How to choose funds that will make money is a primary goal for many investors, but how should you go about selecting funds?
This article shares three steps in selecting fund investments, which I believe are fundamental principles when starting the fund selection process. These steps aim to provide some criteria of consideration, helping you make decisions that meet your needs in choosing funds.
Step 1: Decide the asset allocation ratio.
Before choosing which fund to invest in, the primary step is not to review metrics such as Sharpe Ratio, Beta, or Standard Deviation, or to immediately dive into the monthly fund reports. This is the first “deciding on asset allocation ratios”.
I have already mentioned, while each category of assets covers various investments, assets within the same category tend to have similar risk-return characteristics. Some assets move in tandem, while others have low or even opposite correlations. Asset allocation aims to invest funds on different types of assets (such as stocks, bonds) to significantly reduce volatility without compromising returns too much.
Instead of concentrating investments on a single type of asset, effective asset allocation helps mitigate significant damage from market black swan events.
In essence, determining the proportion of each asset based on its own risk tolerance is a crucial consideration in mitigating investment risks arising from market uncertainties.
Step 2: Decide the level of diversification of funds
Focusing investments on a single asset is not a problem, but excessive concentration in one industry category could lead to cyclical risks.
This means that when an entire industry undergoes a prolonged period of decline, even if you have a diversified portfolio, it could still be concentrated within a specific range.
For example, if you buy shares from multiple technology companies, you may have diversified into 10-20 different shares. However, if there is a global pandemic such as the recent one or a black swan event affecting the entire technology industry, all shares within the same industry will decline, including bonds and REIT (such as data centers) which are highly related to the technology industry. Under systemic risk, it may still be necessary to bear significant volatility.
A common misconception about diversified investment is that diversifying objectives is sufficient. However, the true diversified investment logic should include three levels of diversification:
Diversification of assets: holding different types of assets, such as shares, government bonds, investment grade corporate bonds, gold, cash, etc.
Sector diversification: To avoid the impact of a single specific industrial cycle, invest in ETFs or national or regional funds, typically diversifying across sectors in that country/region.
Stock diversification: Invest in 1-2 ETFs or different funds with different characteristics, or assemble a diversified investment portfolio yourself.
Diversified investment is just one of the investment options. The situation and risk tolerance of each differ. If you have enough time to do research and are confident in your judgment, you may also consider focused investments.
For most people, diversified investment may not always be better, but it is certainly not a worse option.
Step 3: Verification of the composition, commissions and performance of the fund
The essence of a fund is to bring together funds from a group of individuals, collectively managed by fund managers to seek higher returns on investments. It is one of many investment tools, just like ETFs.
If you choose to use funds as an investment tool, the following sequence introduces indicators such as fund composition, commissions, performance and more. These help in selecting a fund that suits your needs.
Step 1: Observation of fund components
Each fund usually lists its first 10 or first 5 participations, which can be found on the fund’s official website or in its monthly reports. When you invest in a particular fund, its investments represent your investment portfolio. Therefore, it is essential to observe whether the selection of the manager’s actions is in line with your expectations. Unless we know a fund manager well, it is unlikely that we know their team’s investment strategy. However, we can obtain information through their selections of actions.
When screening funds, consider these three questions to assess whether a fund matches your investment style:
Are there any top 10 entries you disagree with?
What are the respective weightings of the top 10 companies? Do they meet your expectations?
Where do the recent performances in terms of stock selection come from? Do you agree with this performance?
Remember, whether it’s an ETF or a mutual fund, you essentially pay someone to manage your assets. Therefore, it is essential to understand their management style and decision making. Reviewing the components of the funds helps us understand their decision-making logic.
Step 2: Understand fund fees
When buying or selling funds, you may encounter several main commissions, which can be found on the fund’s official website or in monthly reports. When assessing a fund, in addition to examining whether its performance meets expectations, pay attention to associated fees. High fund fees could affect the fund’s returns. Do not assume that earning more than taxes is sufficient; Even small percentage differences can have a significant impact as the quantity increases.
Especially for products with lower investment returns, high commissions can proportionately increase the total cost, making commission levels crucial to consider.
It is important to note that these are not the only commissions; there are also internal expenses such as the fund’s trading costs. Long-term investment funds usually follow the guideline of maintaining for long periods and avoiding frequent exchanges. Funds with high turnover rates and frequent stock volumes could significantly increase costs. While short-term gains may seem promising, it is essential to wonder if it is beneficial in the long run.
Step 3: Monitoring the performance of the fund
Many people tend to evaluate the performance of a fund as a first step, but I think performance should be the final consideration. After agreeing on the investment style and understanding the pricing structures, deepen the performance assessment.
After all, a fund with stellar performance could follow the trend with various hot stocks at the moment, which may not align with your long-term investment strategy.
Observing the long-term performance of a fund involves two key aspects:
1. Assess whether the fund’s annual performance has consistently exceeded the corresponding index.
For example, a technology equity fund should be compared with equity growth indices to assess relevance. A high yield bond fund should be compared to high yield bond indices to derive meaningful information. While exceptional funds find it difficult to exceed indices every year, observing annual performance provides insight into the quality of the strategy.
2. Observe performance during both bullish and bearish periods, especially in bear markets.
For example, in the stock market, during major declines such as 2008, 2018, 2022, observe the performance of the fund in these years. Pay attention to years with significantly high profits or losses, especially when there is a substantial deviation from the index.
This observation helps you understand the risk and strategy of the fund, helping you determine its suitability for you.
Of course, funds must have a long enough history to obtain substantial data. For funds with less than one year of foundation, it is advisable to observe for a longer period.
When assessing performance, focus not on the net value of the asset, but on performance or cumulative returns at the fund level.
