I have just enrolled in a new 401K plan. One of the important decisions I had to make was the fund to choose. Obviously, asset allocation had a big part to play in my decision. But as I looked through all the mutual funds that was available, I found myself not looking at whether the fund outperformed the index, or the fees that the fund charged. But before I explained how I chose my fund, let’s review what mainstream advice is.
Check Past Performance
Well, this really isn’t a correct headline. Past performance does not indicate future performance. But you certainly want to look at past performance because you do not want to fund to have too many negative years.
Performance Relative to the Index
If 90 something percent to active fund managers failed to beat the index, the theory goes that if you choose an active manager, he or she better outperform the index. Otherwise, just the index? Well, for reasons I’ll explain below, this argument has major flaws in it that too few people bother to discuss. This relates to the fact that an index may be “overvalued”.
Pretty self explanatory. Fees have to be reasonable and not outrages.
Method of choosing investments
I paid close attention this. The reason for this was my experience with most of my funds from 2001 to 2002, when the major market indices as well as most mutual funds suffered massive negative performance for a couple of years.
I tossed out funds that chose “stocks that showed potential for capital appreciation or growth”. I seriously considered on funds that bought “cheap stocks that were perceived to be undervalued by the market”. Reason for this, as I’ll explain later relates to my experience during the last bear market.
How I chose my fund?
Well, let’s get to how I chose my fund. Firstly, this is what I did not bother to check.
1. I did not bother about beating the index. Why? Simply because I want fund managers not to overpay for stocks. I want to cheap and safe stocks because only by having a disciplined approach in ing can you minimize your “permanent loss of capital risk”. This is the type of risk that hardly anyone talks about. Most mainstream articles and financial talk about volatility risk. But there are other risk to consider as well.
2. I did not bother about fees. Because I am not bothered about beating the index, but more about making sure the fund manager only s stocks at an appropriate discount to where he thinks their value should be, I believe in paying a manager to only cheap stocks to minimize the risk of a permanent loss of capital.
3. I did look at past performance. But like I said earlier, I did not look at whether the fund outperformed the index. I looked at how the fund did during 2001 and 2002. This was the period when the S&P had negative returns and most funds had negative returns too. It did not matter to me if the funds “outperformed the market”! A negative return is a negative return.
Why Did I place so much emphasize on returns during the last Bear Market?
It is simply because it tells me how the manager chooses his investments and stocks. It tells me that the manager does not “overpay” for stocks even for “good long term holdings”. Bear in mind that fund managers who had postitive returns in 2001 and 2002 probably “underperformed the market” in the previous years of the technology boom. But they had the discipline of not “joining the crowd”.
But I do not care less if they underperformed the market in the 90s as long they had decent positive returns. Even Warren Buffet underperformed the market in the late 90s. There were articles in the press questioning if “he had lost it!”. It was simply the case that he did not join the hype and “overvalued stocks”. In my opinion, any fund manager that outperformed the index in the late nineties ought to be fired because they bought expensive stocks and were counting on another “fool paying a higher price”.
So at the end, I ended up choosing Dodge and Cox Balanced Fund. Their worst year in 2000 was down 2%, better than those who were down 25% or so, but still “outperformed the index”!. Another fund that I have been watching is Marty Whitman’s Third Avenue Fund, which is now unfortunately closed to new investors.