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Time-Tested Strategies for Picking Funds

Getting beyond indexing and too-frequent rebalancing.
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Robert Zelmin

asked me a question that I hear quite a bit: When I list stocks and funds for a portfolio, "Why did you pick those particular ones?"

This question means it's high time to discuss my selection process for investing. I have said some of these things before, but a summary of my basic guidelines is worth putting together for this column:

Classic asset allocation that requires a certain percentage in each major asset class does not work for me. I know that research proves over a long period of time -- typically 20 to 30 years -- it works very well. However, to always intentionally have money positioned in asset classes that are out of favor (as well as those in favor) makes no sense to me. I resist a strategy that is a formulaic approach to investing in mutual funds. Any formula that stretches my patience and my clients' beyond a reasonable limit gets rejected.

I refuse to use indexing as the predominant strategy in picking funds. If only 5% of the managers are beating a given index, I want to find them. The idea of putting all my money in the Vanguard Index 500 fund is a lazy idea. Advisers that get paid to manage peoples' money actively and put all the money in index funds should reduce their fees to about 10 basis points, as a handholding fee. I am all for handholding, but not when it is accompanied by some excuse for passive, mediocre performance. Here is how the six funds I referred to in my last column performed -- through Sept. 30 -- compared with the S&P 500 for the last one, three and five years:

Why would I want to park money in the 500, when every fund for each period of time significantly beat it? Admittedly, there are single years when a fund did not beat the index: Thornburg Value missed it by 6.32% in 1998. White Oak Growth underperformed it by 9.05% in 1997. Hartford Mid Cap was 5.46% under the 500 in 1998. Artisan International missed it by a whopping 29.89% in 1997 and by about 4% this year. Vanguard Health Care undershot by 1.59% in 1996, 4.78% in 1997 and 14% in 1999. Firsthand Technology Value underperformed by a huge 26.89% in 1997 and 4.86% in 1998. From 1995 through 1998, the S&P 500 was the leading index and few managers beat it. I heard people saying, "It's a no-brainer, just put it all in the Index 500 fund." It sounds like the same people that said in 1999, "Just put it all in tech, it's a no-brainer." They may have both been right, but not using your brain and some common sense leads to mediocre performance and unnecessary losses. Take a look at the table. Would you rather have the overall results of the six funds or the Vanguard Index 500 fund?

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I realize there are a lot of issues that make this a very complicated subject. Issues such as risk-adjusted performance, different indices at different times, sector funds and an entire kaleidoscope of quantitative issues. The ultimate cop-out is, "We only need to make enough money each year to reach a clients' long-range goals." Does that mean that, if we only need 10% in a year when we could get 30% with a similar amount of risk, we should give back 20%? Of course, I believe in managing to a clients' objective, but I want to do even better if reasonably possible.

It seems like everybody is into rebalancing. Rebalancing means when an allocation gets out of whack because some managers are making too much money we ought to take that money and give it to a manager that is underperforming. That is like saying, "Let's take Terrell Davis of the Broncos out of the game, because he has already run 100 yards." I let the winners run until they start to stumble. Sure, I may take a hit at some point, but in most cases, I'll still be ahead.

If I am getting paid to manage money, I'm probably not going to buy and hold any fund forever. At the very least, I will probably reduce my allocation to a manager that is going through a "soft" period. For instance, Bill Miller of Legg Mason Value is having a slow year. Though some of his growth holdings have taken a pounding, I'm sure he is not too worried, because he has bought some value stocks (although they may take awhile to move). Miller is a very smart manger, but temporarily I am underweighting him and putting more money with Bill Fries of Thornburg Value and Jim Oelschlager of White Oak Growth.

I look at all the quantitative stuff through the eyes of Morningstar. Any fund I pick needs to have beaten its benchmark over three and five years. I generally won't put more than 5% to 10% in a sector. International fund allocation will generally not exceed 30%. For most years, it won't exceed 10% to 15%. I try to get to know the manager of each fund I use. I ask them a lot of questions but the top three most revealing are: What are your criteria for buying a stock? What are your criteria for selling a stock? What are your favorite sectors and why?

To sum things up, I think good management is as much art as science. The art part becomes very individual and stylistic. Therefore, it doesn't lend itself to easy definition, standardization or the ability to transfer it to someone else. This is the part that frustrates the formula academics. When the process of selecting funds to build a mutual-fund portfolio becomes totally black box definable, you are probably no longer challenging mediocrity. In that case, you might as well index and hold on forever.

Vern Hayden is a certified financial planner in Westport, Conn. He is a financial consultant and advisory associate of Financial Network Investment Corp. He also is an owner of Hayden Financial Group. His column is not a recommendation to buy or sell stocks or to solicit transactions or clients. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks or funds. While he cannot provide investment advice or recommendations, Hayden welcomes your feedback at

vhayden@thestreet.com.