Fund selection criteria

Mutual Funds and ETFs

Asset classes are represented in a portfolio using low-cost and broadly diversified investments. Academic literature on Modern Portfolio Theory (MPT) is based on financial market returns. As such, a portfolio based on MPT works exceptionally well with index mutual funds and exchange-traded funds (ETFs). These funds are well-suited because they are designed to replicate financial market returns less a small fund expense. Index funds have low turnover of securities that make them more tax-efficient than other mutual fund types.

Both index mutual funds and ETFs follow market indexes. The primary difference is how they are traded. Index funds are bought and sold once per day at the end of the day at Net Asset Value (NAV).  Trading of index mutual funds is direct with the mutual fund company that manages the fund. In contrast, ETFs are bought and sold during the day on a stock exchange, and trading is accomplished with other investors. ETFs trade close to their NAV, although there can be a very small discrepancy in the price of shares and the underlying securities that make up the fund. Those discrepancies do not last long because professional traders will arbitrage the difference. We monitor fund values closely to ensure our clients receive fair pricing. For in-depth information on ETFs, read The ETF Book by Richard Ferri.

There are a number of index mutual funds and ETFs available in all asset class categories. Portfolio Solutions analyzes and selects the most appropriate funds for our clients’ portfolios. In our analysis we consider and evaluate underlying index structure, portfolio turnover, management fees, fund liquidity and several other factors.

Why Actively Managed Funds Do Not Fit Well

Experienced investors know that costs matter. The more you pay in investment costs, the lower your long-term returns are expected to be. High expenses are the primary reason why most actively managed mutual funds underperform index funds. William Sharpe, Nobel Laurite in Economics Sciences, eloquently states this point in his timeless article, The Arithmetic of Active Management.

Properly measured, the average actively managed dollar must underperform the average passively managed dollar, net of costs. Empirical analyses that appear to refute this principle are guilty of improper measurement.

Sharpe’s argument is intuitive. Mutual funds are a $5 trillion dollar business, and that is more than one-third of the value of the entire U.S. stock market. As such, mutual funds in aggregate can only return what the entire stock market returns, less costs. There will always be a few actively managed mutual funds that will outperform the indexes over the long-term, but those funds cannot be identified in advance. Past performance is not a reliable predictor of superior future returns. It is very common for the top active funds in one period to fall to the bottom over the next period.

In the long-term, fees matter. The difference in return between mutual funds is influenced greatly by the expenses in those funds. As Figure 4 shows, large actively managed U.S. stock mutual funds with higher fees performed below actively managed funds with lower fees, and both performed less than the index funds with the lowest fees.  

Analysis of Funds

We are not biased toward one mutual fund company or another, or have a strong preference to open-end funds or ETFs. Typically, a client portfolio will hold funds from several different providers of both open-end mutual funds and ETFs. The fund providers commonly used include The Vanguard Group, Dimensional Fund Advisors (DFA), Barclays Global Investors (BGI) and State Street Global Advisors (SSgA).

Portfolio turnover is very low in client portfolios. Most investments are held for many years. There are new funds coming to the market weekly. However, after review, most are dismissed quickly because they are either too expensive or do not adequately cover an asset class. Occasionally, a new fund is introduced that is worthy of a closer look, and it is our responsibility to analyze these funds in-depth. We are always interested in saving our clients money if a lower-cost fund option is introduced or a new fund improves the diversification of the portfolio.

For more information on security selection, see the articles, links and books in the Research Library. Read All About Index Funds and The ETF Book for an in-depth explanation of these investment products.

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