For CPAs just entering the financial services arena, picking mutual funds can be a staggering task.
Beginning advisors must choose among the nearly 8,000 funds of varying investment styles, costs, families and distribution avenues.
Experienced advisors have developed their selection criteria by studying and by correcting mistakes. But they have also found that the process doesn't end. New funds, new client needs and new investment strategies demand ongoing attention to methods of choosing.
Low costs head the list of criteria for many CPA advisors.
Peter F. Bauer, president of Oakbrook Financial Group in Oak Brook, Ill., said that they start every search with the lowest-cost closed-end funds, then consider exchange-traded funds, no-load open-end funds and, finally, front-loaded open-end funds - in that order.
"We try to keep long-term costs down," said Bauer, who is both a CPA and CFA. "Sometimes we select the front-loaded fund because most often they end up to be the cheapest in the long run, because of lower annual costs."
Once mutual funds pass the cost hurdle, other criteria kick in. "These days I stay away from funds depending on the brains of one guy," said Benjamin Tobias, CFP, CPA, CIMA, of Tobias Financial Advisors, in Fort Lauderdale, Fla. "I look for teams of portfolio managers or I use purely passive index funds."
Tobias varies these rules for asset classes beyond the most efficient, like large-cap domestic stocks or investment-grade fixed income. In the international class, the costs are somewhat higher, and he uses active managers, especially in emerging markets.
Advisors see benefits in tailoring funds to certain types of accounts, as well as to certain asset classes. Oakbrook, for instance, uses mostly single issues of stocks and bonds, but seeks mutual funds to fulfill certain sectors. Client assets allocated to China, the energy sector and high-yield bonds go to fund managers. "We look to some funds for management expertise that we don't have," said Bauer. "We'd also put funds in a smaller account like an IRA for any client."
It may seem obvious to list good investment returns as selection criteria. But picking simply on past performance is a rejected strategy for two reasons, according to Ken Eaton, CFP, CFA and a principal at Stepp & Rothwell, in Overland Park, Kan. His firm chooses well-performing funds that are less risky, or have lower betas, than their peers in the style grouping. Secondly, last year's top performer is too often next year's worst.
"Clients come in with those year-end lists of top funds and want to buy some," says Eaton. "Not only are the funds not likely to repeat the good performance, but too often they're also completely inappropriate in the client's portfolio."
Keeping clients happy
An element of good mutual fund selection is the level of investor comfort with their portfolio. Studies show that investors who stick with a strategy have greater long-term success. Fewer and smaller fluctuations in the value of their assets are characteristics that assure investors. "Most of our clients have already made it, and our job is to make sure they don't blow it," Eaton said.
Veteran advisors know that their selection criteria are working, but continue to study and seek improvements. New funds come out, new research points the way to additional assets, and market changes demand refined allocations.
Eaton's firm is looking at adding a commodity component to further reduce volatility in portfolios. They are looking to expand the fixed-income securities to include foreign bonds. "With the flat yield curve, we're looking to integrate global debt offerings into our clients' fixed-income allocations for greater diversification," he said.
Tobias has added a new class to clients' portfolios that he calls "tactical." Depending on where the client is on the aggressiveness chart, the portfolio might have from 2 percent to 10 percent allocated to the new class. While little is allocated to the new class as yet, Tobias lists possible investments as real estate investment trusts or emerging market funds in the event of a crash that severely reduces market prices. "I allocate the assets and move into opportunities at my discretion in the tactical class," he says.
A relatively new fund from a relatively new manager currently occupies some of Tobias' clients' tactical allocation. The Hussman Funds started their Strategic Growth Fund in 2000, and it now holds $1.8 billion of investors' money. Annualized returns in excess of 14 percent since the fund's inception have attracted attention. "The manager is a guy that plays," says Tobias. "And the fund is less volatile with less downside risk than others in the group."
Learning to choose
Beginning advisors may find specific phases to their professional development. Tobias attended three to four meetings a month held by professional organizations or vendors when he started. Before he felt confident enough to choose a fund, he studied everything that he could get his hands on and took the course work for the CFP designation.
"I was a sponge for knowledge," he said. "The only thing I wouldn't read was mutual fund literature. The old auditor in me directed me to get information from third parties."
Oakbrook Financial started out offering mutual funds, but quickly found that clients preferred individual stocks and bonds. Clients viewed mutual funds as a commodity product, and Oakbrook felt outclassed. On top of that, the loss of control of tax planning bothered both advisors and clients. "When we offered only funds, we felt like the brokers got the real money and clients gave us their 'play' money," explained Bauer. "Clients want tax control, customization and social control."
Moreover, dealing direct with mutual funds places burdens on both the advisor and the relationship with the client. Advisors are locked into a singular relationship with a fund or fund family, and processing orders through mailed applications is cumbersome. "Plus, the fund family's name is placed more prominently on the client statement than that of the advisor," said Bauer. "They're promoting themselves to our clients, at our expense."
Yet Bauer advises CPAs just starting out with financial services to work with one good family of funds with a good long-term track record: "Get to know one fund family very well. And then branch out from there."
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