Build Your Own Mutual Fund

Everybody loves getting in on a secret. It doesn't matter what it's about, whether it's the designer of the clothes some celebrity's baby wore yesterday or the identity of the leaker in the Watergate scandal. While some secrets cost you only the price of a grocery-store tabloid, some people will try to collect quite a bit more.

Consider how much you would pay to learn the secrets of successful investing. Many well-known financial gurus have written books that try to explain their winning recommendations; several, such as Peter Lynch's One Up on Wall Street, have become best-sellers. Even now, many fund managers define their aspirations for success by seeking to become the next Peter Lynch or Bruce Berkowitz.

It turns out, however, that the secret of how successful fund managers pick investments isn't much of a secret at all. You don't have to buy a book or a magazine to find it. In fact, it doesn't take a lot of effort to find out all sorts of things about how the best fund managers are investing.

The worst-kept secrets of successful fund managers
Sounds like a good book title, doesn't it? In truth, fund managers aren't allowed to keep their investment choices secret for long, because mutual funds are required to fully disclose their holdings. The Investment Company Act of 1940, which governs mutual funds, requires funds to disclose several types of information to fund shareholders at least twice a year, including financial statements of income and capital flows, fees charged by management, and lists of securities held. The SEC has considered requiring more frequent disclosure, and many funds voluntarily release information on a more frequent basis.

This means that if you identify a fund manager whose style you like, and whose results have been good, you can look at what investments have contributed the most to the manager's success. There are a few different ways of doing so.

Analyzing fund holdings
Some mutual fund managers choose to take large positions in a relatively small number of individual stocks. If the fund performs well, it's usually because those large positions do well. So by looking at the largest holdings in a particular fund, you often identify individual stocks that have performed well. For instance, in looking at the market-beating performance of the Fairholme Fund, the top 10 holdings constitute almost 65% of the entire fund. Focusing on holdings like Pfizer (NYSE: PFE  ) , Berkshire Hathaway (NYSE: BRK-A  ) (NYSE: BRK-B  ) , and Echostar (Nasdaq: SATS  ) , you can see that each has managed to limit its losses this year, which helped contribute to the fund's overall performance.

Not all of a fund's top holdings have to be winners for the fund to perform well. For instance, a look at T. Rowe Price Health Sciences Fund shows that while investments in Genentech (NYSE: DNA  ) and Cephalon (Nasdaq: CEPH  ) have done well, the fund's shares of BioMarin Pharmaceutical (Nasdaq: BMRN  ) put the brakes on fund performance during 2008. Sometimes, the best-performing choices won't even be among the top holdings.

If you're willing to do a little more research, you can compare quarters to see what changes a fund manager is making in the fund's holdings. If a company drops off the holdings list, then you know that the manager has lost confidence in that company. Similarly, if a new company appears, or holdings in an existing company increase dramatically, then the manager believes that company will do well.

Building your own fund
By looking at the best investments of successful fund managers, you can create your own portfolio, including the best of the best. One excellent way to build a well-diversified portfolio is to pick a few companies from each of your favorite funds in a variety of asset classes, thus quickly putting together a portfolio that includes companies across a wide spectrum of company sizes, regions, and industries.

Limitations of using fund data
But, like other investment strategies, using fund holdings data doesn't guarantee success. For one thing, many funds buy and sell stocks frequently, so a stock that appears on a list of holdings one day may be sold from the fund the next. As a result, you may buy a stock at exactly the time the fund has sold it. For funds with high turnover ratios, it's important to identify core holdings that the fund has owned for a long time.

Also, many funds own stock in a huge number of companies, so even the top holdings don't represent a large percentage of the portfolio. When such funds outperform their peers, it's more likely a result of more subtle differences in allocating money among similar companies. For instance, a fund might have 4% of its assets in a stock, while the index gives it only a 3% weighting. So if that company does well, the fund will benefit from the larger position. You may not be able to the results of these subtle differences simply by looking at a fund's list of holdings.

However, if you're looking to understand how your favorite fund manager thinks, or if you're looking for good companies to consider, looking at a fund's list of holdings isn't a bad place to start. Keep in mind that you can always just buy the fund and let the manager do the work for you.

For more on funds and your portfolio, read about:

For more information on using mutual funds to improve your portfolio's performance, take a look at the Motley Fool Champion Funds newsletter. The Fool's fund expert, Amanda Kish, provides picks, manager interviews, and model portfolios. Click here for more information on a free, full-access trial of the newsletter.

This article was originally published Sept. 1, 2006. It has been updated by Dan Caplinger, who owns shares of Berkshire Hathaway.

Fairholme and T. Rowe Price Health Sciences Fund are Champion Funds recommendations. Pfizer is a Motley Fool Income Investor pick. Pfizer and Berkshire Hathaway are Motley Fool Inside Value selections. BioMarin Pharmaceutical is a Motley Fool Rule Breakers pick. Berkshire Hathaway is a Motley Fool Stock Advisor recommendation. The Fool owns shares of Pfizer and Berkshire Hathaway. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy tells all.


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