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A Checklist for Fund Investors

Questions to ask when deciding whether to invest in a fund.

Kevin McDevitt, CFA, 12/19/2013

Last weekend The Wall Street Journal columnist Jason Zweig wrote an excellent piece about the importance of using checklists as a way to avoid behavioral errors when investing. As he points out, investors can be wildly inconsistent in the parameters they use when evaluating potential investments. This leaves them prone to making decisions based on emotion rather than a systematic process. Employing a checklist ensures that investors consistently address the issues that really matter, and it helps them avoid repeating past mistakes.

The column suggests potential questions to ask when investing in individual equities, but it doesn't have specific suggestions for mutual fund investors. So, what would a fund checklist look like? These questions should go beyond what one might include in a simple screen. Let's assume that investors--or at least regular visitors to this website--know to generally stick to funds with low costs, proven management teams, and strong risk-adjusted performance. But such data points are just the beginning.

What follows are questions that likely aren't new and are mostly common sense, but they can be easy to ignore in the heat of the moment. They may require a little more digging and self-reflection on the investor's part too, but if they're addressed diligently, the effort can lead to better decisions and better outcomes.

How does the portfolio fit with my existing holdings? 
There are two aspects to this question. First, is there significant overlap between a given fund portfolio and one's existing holdings? Portfolio overlap can lead to undue concentrations in certain areas, leaving an investor less diversified than he might have thought. Undue concentration and limited diversification can leave a portfolio more vulnerable to performance swings and greater losses when times get tough.

Even when holdings or style overlap isn't a problem, take this analysis a step further by asking, What would this fund add to my existing portfolio lineup? Be aware that asset classes that are quite different can sometimes be subject to similar dynamics. For example, adding a high-yield bond or bank-loan fund to an already equity-heavy portfolio likely wouldn't provide much diversification benefit given that credit-sensitive securities tend to have fairly high correlations with equities.

Am I chasing past performance? 
This one is as much about self-evaluation as fund analysis. Nearly five years into a bull market characterized by extremely low interest rates, it's easy to rationalize stretching for extra yield or return. ("This small-growth fund is just the thing I need to be better diversified.") The danger of doing this, of course, is taking on more risk than one is prepared to bear, especially in the near term.

One way to get at this is to investigate what's driving performance. Market-beating returns are all well and good, but they don't tell you that much by themselves. It's critical to understand the context for a fund's returns. That is, how much risk was a manager taking on to earn those results? Try to find the causal factors within the strategy and portfolio that are driving performance rather than simply looking at descriptive statistics.

What is the fund's downside and am I comfortable with it? 
This leads to the next checklist item, and perhaps the most important. Despite what some alternative managers say, every investment carries risk, and every fund has a downside. It's critical to first accept this fact and then identify what the risks are in advance. Always ask yourself what can go wrong and then assess whether or not you can live with that.

Kevin McDevitt is an Editorial Director with Morningstar.

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