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Key Factors When Evaluating Funds for a Retirement Portfolio

Christine Benz
Jeremy Glaser

Note: This video is part of Morningstar's January 2016 5-Step Retirement-Portfolio Assessment Week special report.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. It's the 5-Step Retirement-Portfolio Assessment Week here on, and I'm joined today by Christine Benz--she is our director of personal finance--to look at what fund investors should keep in mind when evaluating the quality of their portfolio.

Christine, thanks for joining me.

Christine Benz: Jeremy, it's great to be here.

Glaser: So, if I'm in accumulation mode--I'm gathering assets for retirement--and I'm looking to assess the quality of my portfolio, what's the first thing I should look at? Is it just performance? Is that the first thing?

Benz: Well, it's a good starting point. Unfortunately, I think a lot of investors kind of begin and end their due diligence with a look at trailing returns. They think that if the trailing returns look great, it's a good fund; if they don't look so great, it's a poor fund. Or if it has a high star rating, that makes it good; if it's a low star rating, it's not so good. That's a decent first step, but it shouldn't be the ending point of your due diligence.

I think what's way more valuable than those trailing-return rankings, which can really swing around quite a bit, would be to take a look at the calendar-year-return rankings. So, you're looking not just at the fund's absolute return but also looking at its ranking within its peer group and looking at it on a year-by-year basis.

So, on, for example, you can stretch this out going back quite a ways, and I would urge investors to not just look at the past several years, which have been pretty decent for equity investors, but also take a peek back to 2008 to see how the fund performed during that period because a really common profile for more defensively positioned funds is that, until very recently, their trailing-return rankings weren't very good--but they were great defensive performers during the bear market. So, spend some time using those returns to kind of get a sense of what the holdings' characteristics are and what sort of strategy is in place. And you can use that to make sure that you have adequate diversification in your portfolio. So, not every holding needs to be a good defensive performer--you need more-aggressive holdings as well--but you want a balance of the two sets of characteristics.

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Glaser: So, for someone with an accumulator's portfolio who's saving for retirement, there is no hard or fast rule for if something falls below a certain ranking, they should absolutely sell it.

Benz: No. Some investors like to operate with those sorts of rules. So, for example, if its five-year return is no longer in the top quartile, they're going to cut it loose. That's a recipe for terrible investment results because oftentimes funds look the worst, in terms of their trailing returns, right before their strategy is set to shine. So, I definitely wouldn't use those rigid guidelines when making my buy-and-sell decisions. If you see a fund that has dramatically underperformed, it is your cue to get in there and poke around and see what's driving it. It may be that the strategy is simply a little bit out of favor, or it may be that there is something more seriously wrong; maybe there has been some change with the management or some change with the strategy. But you definitely don't want to use those reflexive sell rules based on performance alone.

Glaser: Beyond performance, what else should be on your checklist as a fund investor here?

Benz: Well, our analyst team would certainly say that, based on all of their research, cost should be top of mind for investors who are aiming to make good decisions about their holdings. When we run almost any dataset looking at which data points tend to be most predictive of good returns in the future, one thing we find time and again is that low costs tend to predict good performance. That's not to say every low-cost fund will be a good performer; but certainly if you want to stack the deck in your favor, you want to focus on low costs.

Some investors might say, "Well, I'm not sure what a low expense ratio is." So, one thing we have on the website is a cost rating that will show you, in words, whether that fund's expense ratio is low, high, or somewhere in between. So, that can be a good guide for people who aren't sure whether 0.75% is a cheap expense ratio for a bond fund or if it's expensive. Those words can help you get in the right direction. Incidentally, this is one reason that index funds or exchange-traded funds tend to be so highly recommended among our analyst team, because they generally--not always, but generally--show pretty well from the standpoint of having nice, low costs.

Glaser: So, things like performance and costs are very easy to quantify. Is there anything less tangible in your checklist that you should be looking at?

Benz: Definitely. This is where the evaluation approach becomes more art than science. But there is certainly a set of characteristics that investors would want to look for. You'd want to look for a strategy that you think makes sense and that's a defensible strategy--one that you understand and that you can stand by even if it doesn't lead to stellar performance at certain periods of time. Certainly, if you have any sort of actively managed product, you want to make sure that that team has a decent amount of tenure--not necessarily on that particular fund but in the industry and on similar strategies.

Finally, stewardship is an important consideration as well. You want to take a look at the quality of the fund company: Have they tended to act as good stewards of shareholder capital over time or are they simply peddling the flavor of the month? So, you want to make sure that you are investing with a good steward. I would say that our analyst reports do a good job of really wrapping together a lot of these intangibles, helping investors make sense of whether a fund looks good on these measures or maybe is an also-ran.

Glaser: After you've gone through all of these items, then, how do you know if this fund is actually right for you, or if it's a good fund but it just isn't a fit for your portfolio?

Benz: There is an important set of considerations here because you might have a fund that looks good on a lot of these measures but really doesn't make sense for you as an investor. An example would be a fund that, even though it's a good fund with a good strategy, maybe has been way too volatile. It's made you uncomfortable to own it. You haven't been comfortable with the fact that, one year, it's in the 99th percentile, and the next year it's in the top percentile. That's a defensible reason to cut a fund loose. Maybe it's a fund that duplicates some exposure that you already have in your portfolio, but you like the other fund better. Or an example would be asset location; so maybe it's a fund that, over the time that you've owned it and for the foreseeable future going forward, has been tax-inefficient. So, it's been making lots of capital gains distributions and you hold it inside of a taxable account. Those are examples of funds that may look good on these other measures but just may not make sense for you as an investor.

Glaser: If you're already in retirement, are there any special considerations when evaluating your portfolio?

Benz: A lot of the things that we've already talked about apply for retirees. And certainly, it's too big of a generalization to say that retirees should have wildly more conservative portfolios than accumulators. Retirees typically have a nice, long time horizon at the outset of retirement. They might have 20 or 25 years in which they expect to be relying on that portfolio, so that portfolio needs to have growth. It needs to be balanced across more conservative and more aggressive investments. But when I think back on how I structured the bucket portfolios that we've got on, I definitely look for funds that give more all-in-one exposure--the thinking being that most retirees probably don't want to wrestle with a lot of moving parts in their portfolio. So, I look for funds that give a lot of diversification in a single shot.

I would also urge retirees to emphasize costs even more than accumulators. Even though they are important for both sets, costs tend to be particularly important for retirees because the return that a retiree can expect from a more conservatively positioned portfolio in absolute terms will be less than what the accumulator with a more stock-heavy portfolio can expect. So, if a retiree is forecasting returns for his or her portfolio and it's maybe 4% or 5% on an annualized basis, paying 1% in terms of ongoing expenses is going to take a big bite out of that return. So, emphasize, certainly, the expenses as well. I also tend to prioritize funds that have a little bit more of a high-quality cast. Vanguard Dividend Growth (VDIGX) seems to come up in every fund conversation we have, but it's a good example of a fund that is a higher-quality cut of the total stock market.

I would do the same with fixed-income holdings as well because, for retirees, it's particularly important that their fixed-income holdings serve as ballast for the equity holdings that they have. So, I definitely would favor a more high-quality complexion for the fixed-income portion of a retiree portfolio or a pre-retiree portfolio.

Glaser: Christine, thanks for sharing this checklist today.

Benz: Jeremy, thank you.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.