A five-tool fund

Posted by on November 19, 2013 @ 11:30 am in investing

It’s hot stove season and time to talk about the baseball season gone by and the promise for our favorite teams in 2014 and beyond. It was an exciting year—tight wild-card races, a play-in game, a back-and-forth World Series, as well as the emergence of new stars like Andrew McCutchen and Yasiel Puig and young, five-tool players, such as Mike Trout and Bryce Harper.

Most baseball fans are familiar with the concept of the five-tool player: One who can hit for average and power, run, field, and throw. Which got me thinking. What would make a five-tool mutual fund?

I came up with: 1) low costs, 2) broad diversification, 3) experienced management, 4) a clear investment approach, and 5) competitive performance. I touch each of these bases below with some practical tips on evaluating funds—active or index.

Low costs. The mutual fund equivalent to a high batting average is a low expense ratio. Study after study show that funds with lower costs tend to outperform funds with higher costs. There’s no Mendoza line for costs, but consider expense ratios that fall in the bottom quartile. Some broad stock market index funds feature expense ratios as low as 0.05%. That’s $5 for every $10,000 invested in the fund—or the cost of one hot dog at many ballparks!

Broad diversification. A fund with broad diversification mitigates the risks associated with a particular company, sector, or segment. Diversification dampens volatility too. Think about it in terms of having a deep pitching rotation instead of one ace.

Experienced management. Connie Mack managed for 50 years and won five championships. While you’re unlikely to find a fund manager with similar longevity and success, assess the experience, expertise, and tenure of the fund’s skipper. And pay some attention to the fund provider—its stability, track record, and character.

Investment approach. Baseball scouts can discern a considerable amount from how a player approaches plate appearances. Is the batter patient? Disciplined? Consistent? Similarly, evaluate a fund’s investment approach. Is it understandable? Enduring? Easily articulated?

Competitive performance. The returns of the financial markets are obviously beyond our control, and past performance is no guarantee of future returns. Nonetheless, a fund needs to perform. An index fund should demonstrate consistent tracking to its underlying benchmark. An active fund should outperform the majority of its peers and an appropriate benchmark over varying market cycles and longer time periods.

I am no Billy Beane, but hopefully the investing sabermetrics outlined above will better equip you to select funds and build a well-balanced portfolio.