The asset allocation decision is the heavy lifting in the investment process. Having decided on an appropriate asset allocation plan, our quest now turns to finding the appropriate funding vehicles to best represent each asset class. As it turns out, mutual funds are almost the ideal building blocks to construct your globally diversified investment strategy.

We have absorbed a fair amount of financial theory — now it’s time to get down to the nitty-gritty of selection. You shouldn’t be surprised that our criteria will meet the needs of the process.

The Rise of the Mutual Fund Industry

Unless you have been on an extended vacation, you can’t have helped but notice that mutual funds have become a very popular way for Americans (actually much of the world) to invest. In a reasonably rational world, things like this don’t just happen. Mutual funds have become popular because they offer huge advantages to small (loosely defined as those with less than $50 million or so to invest) and large investors. The advantages are just about overwhelming.

Mutual fund companies are good capitalists, and they certainly are not dumb. They have spent freely on advertising and public relations to educate us to all the advantages. They have been very successful in getting their message across. By now, almost every small school child can effortlessly list all the reasons why mutual funds are the investment vehicle of choice.

Traditionally, we have thought of diversification, low cost, and access to superb managers as the chief advantages of mutual funds. The first two are certainly true. Where else can an investor purchase a portfolio containing hundreds or even thousands of individual issues across a market with as little as $500 or less? How could he do it without being destroyed by transaction fees? Now, of course, we have to wonder if management can add value. If the investor is convinced it can, then by pooling his funds with thousands of others, he can attract the attention of the best talent available. If the investor doesn’t believe that, then he has the alternative of investing in index or passively managed funds.

As designers of a superior investment strategy based on strategic global asset allocation, we will select mutual funds which allow us to very tightly control our portfolio. We will be seeking very precisely targeted funds in diverse markets and investment styles. This will require us to leave behind any notion that there is a single “best” fund which might meet our needs, abandon the ever popular but childishly simplistic and ineffective magazine ratings, and redefine our performance benchmarks.

Unwarranted Concerns about Fund Trends

All the money flowing into mutual funds gives rise to a constant stream of concern by writers in the popular press that somehow mutual funds are going to be responsible for the next big market crash. Under this theory, individual investors have not been tested by a bear market recently. When the bear arrives, all the neophyte fund investors will head for the door at once. The resulting redemptions will trigger a liquidity crisis and vicious unending downward spiral in the markets. The core of this argument seems to be that only mutual fund investors will behave irrationally. The evidence seems to point at large institutions, traders, and speculators as equally liable to panic.

In fact, mutual funds are simply replacing other investment mechanisms that are less efficient and economical for investors. Rather than sit around worrying about too much money going into mutual funds, those same writers ought be considering how to encourage individuals to increase their long-term investing, and the percentage that goes to equities. The overriding concern I have is that Americans are investing too little and too conservatively to meet their long-term needs. All investors, whether invested in funds or individual issues, need to restrain themselves from irrational behavior during the occasional, inevitable, temporary market decline. We will examine investor behavior and its effect on markets in a later chapter. For now, I will assert that mutual fund investors seem as rational as any other large block of investors.

Two other recurring themes crop up enough to bear comment. One would have us believe that mutual funds are some type of passing fad, soon to fade from sight like the hula hoop. The other implies that funds are somehow inferior devices designed for the unsuspecting rube, and that larger sophisticated investors will soon outgrow them. This makes me wonder what the authors have been smoking. Mutual funds are gaining market share because they are a better investment medium. And not just for small investors. Huge institutions routinely buy funds. We can assume that they are aware of their alternatives and have made reasonably intelligent decisions.

Mutual funds have a few flaws left which we must soon address. As we do so, keep in mind that warts and all, this is the best solution for the overwhelming majority of investors. We are not in the position of having to accept the best of a bad deal. Rather, we have an abundance of truly great deals to choose from.

A Huge Universe of Funds

This abundance causes a problem. Today there are over 6,500 non money-market funds, and over 1,500 were added just last year. So, rather than have too few choices, in most asset classes we are buried in them. With more than three new funds coming on stream each business day, just reading the new offering prospectuses would be a full-time job.

Of course, there is lots of information from numerous sources. You don’t even have to leave your home. You can spend all day and all night surfing the Net. Before the end of next year it will be a sorry mutual fund family that doesn’t have their own Web site. But, data, facts, and information aren’t knowledge.

