How to Choose Funds For Your Portfolio

How to Choose Funds For Your Portfolio

Learning how to choose ETFs and Mutual Funds for your portfolio can be intimidating at first. I still remember the first ETF I bought. I was wondering if I should wait to try to buy it at a discount. Part of me was annoyed with having to pay a commission. Are the advantages really worth it I wondered?

Today I'm going to help you navigate some of the big topics you need to know about choosing ETFs and Mutual Funds for your portfolio. I'll try to cover most of the "need to know" in moderate detail. Keep in mind that there is always more to learn and understand when it comes to investing. We're just going to get you pointed in the right direction.

ETFs VS Mutual Funds

There are actually quite a few minute differences between mutual funds and ETFs when you start to dig deeper. We're not going to dig that deep. Here's what you really need to know.

Mutual funds are priced one per day, at the end of the day. ETF prices can fluctuate minute-by-minute.

It doesn’t have to be one or the other. I own a few of each type, for different goals.
— Casey

Mutual funds can only be bought and sold at the end of the day. ETFs can be bought and sold intra-day.

The price you pay for a mutual fund is always equal to the sum of the prices of each underlying security. The price you pay for an ETF may be higher or lower than the actual worth of the underlying securities. This is known as a premium or discount.

Both ETFs and Mutual Funds are a single pooled investment made up of many underlying investments.

A type of mutual fund called "no-load" costs you nothing to buy or sell but usually has a penalty for selling less than 90 days after purchase. ETFs always cost a commission to buy and sell unless you use a commission free broker like M1 Finance.

Mutual funds, when bought through an adviser, usually feature upfront sales charges in excess of 5%. There can be many other hidden fees with mutual funds, particularly when bought through an agent.

Mutual funds tend to have slightly higher expense ratios than ETFs.

Prospectus & Where to Find Them

Where to find the prospectus on Morningstar.com

Each mutual fund and ETF must have a prospectus. This document is legally required by the SEC and is kept on public file. It must be updated at least one per year. In the prospectus you'll learn:

  • The fund's goals and objectives
  • What type of strategy it uses to meet its goals
  • What industries, sectors, etc. the fund is invested in
  • Past performance of the fund
  • Principal risks of investing in the fund
  • Breakdown of expenses
  • Fund management team

Generally, the prospectus is the last stop I will make before buying a fun. It's possible to find the majority of the necessary data without digging into the prospectus. once you think you've narrowed down your choices, then give the prospectus a full read before purchasing.

I like to get most of my preliminary data from Morningstar.com and the photo above shows your exactly where to find the prospectus for your fund.

Expense Ratios

Mutual funds are almost entirely actively managed. That means there's a team of people, as well as a fund investment adviser, working to pick out the best investments for the fund. This cost money. Often the fund manager's paycheck looks like multiples of millions of dollars. These are collected as fees and expenses from your investments.

How to find expense ratios on Morningstar.com

There are, of course, many other expenses that are paid using the overall fees charged to investors.

However, actively managed funds will always have higher expense ratios than passively managed funds. Expect passive funds to have expenses of 0.04% to 0.25% or so. Active funds may range from about 0.5% to 3% or more.

A passively managed fund has a much simpler concept and is largely operated by computer systems which need minimal human oversight. Usually, these are index funds of some sort - such as an S&P index fund like the famous SPY. Having such low maintenance means lower expenses which are passed on to you!

If you want to know all the nitty-gritty details about that the expense ratio pays for, it is disclosed in each fund's prospectus.

Please remember that having a low expense ratio is not the only factor in choosing your fund. It is, however, quite important to minimize expenses where all else is equal.

Fund Manager Tenure

Particularly where it comes to mutual funds, paying attention to fund managers can be crucial. Why care who is managing your fund? Okay, I'm not even pretending that any of you will research the history of each fund manager and their performances.

One of my favorite funds, PARWX, has had the same manager for over 12 years since inception. Perfect!

However, if the fund has just recently changed managers, this can be a good indicator that the upcoming years of fund performance may change. When a fund loses an established manager and gains a new one, anything can happen. This simply introduces an unwanted layer of unpredictability.

What I like to see here is a track record of good performance with a fund manager who has been in charge of the fund during that time. If I see a fund has performed well over 10 years and still has the same manager, I consider that a great signal.

Past Performance

This is an area where there is much debate. Should we focus on past performance? Well, everyone will tell you, "it's not an indicator of future results". That just means the market can do anything in the future.

So, if it's impossible to know which fund will do the best tomorrow, how do we pick? We use all the factors available to make an intelligent decision. That's all.

Since past performance of a fund is a relatively good indicator of anticipated future direction, we'll use it as a measure. Just remember, in some cases past performance can be wholly misleading.

Don't Be Fooled...

Take SDS, for example. It's an 2x inverse (short) S&P 500 index fund. That means if the S&P drops 10%, SDS goes up 20%. If the S&P climbs year after year, SDS drops year after year.

