By JONATHAN CLEMENTS
Staff Reporter of THE WALL STREET JOURNAL
If you want to build a top-performing mutual-fund portfolio, you should start by hunting for top-performing funds, right? Wrong.
Too many investors gamely set out to find top-notch funds without first settling on an overall portfolio strategy. Result? These investors wind up with mishmash of funds that doesn't add up to a decent portfolio.
"A bunch of good funds isn't a portfolio," says Kurt Brouwer, co-author of "Mutual Fund Mastery" and an investment adviser in Tiburon, Calif. "If you just buy the best-performing funds at one particular time, you'll end up with a lot of funds that look quite similar. You end up with what's recently worked well. But the funds may not fit with your investment objective and they won't make any sense as a portfolio."
Want to cook up a top-notch fund portfolio? Here are seven tips:
So what should you do? With over 11,000 stock, bond and money-market funds to choose from, you couldn't possibly analyze all the funds available. Instead, to make sense of the bewildering array of funds available, you should start by deciding what basic mix of stock, bond and money-market funds you want to hold. This is what experts call your "asset allocation."
This asset allocation has a major influence on your portfolio's performance. The more you have in stocks, the higher your likely long-run return.
"That's what's going to really determine your investment results," says William John Mikus, a Los Angeles investment adviser. "Even the best money-market fund isn't going to outperform a mediocre stock fund over a long period of time."
But with the higher potential return from stocks comes sharper short-term swings in a portfolio's value. As a result, you may want to include a healthy dose of bond and money-market funds, especially if you are a conservative investor or you will need to tap your portfolio for cash in the near future.
Once you have settled on your asset-allocation mix, decide what sort of stock, bond and money-market funds you want to own.
This is particularly critical for the stock portion of your portfolio. One way to damp the price swings in your stock portfolio is to spread your money among large, small and foreign stocks.
You could diversify even further by making sure that, when investing in U.S. large and small-company stocks, you own both growth stocks with rapidly increasing sales or earnings and also beaten-down value stocks that are cheap compared to corporate assets or earnings.
Similarly, among foreign stocks, you could get additional diversification by investing in both developed foreign markets such as France, Germany and Japan and also emerging markets like Argentina, Brazil and Malaysia.
In fact, many investors aim to have one fund for each of these market segments, so that they own a large-company growth fund, a large-company value fund, a small-company growth fund, a small-company value fund, a foreign-stock fund and an emerging-markets fund.
But you could get the same exposure using a smaller number of funds. Indeed, many fund companies now offer so-called life-cycle funds, which give you a global stock portfolio and a smattering of bonds and cash investments in a single mutual fund.
"The more money you have, the more you can fine tune and the more you can diversify," says Robert Bingham, an investment adviser with San Francisco's Bingham, Osborn & Scarborough. But he says investors shouldn't buy additional funds unless they can invest at least $5,000 or they can reach that threshold fairly quickly.
You should also give some serious thought to what type of bond and money-market funds you want to own. If you are in the 28% or higher income-tax bracket, you may find it's worth owning tax-free municipal bond funds and tax-free money-market funds. Meanwhile, those in the 15% bracket should stick with bond and money-market funds that own taxable corporate or government securities.
If you have large bond holdings, you may also want to take a small stake in some of the more exotic bond funds, such as those that buy high-yield junk bonds, emerging-market debt and the bonds of developed foreign countries.
Once you have decided what types of funds you want to own and how much you plan to invest in each, the task of picking the actual funds is fairly easy. Rather than wading into a pool of 11,000 funds with some vague notion of "picking the best," you have a much better idea of what sort of funds you are looking for.
"Of those 11,000 funds, probably 10,000 fall by the wayside very quickly," Mr. Mikus says. "Many of these funds aren't going to be appropriate for your portfolio. A lot of them are too expensive, a lot of them have rotten track records and a lot of them have investment objectives that won't match your investment objective."
For each slot in your portfolio, draw up a shortlist of possible funds. For instance, you might identify five or six foreign-stock funds that appear to be well-run. Compare their past performance and make sure the manager responsible for each record is still at the fund's helm.
But don't fixate just on performance. Instead, also pay a lot of attention to costs. If you use an investment adviser, you will clearly have to pay for the advice through mutual-fund sales commissions or some other type of fee. But if you pick your own funds, make sure you stick with no-load mutual funds.
In addition, check out other costs, especially a fund's annual expenses. With stock funds, "a strong predictor of future performance is a low expense ratio," Mr. Bingham says. "Many people look at the track record first. But if you look purely at the track record, there's no indication that that predicts future performance. Low cost is a better predictor."
Ditto for other funds. "With bond funds, cost is even more important," Mr. Bingham says. "And with money funds, it's everything."