Since leaving Morningstar and rejoining the Fool, fund guru Shannon Zimmerman has racked up impressive returns of 19%, versus 8.4% for the market since the inception of his Motley Fool Champion Funds newsletter. At last report, fully 34 of Shannon's 35 picks are making money for their investors, giving him a .971 batting average. Fool contributor and fund novice Rich Smith recently interviewed Shannon to try to learn a bit more about this "fund thing."
Rich: So how much time does it take you to find a fund worthy of investment?
Shannon: Well, with more than 7,000 funds vying for your hard-earned investment dollars these days, you have to be just as rigorous with fund research as equity analysts -- at least those who earn their keep -- are with stock research. And maybe even more so. Funds are buy-to-hold (and hold and hold) propositions, after all, and they come with lots of moving parts.
You can screen for things like performance, fees, turnover, and managerial tenure to winnow the playing field relatively quickly, but assessing more qualitative factors is just as important, and that's what takes time. I approach that part of the job with what I affectionately call an interrogation. What's the manager's track record over the course of his career -- even at funds other than the one I'm considering? Has he been a performance chaser, or has he stuck to his strategic guns even when his investing style is out of favor? I also want to know if the manager "eats his own cooking" by investing his money alongside yours. As much as I love crunching mutual fund numbers, few data points will ever tell you more than that one.
One other area for further research is the quality of the shop behind the fund. Have they been responsible stewards of their shareholders' money by, for example, lowering fees as assets under management have risen, or closing funds before they've gotten too big? That last point is especially important to me: I'm a big fan of shops that are willing to forgo additional inflows -- and the fees those flows would generate -- in order to make sure the size of a fund's asset base doesn't undercut the manager's stock-picking strategy.
The bottom line is that picking a great fund takes time, and in my experience, the most successful investors are the patient ones -- and the ones who are most thorough with their homework.
Rich: Why don't people take more time to find great funds, then? The legendary founder of Vanguard, John Bogle, has cried "For shame!" at the mutual fund industry -- citing high costs, overactive trading leading to high taxes, rampant underperformance, and sugarcoated advertising. Yet millions of investors continue to blindly buy funds with a history of laggard performance and overly high fees.
Shannon: It's a great question, and Bogle -- whom we interviewed for the newsletter a couple of months ago -- is exactly right. I think a lot of it is down to marketing. Folks with plenty on their plates beyond conducting rigorous financial research see an ad touting a five-star fund and think, "Gee, that's got to be a good one, right?"
They don't think to ask whether or not the manager who earned that track record is still on the case. If he isn't, those five stars don't mean a thing, and even if he is, the fund still may not be right for a particular investor's risk tolerance and timeline.
Beyond that, too many folks are tempted by the allure of last year's returns. You know, "XYZ Energy fund was up a gazillion percent last year, so I have to get in NOW!" To put it bluntly, chasing performance is a rotten idea. "Hot" areas of the market have a habit of turning cool when investors perceive that their valuations have gotten rich. Just ask folks who invested in Cubes
Rich: How many funds do you think an investor -- one who does not want to worry about volatility -- should own?
Shannon: We track three model portfolios in Champion Funds: The Aggressive and Moderate models include 12 funds each, while the Conservative has 10. But really, there's no magic number, and rather than focusing on how many funds to own, I think investors should focus on which kinds of funds to own.
To be smart about it, they'll need to have an asset-allocation game plan in place before slotting picks into their personalized pie charts, and they'll need to think broadly about diversification. We tend to think of diversification in terms of market cap and the growth/value spectrum, but strategic diversification is important, too.
For example, we have two funds in the Aggressive model that both land in Morningstar's large-blend peer group. One, however, is an index tracker whose portfolio includes thousands of names, while the other is an actively managed concentrated fund that, at the end of November, had just 34 holdings. Is it redundant to invest in both? Not at all. It's true that they live in the same category, so to speak, but these are very different animals, and each has added value to the model, which has trumped the S&P by more than seven percentage points since we launched it.
Rich: What is one of your least favorite funds today, and why? And what are some of its top equity holdings?
Shannon: One of the newsletter's regular features is our Dud of the Month column, where I highlight a lousy fund that people should avoid but can learn from. Early on, I singled out Morgan Stanley S&P 500 Index (SPIAX) for Dud status. As its name indicates, this is an S&P tracker, and so its portfolio is anchored in tried-and-true companies like ExxonMobil
So far, so good, but here's the thing: There's absolutely no reason to pay any more than you absolutely have to for a fund that simply tracks an index, and this is a load fund with an expense ratio of 0.7%.
For comparison's sake, Fidelity Spartan 500 (FSMKX) and Vanguard 500 Index (VFINX) are both no-load funds with expense ratios of just 0.1% and 0.18%, respectively. What's more, nearly half of the Morgan Stanley fund's assets are parked in its B share class, which runs with a ridiculous expense ratio of 1.46% and carries a deferred sales charge if you sell your shares within six years of purchase.
If you encounter a fund that strikes that profile, run -- don't walk -- away!
Rich: What is one of your most favorite funds today, and why? And what are some of its top equity holdings?
Shannon: Dodge & Cox International Stock (DODFX) is a terrific fund. It's relatively young, but the management team is experienced and uses the same strategy that's led to tremendous success at Dodge's Stock (DODGX) and Balanced (DODBX) funds, both of which are currently closed to new investors.
International Stock's expense ratio is just 0.77%. Its top holdings recently included the likes of Vodafone Group
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Rich Smith does not own shares of any company mentioned. Vodafone and Microsoft are Inside Value recommendations. The Fool has a disclosure policy .