SDS has lost money every year over the last handful because the market has been going up. Does that makes SDS a bad fund? No, of course not. It's always going to lose money when markets go up. But if you buy it just before the markets fall... it could make you tons of cash!

This is why it's important to fully understand each fund outside of simply looking at its performance.

Finding Past Performance

To find past performance on Morningstar, just click the "Performance" tab.

You can see the 10-year average performance and the "rank in category" in this example.

You're looking for two main things. First, make sure you have at least 5 years of performance history. I prefer funds with 10 years of history since it shows me their performance during the Great Recession (2008-9). Funds with less than 5 years history cannot be evaluated on a long-term basis.

Second, you'll find a metric called "rank in category" at the bottom. This is Morningstar rank which compares this fund's performance to those of all others in the LG (large growth) category. Expect funds to fluctuate on a yearly basis. Funds with top rankings in the 3, 5, 10, and 15 year marks are seriously powerful returners.

For this example I used the Parnassus Endeavour Fund (PARWX) - one of my all time favorites.

If you need history further back or during specific time frames for ETFs, head over to TradingView.com and type in the ticker symbol. You'll be able to see daily details of the fund's performance and price over any time frame.

Fund Goals, Objectives, and Strategies

This one can be a bit harder to find, although I'll show you a few shortcuts. Once you get better at reading fund names and all the technical jargon, it can be easier. However, getting started means you'll need to thoroughly read the details to be sure you're not making a simple mistake.

The summary prospectus strategies section from PARWX.

Head over to your favorite website of choice and find the summary prospectus for the fund. The summary prospectus just cuts to the chase and gets all the most important information in front of you as quick as possible. It's a great way to make an initial decision about a fund. Prospectuses can always be found on each fund's parent website as well!

Once you're there, find the "Principal Investment Strategies" segment. This portion is usually several paragraphs long and details how and what the fund will invest in. Remember, changes to these portions of the prospectus must be voted in by the shareholders (you).

If you don't understand any part of the strategy of your fund, leave a comment and I will help clear it up. DO NOT invest in a fund if you can't understand its strategy. It's a surefire way to fail.

Industries and Sectors

On Morningstar.com you'll be able to navigate to the "Portfolio" tab for your chosen fund. Just type in the fund ticker symbol in the quote search bar, and then click the portfolio tab.

Click here to see the PARWX example.

One you're there you'll have access to a wealth of information about what the fund invests in. How big are the companies it invests in? Where are they located? Which industries and sectors are they in? What's the largest holding of the fund?

It's all laid out in this tab and Morningstar does a great job of organizing it for us in a really helpful way.

Principal Risks of Investment

Each fund has slightly different risk, though most share several risks. When most people think of "risk" in the stock market, we think of losing money or change in prices. I want you to get away from that idea.

Risk in the stock market comes in many flavors. The traditional risk of changing prices is called Volatility Risk or Market Risk and it's just one of many.

Let's look at the risks involved in PARWX by pulling up the Summary Prospectus on Morningstar.

Principal risks of PARWX as laid out in the summary prospectus.

Principal risks of PARWX as laid out in the summary prospectus.

Generally, the prospectus will define each risk pretty well. If there is any confusion, simply Google the type of risk and you'll find plenty of helpful articles detailing each type of risk.

Don't get confused if you see some conflicting information. There is some overlap of names and definitions. I have noticed that from person to person, or website to website, the exact definition of each type of risk may fluctuate slightly. Don't worry, just try to understand the overall concept.

Commissions & Sales Charges

Let's clear this up. ETFs charge a commission from the brokerage you bought them through. After that, they charge you an expense ratio (talked about above) each year.

Mutual funds charge a sales load or "front end fee" on A shares. Unless, of course, you purchase no load mutual funds which charge zero front end fee. They will charge a back end fee if you sell the shares within 90 days of purchase. This is to keep people from "trading" mutual fund shares.

Mutual funds also charge an expense ratio each year.

I know this can be a bit confusing. So, here's the quick breakdown.

Commissions, expense ratios, and sales loads all cost you money. Spending money on those means having less money to invest. All other factors being equal, always seek to minimize expenses and fees.

To get commission free ETFs, try using M1 Finance - it's my favorite commission free brokerage for ETFs.

To find no load mutual funds, you should be able to perform a simple search at your brokerage. This is an example of just a few no load mutual funds, however each brokerage may have access to different ones. Just call your brokerage if you're confused about finding a no load fund.

Conclusion

Choosing an ETF for your portfolio can be as simple as these steps listed above. Once you've read and understood everything outlined in this article, you'll have a much better idea of what you're buying for your portfolio.

What we have not talked about is understanding the big picture of your portfolio. Asset classes, sectors, and industry allocations are important! I'll be writing a future article about portfolio creation which will include all these details for your consideration.

Remember, to avoid commissions on ETF purchases I highly recommend M1 Finance. It's the very same brokerage I use myself for creating custom ETF portfolios since the advantages are so great! If you want to know more, you can read the full review of M1 Finance here.

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