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Your mutual funds need attention, too
Sunday January 23, 2011
Bradley R. Newman

Many of the recent articles associated with planning for the New Year have had an almost singular focus on the need to increase retirement savings. While increasing your level of ongoing savings will certainly not be detrimental to your long-term financial health, letís take a minute to focus on the impact of managing the dollars that you have already accumulated in an appropriate fashion.

A critical component of portfolio management is security selection; i.e., determining which investment to purchase. For purposes of this discussion weíll focus mutual funds. Even with all of the right choices being made at the macro level (asset allocation, sector weighting, investment style, etc.); poor security selection will prevent you from realizing appropriate investment returns for the risk that you are taking.

So Many Options

The proliferation of mutual funds available has exploded over the past decade; based on December 31, 2010 Morningstar data, there are over 25,460 mutual funds available for purchase.

The problem is that some funds are very good options, some are average options and some are very poor options. A subset of this problem is that everyone you speak with would lead you to believe that their fund selections; i.e., the funds they are selling, are superior to the funds everyone else is selling.

How Do You Choose

Unfortunately there isnít an easy way to take all of the variables associated with mutual fund performance (cost, management expertise, etc) and effectively create an appropriate yardstick by which all funds can be measured. However, by reviewing the historic comparisons of how a particular fund performed versus the other funds in its peer group (large cap value, large cap growth, etc), you can determine if a particular fund has a proven track record of success, failure or sporadic periods of each.

Letís fully acknowledge that past performance is no guarantee of future results. Additionally, letís acknowledge that our goal is not necessarily to pick the best fund in each asset class, but simply to utilize funds that are consistently in the top quartile of the peer group of their asset class.

Bottom Line Numbers

Bottom line impact of dealing with a fund that consistently delivers top quartile performance versus one that regularly delivers bottom quartile performance is notable. For example, reviewing the 1,725 large cap growth mutual funds with a three year track record as of December 31, 2010, the differential in return for the median performing fund of the top quartile versus the median performing fund of the bottom quartile is 6.5% per year or almost $185,000 on a 1 million dollar portfolio over a three year period.

Median of Top Quartile +0.8%
Median of Bottom Quartile -5.6%
Average Annual Difference 6.5%

Why Do Some Funds Perform Poorly?

The most common contributing factors to bottom quartile performance are high sales charges, high internal expenses associated with fund management and an undisciplined management process; a 5.75% front-end sales charge or an ongoing 2.25% expense ratio are significant hurdles to overcome.

The real question is ďWhy would any investor own a fund that is perennially a bottom quartile performer?Ē The most likely answer is - they were sold that fund and never asked for independent data to compare that fund to alternatives in its peer group.

Not Once and Done

Security selection is not a set-it-and-forget-it type activity. Your mutual fund selection should be reviewed on at least a quarterly basis; funds will fall out of favor for a variety of reasons and you need to be prepared to adjust the portfolio accordingly.

Increase Your Odds of Success

By working with an advisor whose compensation is not tied to which mutual fund family or mutual fund share class that you utilize, you can take a significant variable out of the decision making process. Regardless of compensation structure, utilize an advisor who is willing to show you the independent third-party data that provides a compelling rationale for the funds being recommended to you.

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