How To Pick A Quality ETF, Mutual Fund or Race Horse

“In the business world, the rearview mirror is always clearer than the windshield.” -Warren Buffett  

As the weather heats up in May, people are breaking out their checkbooks, mint juleps and fancy hats to welcome in the tradition of the Kentucky Derby, Preakness and the Belmont Stakes, all part of the American Triple Crown. 

This year, the 144th running of the Kentucky Derby, otherwise referred to as “the greatest two minutes in sports,” has 20 horses running with colorful names including Firenze Fire, Magnum Moon, Good Magic, Vino Rosso, Enticed, Lone Sailor, and Instilled Regard.

In a similar fashion, major investment companies on Wall Street are always coming up with catchy names and gimmicky strategies each year to attract investors dollars into one of thousands of active and passive fund strategies with fancy names and jargon such as unconstrained, non-traditional, market-neutral, smart-beta, hedged, opportunistic, absolute, dynamic and contrarian.

In most cases, the outcome of a race horse or a fund’s performance does not always live up to its grandiose name. In fact, only 17.9% of active large-cap managers beat the S&P 500 over the 10-year period ending December 31, 2015. (SPIVA US Scorecard,12/31/16) 

“Mind Your P’s”  

Successful horse bettors go way beyond silly handicap factors and superstition when attempting to pick a winning horse. Betting on a race horse’s unique name, or on your own “lucky number” will not get you far. 

The race horse-betting veteran will methodically break down every piece of data to try to get an edge, including: the horse’s bloodline (breeding), form, class, speed, condition, trainer, jockey, the weather report, racetrack conditions and how fast the horse ran in previous races. 

At the same time, sophisticated investors and wealth managers go well beyond darts, tarot cards, intuition, water cooler talk, “star-ratings” or published “fund manager of the year” reports when selecting a strategy.

When evaluating a mutual fund, consider utilizing the “Five P’s”: (1) Process (2) Performance (3) People (4) Parent and (5) Price

While a realtor’s mantra is “location, location, location,” a disciplined investor’s mantra should be: “process, process, process,” as the most important evaluation criteria. Expenses do matter, but performance without process is just plain luck. 

Don’t just pick a race horse, stock, sector or actively managed mutual fund just because it recently outperformed over the past year, which is a case of “hindsight bias” and chasing returns. Past performance does not always indicate future results in any game. 

While you can utilize a fin-tech service such as Morningstar to quickly screen a mutual fund for many financial metrics and benchmarking comparisons, it is acutely more challenging to screen for an investment manager’s process and philosophy.

Investment companies provide specific guidelines and ranges for their managers to follow regarding various granular components such as the exposure to different countries, currencies, market caps, asset classes, sectors, industries, maturities and credit quality factors along with a bevy of possible hedging tools such as futures, options and derivatives. 

An investment manager’s past behavior and track record utilizing provided parameters through different inclement market conditions can be a good indication of his or her future behavior and risk taking.

“Don’t Bet the Farm” 

Sophisticated bettors and investors don’t worry about being “right” on one horse or one investment, they worry about “ROI” (return on investment) over time while managing risk with multiple strategies at the same time.

When race-horse betting, experienced investors put themselves in the best possible position to win by wagering on multiple horses to place, to choosing a winning horse for consecutive races which is indicated by terms like “daily double, pick 3, pick 4 or pick 6. 

For every race, each horse will have the odds of it winning next to its name in the program. Just remember, as hard as you try to beat the odds, the odds are against you. 

The favorite to win is the horse with the lowest odds. Betting the “race favorite” to win, may pay off 33.3% of the time. Sounds easy? Not really. You may not want to risk losing your money 66.7% of the time with a horse, stock or managed investment. 

This is not an argument over active and passive investing. While there is no such thing as a free lunch, the one strategy you can apply to try to improve your odds over time as an investor is through diversification across multiple asset classes and strategies according to your risk tolerance, not trying to pick individual winners. 

Smart money does not chase performance but instead looks for values, trends and opportunities from a macroeconomic perspective. The moral of this story is to consider diversification and not to “bet the farm” with your retirement savings.

It’s highly more intelligent (and less stressful) to implement and manage a solid “all-weather” investment portfolio approach that matches your age, goals and time frame for the long run than to bet on one stock or horse. This is the same principal as to not put all your eggs in one basket.

        For more information on our firm or to request a complementary portfolio stress-test and retirement check-up with Jon W. Ulin, CFP, please call us at (561) 210-7887 or email [email protected]

IMPORTANT DISCLOSURES

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing.  

All performance referenced is historical and is no guarantee of future results. The S&P 500 is an unmanaged index which cannot be invested into directly.