How NOT to pick a mutual fund

The Wall Street Journal had an excellent article recently about how NOT to pick a mutual fund:

1. Focusing too much on past returns.  Separating luck from skill is extremely difficult, so you don’t know whether the fund with excellent past returns is going to do well going forward or blow up.

2. Not understanding how the money is invested.  The process of investing generates results, so you need to focus on the cause, not the effect.  If you don’t understand the process, there’s no proof it works, or it’s too narrowly focused on what has worked well recently, stay away.

3. Diversification in name only.  Diversification is only worthwhile is if it’s truly diversified and if it’s very low cost.  If diversified means 5 different mutual funds focused on gold, you’re toast.  If it means you buy 5 full cost (1% annual fees) mutual funds that cover large, small, value, growth, bonds, etc., then you’re throwing your money away.

4. Chasing headlines.  If you buy something because it’s in the headlines of the news, then you’ll almost certainly get crushed over time. The smart money has already bought and sold before it’s in the headlines.

5. Buying on ratings alone.  If you focus on the ratings/stars that most mutual funds advertise (there’s a reason why they are advertising that fund now, and not at other times), then you’ll likely get bad results.  Most returns aren’t persistent (they don’t continue in the future), so if you buy what has done well recently, you’ll probably lose money.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

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How NOT to pick a mutual fund

Mutual fund over-diversification (the artist formerly known as di-worse-ification)

One of John Mauldin’s recent Outside the Box articles by James Montier (of Dresdner Kleinwort) highlights the fact that the average mutual fund holds around 160 stocks.

Now, this may not sound ludicrous to you, but let me walk you through why I think this is nuts.

First off, 160 is average. That means that some managers hold many more and some hold many less than 160, but let’s just work with 160 to illustrate my point.

There are around 250 workdays in a year (52 weeks minus 2 weeks for vacation gives 50 weeks, multiply that times 5 workdays per week).

Most companies report their earnings once a quarter and provide a conference call with that.

That means a mutual fund manager must monitor around 5 companies every 2 workdays (160/(250/4)x2).

Given an 12 hour work day and a 5 day workweek, that means each mutual fund manager can devote 4.8 hours per company each quarter.

Most conference calls last 1.5 hours, so that leaves only 3.3 hours to understand, model, value and evaluate each company.

Let me add that this doesn’t include time to visit companies, watch additional presentations that almost every company gives, look for new investment ideas, interact with clients, vote proxies, do administrative tasks, talk around the water cooler, etc. You get the idea.

Granted, such managers may have a herd of analysts chasing down details. But, the mutual fund manager is the one who has to make decisions, and how well can he understand a company and make decisions if he has so little time to follow and evaluate each company?

I know that when I look at a new investment, it usually takes me 3 hours just to read one 10k (annual report filed with the SEC). But then, I still need to read old 10k’s (at 3 hours a pop), plus 10q’s (quarterly reports filed with the SEC, 0.5 hour each), listen to conference calls and presentations (1.5 hours each), read current and old reports to shareholders (1.5 hours total), look up articles about the company (2 to 4 hours), read competitor’s reports (another 10 hours), etc.

In other words, just to look at a new investment idea, I have to spend around 20 to 30 hours just getting to understand the business. And then, I need to think about the business analytically, evaluate management, analyze competitive advantage, drill down into the business’s economics and business model, model the business into the future, analyze financial statements over time, etc. It takes a lot of time to thoroughly research a new investment idea.

To keep up with current investments, it usually takes about an hour to read the press release and think about and analyze the financial statements, 1.5 hours to listen to the conference call, 1.5 hours to update my model of the company, 1.5 hours to analyze the latest 10q or 10k, etc. It takes me about 6 hours per company just to stay up.

And then I still need to vote proxies and listen to annual meetings and analyst presentations!

It takes all my research time to keep up with 40 companies, have time to screen through a bunch of new ideas, and thoroughly research 10 to 20 new ideas a year.

So how can a mutual fund manager hold 160 stocks? By not doing a very thorough job of understanding the companies he owns. I think that’s an irresponsible way to invest. Perhaps that’s why 80% to 90% of mutual funds under-perform the market over the long run.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.