later rise above the valuation and yield a capital gain. This is due to the fluctuating nature of stock prices which alternate above and below the stock's fundamental valuation. These are generally considered moderate risk investments in the long-term but still provide reasonably good returns. In the short-term they are a moderate risk.
- Dividend Investing Funds: These funds locate stocks which pay above average dividends. Their primary objective is to produce an income stream from the dividend payments while still achieving a modest capital gain in line with the economic growth. These are generally considered moderate risk investments in the long-term which still provide reasonably good returns. In the short-term they are a moderate risk.
- Market capitalization Funds: Funds can specialize in a particular market cap size and they can utilize any of the main investing styles. For example, a fund may specialize in the growth of small-cap stocks. The larger caps are generally lower risk and the smaller caps are generally the highest risk. The amount of risk also decreases as the investing time frame increases.
- Sector specialty Funds: Funds can specialize in a sector or even a particular industry group and they can utilize any of the main investing styles. For example, a fund might specialize in technology stocks that are undervalued. These are generally considered high risk investments in the long-term but can provide excellent returns. In the short-term they are usually high risk.
- International Funds: Some funds concentrate on international investing and invest in foreign stock markets. They can utilize any of the above strategies. There are also funds that invest in both domestic and international markets and are known as global funds. The risk of international investing has both the stock market risk and also the currency exchange risk. The stock market risk is dependent on the investing strategies utilized. The currency risk is the risk that the exchange rate moves against the value of the funds portfolio since the portfolio was purchased in the foreign currency. Basically the exchange rate risk increases as the time frame for the investment increases as there is more time for the currency to move.
The funds investor needs to consider what their own objectives are and then compare that to the above list of fund types. Some of these considerations are the time frame for the investment, the accepted volatility of the returns, tax liabilities and the importance of an income stream.
The amount of time the funds investor expects to hold their investment is a major factor in determining which fund type would be more appropriate. The general rule is that the longer the investor's time frame is then the more risk they can take on and in the long-term they will end up with a higher return. In the short-term the stock market fluctuates up and down considerably and essentially goes on a roller coaster ride, but in the long-term this roller coaster is tilted uphill and continues to climb higher.
Long-term investing has a time frame of 20 to 30 years or more and the more aggressive strategies such as growth investing are more suitable to long-term investing. These growth investing funds can also incorporate small-cap stocks and even selective sectors and industries which can increase the long-term returns. The returns from these growth funds will be extremely volatile which means that the returns will vary dramatically from year to year but in the long-term will produce good results.
Value funds and dividend funds provide a good alternative for the funds investor with a long-term view. Generally these are considered lower risk and less volatile while still providing decent long-term returns.
Value funds and dividend funds provide an
alternative to the popular growth funds
Some funds combine both growth stocks and value stocks into a single fund. This fund type still provides the growth characteristics from growth stocks but is more conservative due to the value stocks that are added to the funds portfolio. The growth value fund is often referred to as a blend fund.
Medium-term investing is generally around 5 years. With this shorter time frame, the funds investor may be more comfortable with the less aggressive investing strategies. Value investing funds may be more appropriate as they tend to be less volatile, however the year to year returns will still vary considerably. Essentially any stock investing strategy is best suited to long-term investing.
For a medium-term investment, the funds investor should also consider allocating some of their capital to a Bonds fund type rather than placing all of their money in a Stock fund. Some where around 25% to 50% allocated to a Bonds fund will reduce the medium-term risk. This will also reduce the potential return and is something that the individual funds investor needs to weigh up. The simple rule is that the higher the return then the higher the risk that the return will not be achieved.
Short-term investing has a time frame of a couple of years. For funds investors with a short-term view all of the Stock funds are inappropriate. Suitable fund types for short-term investing are Bond funds and especially with a high portion of treasury bills. The returns from Stock funds are simply way too volatile and the funds investor runs a high risk of exiting their fund with a loss after only a couple of years. While stock investing provides the highest long-term returns it is also the most volatile in the short-term.
Volatility of Returns
The year to year returns varies considerably with Stock funds. As a general rule the higher risk strategies have the largest variations in yearly returns. So funds that use growth investing strategies combined with small-cap stocks and/or specific industries or even international investing will have more volatile returns than a dividend fund that specializes in large-cap stocks across the broad market.
A funds investor who can tolerate a significant variation in year to year returns would probably be able to handle the high risk strategies. For the conservative funds investor they will find this volatility unacceptable.
