Although, at first sight, choosing funds and shares require a similar approach, there are some key differences that make choosing a fund a more complex task than choosing shares.
There are plenty of posts, articles, books, and research papers on the selection criteria that should be applied when investing in shares, describing in detail stock fundamental analysis. However, there are very few documents on how to select investment funds. This is surprising when we take into account that there are many more investors that build their portfolios on investment funds rather than shares.
The main differences between selecting shares and selecting funds are summarized here:
- There are more funds than shares. Only in Europe there are about 35.000 investment funds. This huge pool to select from calls for strict criteria to help filter the best options. There are basic filters such as requiring the fund to have at least a 3-year track record, or minimum assets of 100 million euros or dollars. There are also fund selectors that require a minimum amount of assets under management.
- The human factor is more determining in funds than in stocks. In large companies, the president’s or CEO’s motivation is important but not essential as in a fund. An unmotivated fund manager can destroy more value than a business manager in a similar situation. A big company’s success depends on many factors and many people, but in a fund the managers’ interests, motivations and alignment with the client’s interests, are essential and should be analyzed and monitored.
- There is a void in fund research. Stocks, especially those of the biggest companies, are subject to numerous public reports that recommend whether to purchase or sell them. However, there are hardly any research or public reports on investment funds. This is why references and opinions from suppliers, clients and colleagues don’t just come in very handy but are a basic pillar of fund selection.
- Indexation is not possible in funds. When you manage a portfolio of US stocks, for example, you can replicate the S&P 500, or even if you don’t follow it completely, if you are unsure you can always buy according to the weight a particular stock has in the index.
In funds this is not possible. If you are managing a US equity fund portfolio, with the objective of beating the category average, it’s impossible to index it to the average because there are hundreds of funds. If a fund portfolio manager takes S&P 500 as a reference, the indexation is to the stock market not the fund market, and will not reflect how he is doing in relation to the average fund. It is possible to be indexed to a certain category of stocks, but not a certain category of funds. Fund portfolio and fund of funds managers always have to decide which part of their portfolio will be invested in passive management products, while betting that passive management will outperform the majority of funds in a given category.
In conclusion, selecting funds can be very tricky and implies significant doses of psychological insights (to evaluate how the human factor affects performance) and a wide network of contacts in lieu of public reports. As we have seen, selecting funds has its own peculiar characteristics, which make it a complex task.
Rafael Hurtado Coll. Professor. IE Business School