May 16, 2023

10 Rules for Fund Selection

By Michael McKeown, CFA, CPA - Chief Investment Officer

10 Rules for Fund Selection

There was a shift away from pension plans decades ago. Previously, an investment committee managed all aspects of a portfolio for pensions. Today, everyone with a company retirement plan became responsible for deciding how to invest.

In addition, with social media today and the TikTok generation, there is a daily onslaught of new stories and “influencers” pitching products or strategies. In real life, a contact may forward you a pitchbook on an idea that is supposedly the next amazing investment.

Having an approach that filters through this noise is a necessity. When one does not see ideas that often, a scarcity mindset creeps in that this could be the one can’t miss idea.

Our research team sits in a fortunate position that allows us to canvas the capital markets, looking for ideas. This covers a range of asset classes – public equity, real estate, private equity, fixed income, and more. We look across regions, sectors, and strategy types. Of course, any firm raising capital is happy to take our call. Filtering through the ones we receive is a process.

Before we get to the rules, there is a major first step. The big step is constructing a portfolio that aligns with your future aspirations and liabilities. This means analyzing scenarios in a financial plan to determine your North Star for your target asset mix between stocks, bonds, and alternative investments. Then putting in place the guardrails around asset classes and rebalancing policy. Without this process, selecting funds puts the cart before the horse.

Back to the task at hand. Here is a short and non-exhaustive list of how to analyze a fund.

  1. Managers only get credit for risk-adjusted outperformance. Beware of whether the right benchmarks, time frames, and peer groups are used for analysis.
  2. Make sure the outperformance is diversified over time. No “one-hit wonders” on a sector or stock.
  3. Team-based systems over a star approach.
  4. Understand potential taxes. Net after-fee, after-tax is what matters.
  5. The firm and strategy must align with our goals. Incentives matter. This sounds obvious, but the incentives, structuring, time horizon, and fees can easily be misaligned.
  6. Operational due diligence is stellar. Use only a verified track record. Funds should have best-in-class service providers.
  7. The size of the fund is appropriate. Raising too much capital can overwhelm an asset class or a manager’s strategy. Too little capital can be a detriment to scale.
  8. Opportunity set is attractive today. We all know the disclosures that past performance is not indicative of future results. Analyze how today’s prices and market compare to the past.
  9. Fees are fair. Understand the market pricing for this asset class and be sure it is in line.
  10. Know the downside just as much as the upside case. If we understand the risks as well as we do what can go right, then we may be confident there is a margin of safety.

I like to ask, “Why am I so lucky?” How did this idea come to our team out of so many other people that were possible?

If you don’t see a dozen pitches daily, every day of the work week for the last 15 years, getting one in your inbox may look interesting. From real estate deals to venture funds, from ETFs, to a “new” income fund, we see a lot of investment pitches.

But it also makes it easier to say “no” because we do it so often. And we follow our investment principles, strategy, and process, and invest time before any dollars are ever allocated.

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