There are several ways to reduce the volatility in returns. One method is to invest in a Value fund or even a Dividend fund as these are lower risk with less volatility in their returns. Another tactic is to split the investment capital between Stock funds and Bond funds. This method naturally reduces the volatility of the returns as Bond funds provide a steady income stream from the coupon payments and their capital gain/loss is minimal. The only downside is that in the long-term the total return is also reduced. As a general rule the lower the volatility in yearly returns then the lower the long-term returns.
A consideration for the funds investor is that of income verses capital growth. When a fund receives a dividend payment this is distributed to the funds investors as a cash payment. Some funds investors are specifically looking for this income stream.
The total return of a fund is obtained from the capital gains and the dividend payments received. Fund investors who are seeking an income stream will find a dividend fund type appropriate since these funds specifically invest in stocks that pay generous dividends. Some of the other fund types may have stocks in their portfolio that pay a dividend, but any dividend payment is not a consideration for the fund and usually the payments are quite small.
A dividend fund would be inappropriate for a funds investor who would prefer to obtain their return from capital gains.
While the following discussion is not tax advice, funds investors need to consider the tax implications for their investment funds. The tax liabilities are incurred by the individual funds investors and not by the fund itself. That is the individual investors pay the tax bill.
The dividend payments that a fund receives are distributed to the funds investors. This means the funds investors receive a payment from the fund which for tax purposes is considered income. Generally, investors pay the reduced tax rate for dividends received from most U.S. companies. Dividends received from other companies, real estate investment trusts (REITs) and American depository receipts (ADRs), the investor will generally pay tax at their income tax rate. The taxation of dividends is treated differently for retirement accounts such as an IRA.
The next consideration is the capital gains and the tax implications. Basically when a fund sells a stock in its portfolio at a capital gain, it is subject to capital gains tax. The funds investors pay this capital gains tax in exactly the same manner as if they directly owned and sold the stock.
The taxation is treated differently depending on whether the fund sold the stock within one year or not. If the stock was sold within one year, the gain is treated as income and the funds investors pay tax on the gain at their income tax rate. If the fund sells the stock after one year, the gains are treated as long-term capital gains and the funds investors are taxed at the lower long-term capital gains tax rate. The taxation of capital gains are treated differently for retirement accounts such as an IRA or a Roth IRA.
Selecting a Bonds Fund
Bond funds provide the investor with a convenient alternative to investing directly in bonds. The popularity of bond funds has increased dramatically over the years. This is partially due to the low upfront capital required to invest in a Bond fund compared to directly buying a bond. Also the bonds investor gets a diversified portfolio of bonds. The only catch is that a Bonds fund has fees which lower the net returns.
Similar to Stock funds there are several considerations for investors seeking to invest in bonds. The first consideration for the funds investor is to determine their own objectives and align those with an appropriate investing strategy.
Bonds have three general maturities which are short-term, intermediate-term and long-term. The short-term bonds are referred to as Bills and are the safest but also have the lowest returns. The most common short-term bond is the Treasury Bill which matures in less than a year. The intermediate-term bond is referred to as a Note and matures in two to ten years. These provide higher returns than the Treasury Bills but also carry more risk. The long-term bonds are simply called Bonds and provide the highest returns but the risk is also higher than that of Notes.
The other consideration for the bond investors is that there are different bonds which are issued by various sources. The most commonly issued bonds are treasury bonds, municipal bonds and corporate bonds.
The return obtained from bond funds consists of both the income stream from the bonds coupon payments and from any capital gains. Investors who buy Bond funds receive the coupon payment.
The return from bonds is largely dependant on future interest rate movements. As interest rates increase the value of bonds decrease resulting in a capital loss, however this is partially offset if new bonds are purchased which now have a higher coupon payment.
Bond funds can invest in a specific bond type or in a combination of bond types.
Treasury Bonds, Notes and Bills
Treasury Bonds, Notes and Bills are the safest investments which are effectively guaranteed by the U.S. government. Basically the longer the maturity then the greater the risk that interest rates will move which will affect the returns achieved. The principle of treasury bonds is basically secured, however the resale value is dependant on the future interest rates. While the bond pays the coupon payment, there is the risk that the capital returns from a bond may be negative. Generally Bond funds invest in a variety of bonds with different maturities which helps offset the capital gain issue.
Table 1. below shows a selection of some of the popular Treasury Bond ETFs on the market (data based on Oct 20, 2017).
