Last week, we looked at various types of investments. This week I’d like to give you some guidelines I use for investment selection. When constructing a diversified portfolio for clients using mutual funds and ETFs, here are some of the criteria I look for.
I want to know what companies are in the fund. Holdings are the underlying investments that the fund “holds.” Some of the things I look for are:
– What is the company size (small, mid or large cap)?
– Where are the companies located (United States, international or emerging markets)?
– What sector is the fund invested in (technology, biotech, mining etc)?
– How many holdings are there in this fund?
– What percentage of the fund does each company comprise?
As a general rule of thumb, I look for funds with fees no greater than 1%. Sometimes funds offer much lower fees. Other times, a client might have a limited offering of funds in their 401(k) which has higher fees, and we have no choice but to choose from these funds. Vanguard is known for providing low cost mutual funds. They illustrate how fees can erode investment returns here.
Here I’m looking at if the “style” of the holdings are consistent. Basically, this means that if the fund says it’s a large cap growth fund, that it doesn’t end up “shifting” so that more holdings are in fact mid cap value. I don’t want the fund manager to try to make up returns by timing the market. Also, having different funds in a portfolio with different styles creates diversification, which I’m looking for. Morningstar has many resources for researching investments. The Style Box they provide for funds is a helpful reference.
I also look at how the fund has performed compared to its peer group. I want to compare apples to apples. If I own a mutual fund that invests in real estate then I compare the performance of that fund to other real estate funds. It’s not accurate to compare all investments to S&P 500. Although this is a very common benchmark, it is only comprised of large cap companies.
Risk vs. Return
It’s important to consider not only the performance of a fund, but also how much its value fluctuates. As investors we want to be sure we’re being rewarded for the risk we’re taking and not exposing ourselves to unnecessary volatility. Two of the measures of risk I use are Alpha and the Sharpe Ratio.
There are additional criteria I use to select funds, but this list is a place to start. I hope this gives you more insight into the selection process and making wise investment choices. Sometimes, seeking the advice of a professional can be helpful. A CERTIFIED FINANCIAL PLANNER™ can recommend funds that are a fit for you. Or reach out to me for a free consultation so that I can determine if I can help you with investment decisions. Be sure to choose your investments prudently in order to SaveUp!
This post was written by SaveUp’s personal finance contributing writer, Catherine Hawley, CFP®.
Image source: Forbes