A Checklist for Fund Investors

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.

Broadly speaking, funds tend to have one of two downsides: underperforming during either bear or bull markets. Neither is bad in and of itself. It's more important to assess which is more palatable to you. As part of their strategies, managers will often say whether they aim to beat their index over the long term by outperforming during rallies or corrections.

Then see how the fund has actually performed during either bull or bear markets. For example,  Sequoia (SEQUX) tries to outpace its peers in relative terms during corrections. Sure enough, it beat its average large-blend rival (it's now in the large-growth category) by 13.6 percentage points during 2008's meltdown and by 15.7 percentage points during a difficult 2011.

On the other hand, any manager who claims that he strives to outperform during both bull and bear markets should be treated with great skepticism because it's incredibly difficult to do over the long term. (To paraphrase the Dread Pirate Roberts, anyone who says otherwise is likely selling something.) Of course, as GMO's James Montier recently pointed out, fund managers know that that's the white whale that many investors are chasing, so they'll keep offering it to them, even if they can't deliver. That's what made Madoff so beguiling: his apparent (and fraudulent) ability to deliver consistently high returns regardless of the market environment. Caveat emptor.

Does the process seem repeatable? Am I chasing a fad?
The prior question leads into this one and is particularly applicable to many of the alternative strategies that have been rolled out in recent years. These strategies have high degrees of complexity, which seem to differentiate them and perhaps give them a competitive advantage, but many such strategies flame out over time. Think of momentum funds in the late 1990s or some quantitative funds following the 2008 credit crisis.

Conversely, many of our favorite funds such as  Yacktman (YACKX) and those from Tweedy, Browne have fairly straightforward strategies. What distinguishes them is how those strategies are executed, which puts the focus more on management's savvy, discipline, and experience. A related question then is how likely a management team is to remain in place during the time horizon of my investment. Long-tenured teams from boutique shops with ownership in the firm are often the most stable.

For actively managed funds: Is the fund better than a passive option?
When considering an investment in a new asset class, passive funds are often a good default option. They tend to be low cost, well diversified, and carry little manager risk. Because actively managed funds usually charge more, they need to bring something more to the table. In most cases, there must be reason to believe that an actively managed fund can beat its benchmark over the long term. If not, then it's best to go with a passive vehicle.

In some cases, though, an actively managed fund may be a good option simply because it has a more palatable risk profile than the passively managed alternatives. That applies to  American Funds New World (NEWFX), which is far more conservative than most emerging-markets equity funds because it owns bonds and a slug of developed-markets stocks. The fund tends to lag its peers during robust emerging-markets rallies, but its portfolio may be better suited to an investor who wants emerging-markets exposure, but without the usual level of volatility.

There are many questions worth asking when considering an investment and those above are a good starting point. Think of the questions that are most relevant to you. As was pointed out in Zweig's column, revisiting past mistakes is a great way to come up with questions that might help you avoid those pitfalls in the future.