Table 1. U.S. Treasury Bond ETFs
Table 2. below shows a selection of some of the popular Treasury Bond Mutual Funds available (data based on Oct 20, 2017).
Table 2. U.S. Treasury Bond Mutual Funds
The returns from Treasury Bonds, Notes and Bills are lower compared to other bond types but the principle is secured. Generally Bond funds tend to have a mix of Treasury Bonds, Notes and Bills.
Bond funds with a high proportion of Bonds will achieve better long-term returns than Bond funds that have a high proportion of Bills in their portfolio. However in the short-term there is a risk with Bond funds which have a high proportion of Bonds that the coupon payment will not cover the capital loss. While the risk is minimal the risk is still there.
Bond funds with a high proportion of Bills are almost capital-loss guaranteed since Bills are short-term and the full principle is repaid plus interest on maturity.
For the conservative Bond fund investor with a short-term view, Bond funds with a high proportion of Bills are the safest but also give the lowest return. If the conservative investor has a long-term view then Bond funds with a high proportion of bonds will provide higher returns but also has a higher capital-loss risk although this is minimal with a Bond fund.
The Bonds fund investor is subject to tax on the income from the coupon payments and is subject to capital gains tax. The taxation of the coupon payments and the capital gains are treated differently for retirement accounts such as an IRA.
Municipal bonds are issued by states, cities, counties and other government agencies in order to finance their capital investments in schools, highways, hospitals and other projects.
These bonds are also considered safe investments but the principle is not guaranteed. They do provide higher returns from their coupon payments and there are certain income tax advantages with these bonds.
Table 3. below shows a selection of Municipal Bond Mutual Funds (data based on Oct 20, 2017).
Table 3. Municipal Bond Mutual Funds
Bond fund investors who are risk adverse but can tolerate some moderate risk may find that Municipal Bond funds appropriate for their needs.
These are bonds issued by companies which can be public companies listed on a stock exchange or they can be issued by private companies.
Corporate bonds are not guaranteed in any way and the coupon payment and the repayment of the principle is dependant entirely on the company's financial ability to make these payments. These bonds carry a much higher risk level than the Treasury bonds or the Municipal bonds since there is now a real risk of not receiving the payments. To compensate for this increased risk the coupon rates are higher. The long-term corporate bonds provide higher returns than Treasury bonds or the Municipal bonds.
Table 4. below shows a selection of Corporate Bond Mutual Funds (data based on Oct 20, 2017).
Table 4. U.S. Corporate Bond Mutual Funds
Most corporate Bond funds invest in high grade corporate bonds. However there are also low grade corporate bonds which are a much higher risk (usually referred to as Junk bonds). These Junk bonds pay very high coupon rates but there is a higher risk of default on the payments and the principle repayment risk is also higher.
The bond fund investor who has a higher tolerance to risk can increase their long-term returns by investing in Bond funds that have a high proportion of high grade corporate bonds in their portfolio.
For bond fund investors who have a much higher tolerance to risk can potentially increase their returns by selecting Bond funds with a higher proportion of Junk bonds in their portfolio.
The general rule with any investing is that the higher the return then the higher the risk that the return will not be achieved. Generally Bond fund investors with a long-term view will achieve better returns than investors with a short-term view.
Funds Selection Summary
By now the funds investor should have a good idea of their preferred fund types from reading the previous articles in this series which included the Fund Selection Process, the Selection of Stock Funds and the Selection of Bond Funds. Some investors may still not be sure so the following hypothetical examples are provided as a guide.
Example 1. A 30 year old is new to investing and is quite risk adverse and likes the idea of receiving an income stream. The new investor has decided to buy mutual funds and has no other involvement with the stock market but would like to receive the long-term returns. The investor wants to allocate 50% of their capital to an actively managed Dividend Stock mutual fund and the other 50% to a Corporate Bond mutual fund. While the new investor is only 30 years old, they did not feel comfortable allocating 70% to stocks. The new investor's intention is to reinvest the dividends and coupon payments back into the funds to maximize the compounding effect
Example 2. A 40 year old value investor currently has a portfolio consisting mainly of value stocks with some real estate investment trusts (REITs) and is a fairly conservative investor. The investor has an online brokerage account and decides to allocate 40% to municipal bonds by buying a closed-end fund. The investor likes the tax advantages of a local state municipal bonds fund and the investor's intention is to buy more shares with the coupon payments received.