Fund Basics

So, let’s see if we can cut through all the noise and clutter to see how the fund industry works. Then we can develop a few simple criteria to drive your selection decisions. This procedure is fairly straightforward, and it allows you to get in control of the total investment process.

Cost: The Natural Enemy of the Investor

Cost is an important consideration for investors. Cost is also one of the few areas over which investors can exercise a great deal of control. There seems to be a concerted effort by the fund industry to absolutely prevent investors from figuring out what their costs really are, and what the implications of the various pricing strategies mean. Don’t despair. It can be explained very simply.

Management Fee

Every mutual fund has a management fee. It is fully disclosed in the prospectus. This fee goes to pay the normal expenses of running the management team and the business. It includes postage, printing, rent, salaries, accounting, lights, telephones, equipment, and the like.

The Dreaded and Much Maligned 12(b)-1 Fee

Some funds charge a second fee called a 12(b)-1 fee. The purpose of this fee is to promote the sale of more shares of funds to the public. The fund might use this fee for advertising, commissions to salespeople, or to pay custodian and service fees to a discount brokerage house.

It’s not important whether the fund breaks out the 12(b)-1 fee in the prospectus. All funds have some type of promotion expenses. Some just choose to show them as a separate cost.

Expense Ratios

Both management fees and 12(b)-1 fees, if any, are included in the fund’s expense ratio. Expense ratios are always fully disclosed in the prospectus. This is the number the investor should zero in on. There is a very strong inverse relationship between total cost and investor return. While purveyors of high price goods invariably love to imply that “you get what you pay for,” on Wall Street it’s often easy to get far less. As you might expect, low expense ratios are very, very good. Expense ratios can vary from under 0.25 percent to over 3 percent.

Trading Costs

Trading costs are not included in the expense ratio, and not disclosed. (More about the second point later.) We may impute some information about trading costs from the portfolio turnover. Some funds never trade, and some may turn the entire portfolio over several times a year. We know that lots of buying and selling is expensive. Just how expensive trading can be varies from market to market. Trading costs are generally very small for NYSE stocks. But when we get into small company, foreign, or emerging market stocks or bonds, prices can get very high. For instance, a “round trip” on a small company stock may exceed 7 percent. So, an average of two trades a year on a small company portfolio can go a long way toward eating up the average profits.

Trading costs fall directly on the fund. When a fund buys a stock, it carries the stock on the books at cost, including commissions. When it sells, it shows the net receipts after commissions. Neither commissions nor the “spread” are ever accounted for. Unless one can demonstrate a very positive benefit from trading, and most managers can’t, then small turnover is good.

The Bottom Line: Well One of Them Anyway!

Simply put, the ongoing cost of running any mutual fund is the expense ratio plus the trading costs. Unfortunately, this definition doesn’t include the impact of commissions.

The Impact of Commissions

Some funds are sold directly to the public. Others are sold by salespeople. The second type of fund has to figure out how to pay the salesperson. A number of interesting arrangements have developed to solve that problem.

In the bad old days, many mutual funds were sold by contract. The investor paid a set amount every month for a number of years to satisfy her contract. During the first year, the salesperson got half of the investment. After that, the salesperson usually got about 4 percent of the continuing contributions. Perhaps that explains the slow acceptance of mutual funds by our parents.

Later, so called “front end load” products emerged with a top sales charge of about 8.5 percent. This sales charge was deducted from the total investment, and the balance ended up in the fund. So, out of a $10,000 investment, $9,150 went into the fund, and the balance ended up in the sales organization’s pockets. Larger investments might qualify for a discount. For instance, at $100,000 the typical sales charge would be 3.5 percent. Front end load products are often called “A Shares” within the industry.

Over time, resistance to the high sales cost drove many companies to cut their maximum sales charge to around 5 percent. But, as true no-load mutual funds cut into the market, funds began to look for ways to hide the sales charge. This effort reached its brilliant conclusion with the invention of the brokerage houses’ no-load or “back end surrender charge” funds. (Commonly called B Shares.)

Until the investing public began to figure it out, the brokerage houses and broker-dealers had the best of all possible worlds. They were able to increase the average commission paid to the salesperson, and at the same time claim that the product was no-load. The broker got a 5 or 6 percent commission the first day, but the client saw all his money go to work in the fund at the same time. This little piece of Wall Street Magic was possible because the sponsoring company “fronted” the commission to the broker. The company recovered their payment to the salesperson by increasing the charges to the fund about 1.5 percent per year. (This charge was the so called 12(b)-1 fee, named after the NASD’s enabling regulation.) In the event the investor liquidated his fund prior to the company recovering the commission, interest, and a profit, the investor was charged a “back end surrender fee” before his proceeds were paid out. This last part of the transaction was not often emphasized during the sales process, so many investors were in for a rude shock if they bailed out for any reason.

