Key takeaways
- Most of us (including myself) tend to pick mutual funds based on star ratings & past returns. But that is a mistake as per Bogle.
- Before you get to selection of mutual funds, make sure you have done the 8 prior steps of an investment blueprint
- Bogle is a legend & a giant in the world of investing. He founded the Vanguard group that handles approx. $10 trillion in assets. His book is also recommended by Warren Buffett.
- Rule 1: Select low cost funds
- Rule 2: Consider carefully the cost of financial advice
- Rule 3: Do not overrate past performance
- Rule 4: Use past performance to determine consistency & risk
- Rule 5: Beware star fund managers & star ratings
- Rule 6: Beware of Asset size
- Rule 7: Don’t own too many funds
- Rule 8: Buy your fund portfolio – and hold it
The debate on whether active or passive investing works better has gone on for decades & will continue to go on for a long time to come. This article is for those people who feel that active mutual fund investing works better.
If one does decide to go down the actively managed mutual fund selection route, it’s important not to fall for the common & typical pitfalls that most investors (including myself) make when selecting a mutual fund. e.g. picking mutual funds based on their star rating and past returns. While I am unable to quantify the impact of a naive mutual fund selection, I would hazard a guess that it could easily end up costing an investor 25% to 50% of his / her net worth over a 25 to 30 year period.
Things to do BEFORE you start selecting Mutual Funds
Before you get to the part for selecting specific mutual funds, ideally, you should make sure all the 8 prior steps in the 13 steps to creating an investment blueprinthave been addressed. For easy reference, I have listed below the 8 prior steps.
- Step 1: Calculate required amount for the goal as of today
- Step 2: Factor in inflation to estimate how the much amount in step 1 will become after some years
- Step 3: Secure term life and health insurance before investing.
- Step 4: Build an emergency fund and invest for short-term (next 5 to 7 years) needs in low-risk debt instruments
- Step 5: Assess your risk tolerance & decide on equity vs. debt asset allocation
- Step 6: Choose mutual fund types using simple Lazy Portfolios adapted to the Indian market
- Step 7: Decide between lump sum investment or staggered investments based on available funds
- Step 8: Calculate monthly SIP required to reach retirement goals
Once the above 8 steps have been completed, you’re ready to get to the part that involves selecting from among thousands of Mutual Funds.
The typical way I used to select equity Mutual Funds
It’s natural & intuitive to start review a fund based on the star rating assigned to it and then pick a fund with the best star rating. After all, that’s what we do in most spheres of our lives right? For example, that’s how we pick an AirBnB or a hotel – based on star ratings. I did that myself for many years.
I would also of course look at it’s past performance in terms of the fund’s returns. So let’s say I wanted to pick a mid-cap fund. I would go to Valueresearchonine.com, select the mid-cap category of funds and sort them by their star rating & then sort them by say their past 3, 5, 7 or 10 year returns, and then pick any of the top 3 funds based on the above filtering.
But Bogle says that: “There remains no evidence – none – that superior past PERFORMANCE is predictive of FUTURE success” There is also mounting evidence & data that suggest that past returns are not predictive of future returns.
So if past returns are not predictive of future returns, what’s the solution to the problem of selecting Mutual Funds? After all, we all want the highest returns we can get right?
Well, after having floundered my way through 180 sub-optimal Mutual fund choices, over nearly 20 years of investing, I am happy to share with you a set of 8 rules on how to select a mutual fund by a legend & giant in the world of investing, John Bogle.
Who is John Bogle & why you could consider heeding his guidelines on how to select a Mutual Fund?
John Bogle was founder of the Vanguard Group, one of the largest investment firms in the world. Vanguard has over $9.3 trillion in assets under management.
Common Sense on Mutual Funds is a book Bogle wrote on investing that has since become a classic for investors worldwide. It is also a book recommended to most investors by Warren Buffett. These rules are from this book of his.
