Why buy?

Seven reasons to buy a fund

Over the years, I’ve reviewed investment portfolios for many, many individuals. For some clients of our firm’s financial advisors, I will prepare an investment policy statement (IPS). An IPS is a detailed document outlining an analysis of a current portfolio, in addition to specific ‘buy’ and ‘sell’ recommendations. The question that inevitably comes back to me most often is: “Why did you recommend that fund” or “Why are you selling this excellent fund’. Over the next two weeks, I will answer those two questions. This week, I’ll review my buy methodology for mutual funds.

Investment process

I search for investment funds run with a well-defined discipline. This means speaking to managers. I expect managers to be able to clearly articulate what they do and how they do it. I have a bias toward value-oriented managers who trade relatively infrequently and are sensitive to the tax implications of their investors. A value orientation refers to stock pickers who aren’t unrealistically optimistic about the future and are sensitive to the price they pay for a stock. My bias results from the existing body of academic research, in addition to my own on these factors and their influence on future returns.

People

My research process favours investment managers with a true team-based approach to managing money. That means no one individual has complete or dominant influence over the investment process. A disciplined process coupled with a team approach lessens the dependence on each individual manager and promotes continuity. Continuity refers to a firm’s ability to successfully and consistently execute the firm’s investment process in light of losing key personnel.

Other qualitative factors

Other qualitative factors that are part of my questioning include details on compensation structure, ownership structure, and the firm’s policies on personal investments by its managers. I look for firms whose managers hold a significant ownership stake; are compensated in a manner that best aligns their interests with those of unitholders; and that have strict policies on personal investments. On the latter, it is ideal if managers and employees are required to invest their personal money alongside that of their clients.

Performance

While not dominant factors, consistency of historical outperformance, relative to each fund’s relative benchmark and peer group, form one of the more important quantitative factors used in the selection process. The focus is consistency of performance, frequency of outperformance, and the size and persistence of that outperformance. The greater those three factors in the past, the greater comfort I have in expecting that relative good fortune to continue going forward.

Risk

While it’s a very personal element, I define risk in three ways in the context of the fund selection process. Downside risk is an absolute measure which looks at historical exposure such as frequency of losses, size of losses and recovery times. The risk of underperforming a pre-specified benchmark is also a measure of risk, particularly when the benchmark is investable. Finally, to the extent that a fund would increase the risk of failing to reach a personal benchmark (i.e. specific rate of return target), it will not be chosen for a portfolio.

Efficiency

The most obvious component of efficiency is a fund’s stated management fees and operating expenses (i.e. MER). However, there are other “costs” resulting from a fund’s management style. Trading frequency, or turnover rate, measure the level of trading activity. As turnover rises, so do brokerage fees (which are excluded from the MER), frictional costs (impact of buy/sell on stock price), and the tax liability resulting from this trading activity.

My selection process is biased toward funds with relatively low fees and low turnover. Again, the bias here is the result of the existing body of academic research which suggests minimizing such factors.

Portfolio constraints

If you are constrained by a deferred sales charge (DSC) schedule, your best bet may be to first look within that same fund family for suitable buy candidates prior to looking “externally”. You just may be able to restructure what you have into a good portfolio without incurring the extra costs of selling DSC funds early.

Fit

While it’s important to choose good, stand-alone, investment products, it’s equally important to make sure that the different investments recommended for your portfolio fit well together. In other words, to the extent possible, your mix of investments should minimize overlap and maximize diversification benefits. Last week’s article (http://stocks.myto.com/mutualfund/articles/tlsFundStory.asp?month=apr&date=04-26-2002) ties in nicely with this factor.

While all of the above criteria are important for all funds, the importance of some factors may really depend on the type of fund being evaluated. For instance, fees are much more important for fixed income funds than for stock funds. Accordingly, my evaluation process will more heavily weight those factors deemed more important for each respective type of fund.

Most of my fund recommendations are the result of a combination of a quanitative analysis in addition to regular conversations with fund managers. Hearing how managers describe what they do (and how clearly they can articulate it) gives some insight into the people running the show. No process is perfect, but what I’ve outlined are things that no star rating system takes into account. Pity, because the qualitative stuff is often more important than the numbers.

Dan Hallett, B.Comm., CFP, CFA is the Senior Investment Analyst with Sterling Mutuals Inc. He can be reached at dhallett@sterlingmutuals.com Sterling Mutuals Inc. is registered as a mutual fund dealer in Ontario, British Columbia, Alberta and Manitoba.