Example 3. A 50 year old active speculative trader is quite aggressive but skillful in managing their trading. The stock trader has opened an individual retirement account (IRA) and has decided to buy an index tracking ETF to place into the IRA. The stock trader is busy actively trading and does not want to actively manage their IRA. The stock trader has a long-term view for the IRA and is not concerned with the value of the ETF in the short to medium-term.
Example 4. A 60 year old investor currently has a growth mutual fund held in an IRA with the fund provider. The investor is looking to retire and wishes to receive an income stream from bond coupon payments. The investor decides to sell 40% of their growth fund back to the mutual fund provider and use the money to purchase a mutual fund specializing in Treasury Bonds from the same provider. The Bond fund will also be held in the IRA.
The above examples are purely fictional but are representative of typical investors. The personal circumstances of each individual investor will result in a unique outcome. This comes about because every individual investor has a different idea of just exactly what aggressive means, what conservative means and what risk adverse means.
The funds investor needs to be realistic and honest. While every investor would like a huge return with next to no risk, the reality is that a huge return involves a lot of risk and a low risk provides low returns. This is true irrespective of whether it's the stock market, bond market or the real-estate market.
By now hopefully the investor has a pretty good idea of what to look for in a fund. The next step is to actually produce a short list of funds that satisfy the investor's criteria by using a screening system which is covered in the next article.
Produce a short list of suitable funds
By now the funds investor has a good idea of the funds they would like to invest in and the next step is to produce a short list of funds that meet the investor's selection criteria.
The easiest method of producing a short list of funds is to run a screen. There are over 10,000 mutual funds and a short list can be easily obtained using a mutual funds screener which allows the investor to select the criteria they require from a fund. There are over 500 closed-end funds and there are over 700 exchange traded funds (ETFs). These can be screened using a scanning tool provided by their stock broker or they can use an online screening tool (a list is provided in the resources page).
The funds investor needs to select the appropriate screener (if screening for mutual funds then make sure the screener is for mutual funds). To produce a short list the funds investor can enter selection criteria or use a preset search filter. Sometimes a preset search filter will suffice while at other times the funds investor will need to enter their own search criteria.
A preset screen will look something like "Small Cap Growth Funds" or "Municipal Bond Funds". Note that screeners generally refer to stocks as equities. Also funds that combine growth stocks and value stocks into the one fund are usually referred to as blend funds.
The preset screen for small-cap growth stocks will basically produce a list that satisfies that criteria. However with a preset screen for municipal bond funds the investor may only be interested in funds that only include municipal bonds from their own state so that the investor can maximize the tax advantages. In this case the investor will need to create their own search if there is no preset screen available.
Screening for growth, value and blend funds is straight forward with mutual funds as these can be selected from the screens filter. However screening for dividend funds is more challenging since the screeners typically do not include dividends as a standard screening filter. The funds objectives are often given in the funds title and an alternative method of locating dividend funds is to search for funds that include the term Dividend in the title. Also the term Preferred Stock can be searched for since this stock class pays a higher dividend and they are common holdings with dividend stock funds.
The list now is reduced and broadly includes funds that meet the general criteria but the list might still be quite large, especially when screening for mutual funds.
Most mutual fund screeners provide some information on the funds costs. The funds investor needs to decide whether it is worth paying the mutual fund load fees since there are numerous mutual funds that do not charge these load fees (these are known as no load funds). The screen can generally be filtered to exclude funds that charge load fees.
Mutual fund screeners also typically show the expense ratio and investor can set a maximum limit with the screener. Mutual funds which are actively managed are generally quite expensive. Investors looking for mutual funds should consider the expense ratio which is the annual cost of owning a share in the fund. Again the expense ratio varies significantly between mutual funds and the investor can readily exclude those mutual funds which have relatively high expenses ratios.
Fund screeners allow the investor to
set limits for the fees charged
The funds investor screening for closed-end funds or ETFs also needs to check the expense ratio. Funds with high expense ratios can be excluded from the short list.
Another consideration with actively managed funds is the out-performance. The investor can exclude funds which did not outperform the benchmark index by a certain percentage. If the screener allows it, usually it's easier to sort the results based on the 5 year or 10 year returns and set the screening filter to exclude those with returns below the set amount.
The Morningstar rating is a convenient rating system frequently used with mutual fund screeners. With this rating system, one to five stars is assigned which reflects the mutual funds historical performance (one star being poor and five stars is excellent). Screeners that use the Morningstar rating can filter the screen for the desired star rating. The only downside with this system is that Morningstar does not rate every mutual fund.