John Bogle’s 8 rules for selecting actively managed mutual funds
Rule 1: Select low cost funds
Here’s what Buffett said in his Berkshire Hathaway Annual report in 1996:
“Seriously, costs matter. For example, equity mutual funds incur corporate expenses – largely payments to the fund’s managers – that average about 100 basis points (i.e. 1%), a levy likely to cut the returns their investors earn by 10 percent or more over time” – Warren Buffett
Bogle feels Buffett underestimated the impact. He feels the average equity fund charges 1.5% and incurs additional transaction costs of approx. 0.5% taking the total fees to 2% and therefore the total over time to a reduction of about 20% in returns.
Bogle says: “The surest route to top-quartile returns is bottom quartile expenses”
Nobel Laureate in Economics, William F Sharpe also said in an interview: “The first thing to look at is the expense ratio”
Rule 2: Consider carefully the cost of financial advice
Most mutual fund distributors get paid approx. 1% of the value of your equity portfolio per year on a recurring basis as commission / fees. An excellent article by SEBI Registered Investment Advisor Avinash Luthria in The Mintsuggests that a 1% commission can result in 26% lower net worth over 30 years. He also shows that a 1% commission can reduce your retirement spending by almost 30% !
Given that a 1% commission is going to end up costing you 25% to 30% of your net worth or retirement spending, its important to be absolutely sure that the fees you are paying are worth that much.
Many people do need and can benefit greatly from having a good financial advisor to help with their investments. There are also many really good financial advisors out there. The key is to do significant due diligence & filtering before selecting one.
Good financial advisors give you significant personalised time & attention, help you avoid some of the pitfalls of investing and provide worthwhile asset allocation and other such financial planning advice. The best advisors help you develop a long range investment strategy and an investment plan to implement that strategy.
For those of you who feel you need advice, one fair priced option is to approach a SEBI Registered “fee-only” Investment Advisor (RIA) who charges hourly fees rather than annual fees based on a percentage of the value of your portfolio.
Rule 3: Do not overrate past performance
Bogle says that a fund’s past track record is hopelessly misleading in appraising how money managers will perform. He says funds that are promoted to you based on their past performance lead you in the wrong direction.
Here’s an article in the Economic Times that bears out the fact that the same principles apply even in the Indian market. A sample chart from the above Economic Times article below:
However, Bogle does say that 2 things indeed CAN be predicted based on the past performance of a fund:
1. Funds with high expenses will underperform appropriate market indices
2. Funds that have done much better than the indices will regress toward & usually below the market mean over time
In simple terms, it’s like the law of gravity. What goes up must eventually come down.
Rule 4: Use past performance to determine consistency & risk
Bogle says that while one should not pay much heed to a fund’s long term aggregate RETURN, there are indeed other useful & important insights that one can glean from a fund’s past record.
Above all, he says, we should look for CONSISTENCY. He says intelligent investors should always give significant weightage to performance consistency.
Bogle’s consistency criteria for funds states that:
a) It should have been in the top 2 quartiles at least 6 to 9 of the past 12 years and
b) No more than 1 or 2 years in the bottom quartile for the past 12 years and
c) Reject funds with 4 or 5 years in the bottom quartile even if offset by the same number in the top quartile
More on how to do a fund performance consistency check in my article here.
In addition, Bogle recommends looking at Morningstar’s risk rating section of a fund. Sample screenshot below.
Bogle says that looking at a fund’s past RISK rating is useful because, (unlike RETURNS, relative RISK levels between funds in the same category have indeed proved to be highly predictable.
Rule 5: Beware star fund managers & star ratings
Bogle says, that while there are precious few highly capable & talented fund managers, it’s hard to identify star fund managers in advance and very few of them have the ability to continue to outperform over the long term.
There is also a constant churn / change of fund managers. As an example, a Morningstar report on women fund managers indicates that only 10 out of 42 fund managers have a tenure exceeding 5 years.
Bogle says that when looking for a good fund manager, look for the fund manager’s experience & steadiness rather than their stardom. (i.e. bursts of exceptional performance). Here is an article that highlights fund managers with long tenures in India.
With regard to following star ratings from sites like Valueresearch or Morningstar, here’s a quote from the Hulbert Financial Digest that reviewed a strategy of chasing 5 star rated funds: “Investors who chase performance — buying the top-rated funds or newsletters and selling those that fall in rank — typically do worse than those who simply buy and hold.”