If investors took the time to do the math, they discovered that the back end surrender funds could be a very expensive way to invest. For one thing, large investments got no discount. An investor placing $250,000 in a front end load fund could expect a one time 3 percent charge. But if she held the same size investment in a back end surrender charge fund until the end of the typical surrender period of 6 years, she would end up paying 9 percent in hidden fees. Assuming growth of the investment, the fees got larger! Finally, the hidden charges continued forever, so the total cost could be huge. Of course, in our example, the salesperson got twice the commission he would have earned in the more straight forward front end transaction. It’s not too hard to see why brokers loved the back end surrender products.

If the evolution of the load fund industry had stopped there, our task would be somewhat simpler. But, as investors began to wise up, fund families tried to stay one step ahead by introducing new types of shares with new pricing. The names they gave the pricing schemes aren’t always consistent from one company to another. “C Shares” look rather like B Shares, but the internal charges fall after the surrender period. “D Shares” have a level 1 percent charge paid to the salesperson each year, but have no surrender period or charge. Many “A Share” funds have introduced a 12(b)-1 charge to finance a “trail commission” to the salesperson on top of the original sales commission. Still other companies are experimenting with reduced front end charges but larger ongoing fees to finance increased trail commissions.

Recently, the NASD issued regulations that prohibit any fund charging a 12(b)-1 fee in excess of 0.25 percent from calling themselves “no-load”. The same regulations have allowed fund families to actually increase trail commissions to salepeople, who now presumably refer to their products as “no front-end load,” all in the name of consumer protection! At the same time, some true no-load funds have expense ratios high enough to choke a horse. So, look beyond the labels.

If all this is beginning to make your head spin, there is a simple solution. Just buy no-load funds. Then all you need to be concerned about from a cost perspective is expense ratio and trading costs. Your broker may not care for that solution. But, it’s not your job to keep her happy. Even if we ignore the effects of embedded conflicts of interest in the commission sales process, commissions have a direct economic impact on the investor. You may think of front end load funds as being the equivalent of running a 100 yard dash from 3 to 8 yards behind the start line. Back end funds might be thought of as running the same race while carrying a 150-pound load.

Another problem with the traditional load products is the psychological feeling of being trapped in an investment by the large cost of moving. Investors will often stay in an inappropriate investment rather than endure a second set of fees required to bail out of the first poor choice. Families of funds mitigate this problem. They allow an investor to switch without penalty within a single family of funds. This still requires the investor to severely limit his choices. With true no-load funds, especially if held as custodian by one of the large discount brokerage firms, the investor may have over 1,000 choices in over 200 fund families, and she can execute them with just a phone call. (Some transaction charges may be tacked on by the brokerage firm, but these are a very tiny portion of the commission charges on load funds.)

One great working solution to defining of a no-load fund is to inquire about the cost of a round trip. If you can buy a fund today for a dollar, and sell it tomorrow for a dollar (assuming the market hasn’t moved), you have something that looks, smells, and feels like a no-load fund. While this definition may not be technically accurate, it will uncover lots of deceptive sales tactics. You will quickly be able to quantify the costs of brokerage and trading costs.

Targeting Your Market Segment

The next big issue we face in building our investment plan is that the funds we select must reliably capture the performance of the market or segment of the market we have specified in our model. We know a great deal – but never enough – about the risk, return, and correlation of stocks based on the size of the firm and the stock’s book-to-market ratio. This information was crucial in designing the asset allocation plan.

If we are going to have control of our asset allocation plan, we must seek out funds that will confine themselves to a definable style. For instance, we know that across most of the world’s economies, the smallest 20 percent of the companies have about a 5 percent higher expected rate of return than the largest companies over long periods. Of course, this return comes with a higher risk, and a correlation with other asset classes. So, if our asset allocation plan calls for, say, a 15 percent weight in small companies, that is what we want to have. One person’s definition of small may vary considerably from the next. So, our terms must be objectively defined. For instance, we might define small as a fund with a maximum size company of $500 million. Other observers might call these companies micro-caps. But if we want the performance that comes with small companies, we are just kidding ourselves if buy the smallest firms in the S&P 500.

