Pragmatic Capitalism

Capital for Living a More Practical Life

What Is the Biggest Mistake When Evaluating a Fund?

There was a good piece in the WSJ about fund selection yesterday.  They interviewed some great advisors.   The answers were mostly the same – watch past performance, watch fees.  What surprised me was that no one mentioned the problem of benchmarking.   This is, in my opinion, the biggest problem in the fund world.

What’s happened over the last 30 years is that we’ve created a mass of various fund styles that don’t really do anything that much different than an index fund.  For instance, most “large crap growth or value” funds are really just closet S&P 500 funds.  If you ran the risk adjusted returns on these funds you’d notice that the correlations are extremely high in 95% of the cases and that they’re basically just fee sucking closet index funds.  They add literally negative value to your portfolio when compared with the low fee option.

I audit a lot of funds these days when I perform reviews for people.  And the benchmarking issue is the one that always comes up as being the most problematic when trying to justify whether a client should own a fund.  The fund is either benchmarked incorrectly or it doesn’t perform well relative to a highly correlated index.  To me, that’s the biggest problem when evaluating a fund.

Not only should we be ensuring that we’re benchmarking the funds properly (because the fund rating companies don’t always do it properly), but we should be ensuring that the funds we’re picking are actually a good value relative to the benchmark.  That requires some risk adjusted return calculations and some modestly sophisticated understanding.  But it’s no excuse for lazily looking at past performance, fees or other problem areas.  The devil is in the detail in most funds.  And sadly, when we look close, most of them are worse than their star rating states….

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