7 Pitfalls to Avoid When Building a Lineup

When Morningstar’s manager selection team assembles lineups for our institutional clients, both retirement and nonretirement, there are always certain positive attributes we’re striving for, such as appropriate diversification, high-rated fund managers, and low net fees. At the same time, we try to be cognizant of potential pitfalls in our lineup design that could trip up investors down the road. Setting up things in a way that minimizes behavioral errors as well as exogenous investment risks can be just as important as, say, picking the right funds.

Below, I cover some of those potential traps and errors that can arise when building a lineup. Although we think about how investors will be using them in a more institutional context, often within a retirement plan, many of these points are equally relevant if you are building your own individual portfolio.

Getting Blinded by the Light of Recent Performance When selecting funds, it's easy to get seduced by recent outperformance, but chasing short-term returns--even three-year results--is a sucker's game. There's too much noise, with the potential for style bias or pure luck to be the swing factors in the results. In addition, mutual fund returns are notoriously mean-reverting, so that outperforming funds during one period may be equally likely to underperform in the next. Ideally, focus on strategies that have seen at least one full market cycle, and examine the fund's full record under the manager responsible for it. Rolling return periods are also a useful lens, as well as discrete periods of both market duress (such as the 2008 bear market) and success (such as the current growth-led bull market).

Overemphasizing High Active-Share Managers There's an understandable tendency when picking actively run funds to emphasize managers with high active share, which is to say those who run funds that don't look like the benchmark. The basic reasoning is that if you are going to pay the fees for active management, you might as well find managers whose portfolios look nothing like the benchmark. That is sound wisdom, as far as it goes. Where it falls short is in the recognition that many investors lack the patience and discipline to stick with a strategy when it has a pronounced slump or performs at odds with the broader market, as often occurs with higher active-share funds. Particularly when designing retirement-plan lineups, while we will include some high active-share/high-volatility funds in which we have very high conviction, we typically limit exposure to such strategies in favor of funds that are easier for investors to use. That doesn't mean you should avoid such funds in constructing your own portfolio, but you should make an honest appraisal of your ability to tolerate significant variance in performance, both on an absolute and relative basis.

Gravitating to Trendy Strategies The fund industry is always coming up with novel ways to market new products. In many cases, those funds are overpriced, higher-risk, or lacking in benefits over traditional, well-established categories. Moreover, they often focus on asset types that have had recently strong performance (which may not be durable) or, worse yet, derive from strategies that look good in back-tests. Some recent exchange-traded fund rollouts seem to lean toward the gimmicky, for instance. In designing retirement-plan lineups, we focus on core asset classes along with a scattering of categories that have demonstrated diversification benefits over the long term or fill specific portfolio roles (such as Treasury Inflation-Protected Securities). You'd be similarly well-advised to avoid the latest trends or buzzy funds when constructing your own fund portfolio.

Creating Unintentional Overlap Allocating to funds based solely on their category, or accumulating too many funds, can lead to unintentional overlap (a topic I've addressed previously). It's important to look beneath the hood, viewing funds at the underlying portfolio holdings level, to ensure that one fund isn't replicating the work of another. When my group designs fund lineups, we perform that kind of analysis so we can construct as much distinctiveness between offerings as possible (some overlap is inevitable), and when we offer multiple funds within a given category or asset class, we try to identify strategies that offer different substyles or that we expect to exhibit differentiated performance patterns from one another.

Neglecting to Include Passive Options It used to be the case that employers leaned toward brand-name active managers in their retirement plans, believing that their employees would have more familiarity with such funds and be more inclined to divert their assets from low-earning money market funds. Increasingly, however, those plan sponsors (like the rest of the investing world) have woken up to the importance of using passively managed funds. We typically recommend a mix of active and passive managers when constructing lineups. Although we most often use index fund for categories, such as U.S. core equity, where beta is cheap and active managers have had a tough time outperforming benchmarks, we'll also use them in ostensibly less-efficient areas, such as emerging-markets equity. Even if you have a bias toward active managers in your portfolio, don't overlook passive options. Not only will they lower the overall cost of running your portfolio, they can help smooth out the performance bumps that the more active managers may cause and perhaps help you stick with your investment plan.

Cluttering the Lineup With Unnecessary Fund Types I've written previously about how you might potentially slim down the number of funds you hold. The most expansive lineups the manager selection team designs do move outside of core investment categories, but we also insist that such categories demonstrate some diversification value or specific investment outcome value (some of those include emerging-market equities, TIPS, and high-yield bonds). But even beyond the trendy fund types mentioned earlier, there are many more-established categories that probably add only limited value to a portfolio, and additionally introduce potential overlaps to your portfolio as well as the headaches of excessive recordkeeping. A technology sector fund, for example, may sound exciting, but if you have a U.S. large-growth stock fund in your portfolio, then you likely already have a sizable exposure to tech (the Russell 1000 Growth Index contains about 30% in technology stocks).

Forgetting About Risk It's easy to fall into the trap of focusing solely on a fund's returns. Even taking pains to measure a fund against an appropriate benchmark or evaluate its returns over very long periods doesn't lessen the limitations of such an approach. Instead, consider integrating two other elements as you build your portfolio: your ability to handle risk and your goals. A fund's long-term annualized returns tend to smooth out the ups and downs over that time. A fund's volatility and downside performance, however, can have a significant effect on your comfort level as well as your ability to stay with an investment. Moreover, your specific investment goals can guide how much risk you can or should take. Folks investing for retirement with a very long time horizon can afford to take more risk across the portfolio, with time to ride out even large declines. If your time frame is shorter, or you expect you'll need to draw on assets for a short-term need, that argues for taking less risk both in your overall stock/bond mix and in the specific investments you choose.