The same goes for value. Value is an even harder term to pin down than size. Lots of managers call themselves value managers, but own portfolios of stock with very low book-to-market ratios. If we want a strong value representation, we must seek out funds with stocks in the highest third when ranking book-to-market scale for each size company.

Style Drift: The Natural Enemy of Asset Allocation

It would be disconcerting to find that a fund we had selected to represent small companies was suddenly investing in GM, IBM, and ATT. Now, many “growth” funds have decided to add foreign stocks to boost their performance. That might or might not work out well for their particular fund, but it skews the model badly.

The tendency of managers to wake-up one day and decide that an entirely different market segment looks more attractive than where they are is called “style drift.” Style drift is the natural enemy of the asset allocation plan. It goes without saying that we have no way to control risk if we don’t know what is in the portfolio, or if the portfolio can change radically without any advance notice.

Traditional Labels and Fund Objectives Obscure Rather Than Enlighten

Traditional labels and prospectus categories are not much help here. In fact, it’s best to forget them. The categories are arbitrary and ambiguous. Just where is the boundary between a “Growth and Income” and a “Growth” or “Equity Income” fund? These nuances have always escaped me. Many fund rating services attempt to use these categories to compare fund performance. The funds often respond by redefining their objectives to fit a category where their relative performance is better.

Defining the investment manager’s style provides us with a great deal more useful insight. Morningstar’s style boxes allow the potential investor to determine at a glance the average size and growth/value characteristics of the portfolio. While far from perfect, this system is a big improvement. The style boxes are limited in that they describe only the average holdings in the portfolio. Some portfolios are hard to properly categorize, and the boxes are no assurance against style drift.

Many mutual funds have wide latitude to invest wherever they wish. Some have demonstrated either superior skill and cunning, or tremendous luck as their portfolio zigged and zagged. Magellan and 20th Century Ultra are famous for refusing to stay put. Their management will, of course, claim skill. Putting aside the question of skill vs. luck, for each happy example, the landscape is littered with failed attempts.

Once we have made our asset allocation decision, we have absolutely no interest in the fund manager’s market forecast. We want him to stay fully invested in the market we expect at all times. We have made the decision as to the exposure level we wish to have, and attempts by the manager to time her little part of the market are unacceptable to us. The mutual fund is simply a building block for our investment strategy, and the more predictable the building block, the better the finished structure. The days when we would turn over our money to a manager who could do whatever she wanted should be long behind us.

The asset allocation approach is a far cry from the traditional view of the roll of the fund manager. Her roll is reduced from exalted guru to subordinate technician. Her mission is to stay fully invested, widely diversified, keep her costs down, and reliably capture the performance of her assigned market segment. Should she stray from her assigned turf, or attempt to market time, she will be replaced. Should she fail to match her assigned market’s performance, she can easily be replaced by an index fund that will. On the other hand, it’s not appropriate to blame the manager if her asset class shows poor performance. For example, Japanese small company fund managers are not to blame that the asset class has shown 6 years of dreary returns.

When it comes to picking funds, very little of what you hear in the popular financial media is useful, unless you just want to collect a few tidbits to drop at cocktail parties. Lionizing last year’s lucky manager is fun and probably harmless, but it tells us little we want to know about next year’s performance.

Rating services such as Morningstar’s star awards, or Forbes Honor Roll, attest to the futility of applying past performance to tomorrow. Investments in either set of recommendations would have produced sub-standard results. If those two organizations, with all the resources they have, can’t make useful predictions, how can the rest of us hope to? So why do people keep listening to that trash? When Wall Street Week starts interviewing next year’s winners, I’ll tune in. If successful investment management simply required counting stars, or buying Forbes’ list, we would all be rich and carefree.

On the other hand, there are some great resources widely available. For example, Morningstar’s database on disk provides a treasure load of information. It allows us to screen well over 100 criteria including P/E ratio, Price/Book ratio (the reciprocal of book-to-market ratio), turnover, medium market capitalization, expense ratios, earnings growth, sector weightings, standard deviation ratings, estimated potential capital gains exposure, minimum purchase amounts, and a host of other information useful in choosing our portfolio components. You can, for instance, with just a few mouse clicks, screen for no-load foreign equity funds with an average firm capitalization not to exceed $500 million, which accepts initial account sizes below $2,000, available through the Fidelity or Schwab brokerage systems, with expense ratios below 1.25 percent and then sort in descending order of P/E ratios. Another click, and you can compare your candidate funds with an appropriate index, check industry weightings in the portfolio holdings, and insure that the fund holds enough issues for proper diversification. Morningstar even gives you the 800-numbers for most funds, so that once you have identified a few likely suspects, you can order prospectuses. Many city libraries have access to this or similar services.