Some screeners will allow the investor to select various industry specific funds while others do not. If the funds investor is looking for funds that specialize in a specific industry and there is no screen available, then the investor can search for funds using a keyword in the funds title.
Example 1. To locate funds that specialize in the energy sector the investor can search for funds that contain energy in their title. The same idea applies to international investing funds as the term international (or an abbreviation such as Int) is usually included in the funds title.
The funds investor should by now have short list that is manageable. Around 10 to 20 funds are sufficient and around 50 funds would be a maximum. The whole point of a short list is to have a manageable number of funds on the list since the next step is to more thoroughly analyze each potential candidate. If there are too many funds on the list then the investor will probably not check each candidate on a long list since it takes too much time, which defeats the whole purpose of having a short list.
Individual Fund Profiles
This is the end of the computerized screening and the investor now needs to check the details of each fund individually. Generally with screeners the investor can click onto each fund on the short list and view detailed information about that fund.
If the funds investor is looking for mutual funds they need to check the minimum initial investment required to buy into a mutual fund. This varies significantly between mutual funds and ranges from a couple hundred dollars to a couple thousand dollars or more. Also if applicable, the minimum ongoing contributions need to be checked if the investor plans on dollar cost averaging. Any funds that do not satisfy the investors requirements are exclude from the short list.
If the funds investor is looking for a closed-end fund or an ETF then the minimum initial investment is usually not an issue since share price is usually well under a hundred dollars. However should the investor choose to add fund shares to their portfolio by dollar cost averaging, then the share price needs to be considered.
Example 2. If the investor wants to add $20 a month to their fund portfolio then the share price needs to around $20. If the share price is $100 then this fund does not meet the investor's criteria.
The past performance of each fund on the short list should be checked. Usually a chart is provided which displays the fund together with the appropriate benchmark index for the last five or ten years (assuming the fund has been operating for that length of time). These charts should be studied carefully, especially with actively managed funds.
An actively managed fund should ideally outperform its benchmark index consistently and not just for one or two years. Preferably the fund should have ten years of history. Funds that have been operating for less than five years should be viewed with caution and some funds investors will exclude these funds from their short list.
The problem with funds that have minimal history is that the investor cannot determine the funds reliability in outperforming the benchmark index since any fund can have a good year or two. The reason the out performance is important is that the actively managed funds generally charge for this in their annual fees. Any funds that do not consistently outperform their benchmark by more than their expense ratio should be excluded from the short list.
Example: If an actively managed fund achieved an annualized 12% return over ten years with an expense ratio of 1% and the benchmark index is 10%, the investor receives a net 1% return in excess of the benchmark index. However if the expense ratio were 3% then the investor's net return is 1% lower than what an index tracking fund would have returned.
With passively managed funds that track an index the amount of history is not as important. That's because these funds are designed to follow an index and not outperform the index. Generally it is preferable if the fund has a minimum of three years history so that the investor can confirm that the fund does in fact reliably track the index.
Funds investors will often exclude index funds with less than three years history from the short list. Also index funds that do not track the index reliably are best excluded from the list. This is especially true if an index fund has outperformed for the last couple of years as this index fund will in all likelihood under perform over the next couple of years.
Finally the investor needs to check the profile of each fund to ensure that they meet their requirements. The profile gives a summary of the funds objectives and the investor should read this carefully. If the investor is looking for a broad market small-cap growth fund but the profile indicates that the fund specializes in small-cap energy growth stocks, then this fund does not meet the investor's requirements and should be excluded from their short list.
The actual size of individual funds vary significantly and some funds investors prefer not to invest with small funds as there is an increased risk that the fund may collapse since they may not be able to operate profitably. At the other extreme, very large funds may find it more difficult to meet their performance requirements and some funds investors also avoid these funds.
Some funds investors place emphasis on the portfolios manager and feel more comfortable with a manager that has significant experience. Thus a manager with 30 years experience is preferred over a manager with three years experience.
Another consideration for the funds investor is the funds portfolio turnover with actively managed funds. This varies considerably between funds and a low turnover implies that the fund takes a long-term view and a high turnover implies that the fund has a short-term view. Some funds investors do not care about the turnover while others have a preference. As a general rule high turnover funds generate more realized capital gains which are taxable gains.
By now the funds inventors short list should be quite short and the investor needs to make the final decision as to which fund to buy. All else being equal the fund with the lowest costs would be the wise choice. If the investor likes several funds and cannot decide between them, the investor can also spread their capital and buy several funds.