Below is a chart on a similar strategy from valueresearch:
In summary, however, Bogle does concede / accept that funds with a 3, 4 or 5 star rating will in general and over a long period of time likely outperform their 1 or 2 star peers.
Rule 6: Beware of Asset size
Bogle says you should avoid funds that don’t have a history of closing their funds to fresh inflows when they get too big. Mirae Asset Emerging Bluechip fund was one that did this a few years ago (it’s name has since then been changed)
He suggests that one check the fund’s quartile ranking (in rule 4 above) and see if you notice a pattern i.e. see if you notice that as the size of the fund has grown, it’s quartile ranking has dropped
This has also been validated by Buffet himself many times in the context of the returns he can generate for his own company Berkshire Hathaway. At one Berkshire meeting he said: “Size is an enemy of performance at Berkshire and I don’t see any good way to solve that problem.” Here’s what he said in his 2005 shareholder letter: “Our performance will almost certainly fall far short of what we’ve achieved in the past. It’s simply a matter of size: the bigger Berkshire becomes, the less impact any single investment can have.”
Rule 7: Don’t own too many funds
Bogle feels that 4 to 5 funds should be more than sufficient. He says that adding too many funds is likely to result in a portfolio resembling an Index fund and will most likely result in a portfolio with lower returns & higher volatility than the Index.
Here are the broad categories of funds Bogle recommends one should have in one’s portfolio:
- Large cap – 50%
- Mid-cap – 10%
- Small-cap – 20%
- Sector – 10%
- International – 10%
Although international diversification reduces volatility, Bogle is personally not convinced of the value of this.
A study by Morningstar concludes that owning more than 4 randomly chosen equity funds does not reduce risk significantly. The study concluded that after 4 funds, the risk remains steady until about 30 funds in a portfolio. It also concluded that just a single large blend fund could provide a lower risk than any of the multiple fund portfolios in the study.
So it’s a fallacy to think that adding more funds (at least beyond 4 to 5 funds) reduces risk.
As an aside, Bogle adds that a single all market Index fund provides as low a risk as did the 30 fund portfolio.
Rule 8: Buy your fund portfolio – and hold it
Once you’ve done steps 1 to 8 of the simple steps to an investment blueprint and once you’ve selected your set of mutual funds using the above 7 criteria, Bogle says you should just “Hold tight” Buffet said: “Inactivity strikes us as intelligent behaviour”. This is what Bogle is referring to here.
Bogle goes further to say that the key to being able to “hold tight” is when you have the conviction that you have “bought right”. Buying right according to him of course is using the above 7 rules to select funds.
In effect, Bogle is encouraging us not to be tempted to switch them every now & then at the smallest excuse of under performance compared to peer funds (as I did in the past). However, if there is extreme under performance or some major shift in the fund’s strategy, then one could switch.
Disclaimer: I am not a financial advisor. My articles are meant for people who are not savvy or well versed with personal finance and investing and find it difficult to grasp all the jargon typically used when discussing such topics. I hope to be able to demystify investing and make it as simple as possible for everyone. I’ve invested in Mutual funds for approx. 24 years. I’ve also been a diligent student of the subject of investing over the past 24 years learning & applying the writings of luminaries in the field. In these articles I’m merely sharing my experience & learning from that investing journey and the books of luminaries in the field in the hope that it might help others in some way. I am in no way directly or indirectly claiming to be a hot shot investor who has generated exceptional or even above average returns during my investment journey. However, I am quite confident that even if all you do is learn from my mistakes, educate yourself on sound investment principles & develop good financial habits you will benefit greatly. Please ensure that you consult a financial advisor before taking any decisions or actions concerning your personal finances or investments. I shall not be liable.
Credits: John Bogle, Valueresearchonline, Prof. Pattu from Freefincal, Sayan Sircar from Arthgyaan, Dr William Bernstein, Rob Berger, JL Collins, Bill Bengen, Darrow Kirkpatrick, Bill Schultheis, Michael Edleson,