I submit that this caliber of information is a great deal more useful than Money Magazine’s “Eight Great Funds for the 90’s” type article. With data like this, you can select and monitor your asset allocation plan segments.

If you have a large portfolio, you may want to have several funds in each category. If so, I would build the core of my holdings around index funds. Today, I personally try to use a minimum of 60 to 75 percent index, or passively managed funds in each category. The advantages of low expenses, low trading activity and cost, and the assurance that we can reliably track our desired market segment are compelling. Additional advantages are a reduced tax exposure, and you will never have to be concerned about style drift.

While I haven’t foreclosed the possibility that active managers might add value, I am strongly leaning in that direction. In a debate that takes on almost religious or mystical overtones within the industry, I guess I am an agnostic. I’ve seen too many high-flying performers suffer ignoble crashes to have much faith left. If you asked me to guess, I would probably say that in 5 years I may have weeded all the active managers out. In the meantime, I am limiting their roll so that if one or two make a few bad plays, it doesn’t ruin my portfolio performance.

A Checklist for Action

Here is a checklist you could use to develop your fund selection process for each individual asset class. My suggestions are included:


  • Decide mix of active and passive techniques. (As a minimum, the core portfolio, say 70 percent, should be indexed.)
  • Define the market as tightly as you can — large, small, foreign, emerging market, Asia, Japan, Europe, etc. Make sure the manager stays fully invested and within the assigned market.
  • Define style — growth vs. value. (A strong value tilt should enhance performance and reduce risk.)
  • Eliminate all load funds. (Never pay a load!)
  • Check expense ratio. (The lower, the better. But remember, some markets cost more than others.)
  • Check portfolio turnover. (The lower the better.)
  • Compare performance to appropriate benchmark, and competitive funds. Try to understand any variation from benchmark. (There is always a reason. Higher returns mean higher risk. For instance, this year’s big heroes are very strongly concentrated in technology stocks. They could easily look like the worst dogs someday soon.)

But what if you are just starting out? What if your budget is very limited? You can still build a Champaign globally diversified portfolio with a beer budget. While a $1 million portfolio might have 20 or more funds, you can do a reasonable job with just 3 or 4 index funds. For example, index funds: the Schwab 1,000, Small Cap, and International would be a good start. Or, Vanguard will send you information on how to index most of the world’s markets. As your portfolio grows, you can tilt toward smaller firms, and value. Later add emerging markets. These are just examples; there are lots of great no-load families that accept very small initial purchases. Many will take on contributions as low as $50.

If you are making ongoing contributions to your investment plan, after you have built up a good core, consider tilting your purchases to the most thoroughly beaten-up markets as you go along. For example, this year I would be looking strongly at Japan and Latin America.

Just do it!

Remember, it doesn’t have to be perfect to be great. Get started. Don’t wait for it to be perfect. It never will be, and you will still be waiting when you are old and broke. If you need a little forcing system, use an automatic check withdrawal to your investment account. The important thing is to get started on a sensible plan, and exercise the discipline to carry it out. Start small and build in pieces. Use your company savings and pension plans. If the choices aren’t perfect, do the best you can. For instance, almost any growth fund in your company plan is going to pay off better in the long haul than any bond or guaranteed account. If the company plan offers foreign, value, small company, or emerging markets, use them. If not, balance your company plan with your own investment plan so that the whole thing looks like your ideal asset allocation.

Coming up

While I am one of the great mutual fund boosters, there are a few problems in the industry that you should be aware of. Warts and all, no-load funds are still the best deal around. But, it’s always a mistake to think that everybody on Wall Street is a choir boy, even in the no-load mutual fund business! I will show you some things to look out for. Remember, if we all demand better, we will get it. Just by voting with our feet we can make the best deal even better. It’s the one way to really get Wall Street’s attention.

There are lots of alternatives to no-load funds, and a few of them even make pretty good sense as part of a balanced portfolio. We’ll take a look at them, too.