We have already seen how laborious can be to pick a share and a bond, in terms of time and skills. With funds we aim to simplify, diversify and optimize costs, while maximizing returns. We won’t be the best performers every year, as no one will be because of reality (refer to the little book), but we will be consistently close to the average, aiming for adequate results to achieve our #imapGoal.
The process to select a fund is quite simple, and we will only need to look at a few parameters. To make this process clear for everyone, we have split it in 5 steps.
Step 1: Funds management strategies, based on the objectives taken against a selected index. We have two approaches:
Active, with the goal of beating the selected market index, making frequent buy and sale transactions that leading to higher fees, taxation and higher risks, due to the bets of the managers.
Passive, with the goal of copying the performance of the selected index to get market returns, holding and minimizing buy and sale transactions and fees.
As you can imagine, passive management is much cheaper than active management. Only via commissions, the difference in profitability can be very large, easily reaching 2% per year in the long term. You can learn more about the importance of compounding costs.
Step 2: Fund type, as we have already explained, a fund can contain shares or bonds. There are mixed funds that combine both in the same fund, but for simplicity and easy-management, we will leave them aside in our journey.
Step 3: Focus of the fund, where we will decide the features of the shares or bonds that the fund will contain.
For shares funds:
Theme, refers to the sector of the shares. For instance, a fund with an infrastructure theme will include companies that works in steel, cement or construction for example.
Style, refers to value (companies that are currently trading below what they are really worth and will thus provide a superior return) or growth (companies that are considered to have the potential to outperform the overall market over time because of their future potential). We won’t use this distinction for passive investment.
Size, refers to a category based on market capitalization: large, medium, and small. We won’t use this distinction for passive investment.
For bonds funds:
Grade, a rating that signifies the risk of default, using different designations for its classification.
Duration, as bonds funds do not have a specific maturity date as bonds do, they are divided into three categories based on the maturity date of the bonds that they contain: short (less than 5 years), mid (between 5–10 years) and long (more than 10 years).
Issuer, having two main categories: government, issued by states, cities, counties and other governmental entities; and corporate, issued by private companies.
Step 4. Other criteria to look at to filter the funds that we want to hold. We won’t look at past performances to select funds.
Index, that the fund is copying. There are three main strategies for index replication: physical (or full replication), where the fund holds the shares/bonds; optimized, where the fund holds the most representative shares/bonds sample of the index based on correlations, exposure and risk; or synthetic, where the fund holds derivatives such as swaps. Physical is the recommended one as it is the easiest to understand and to follow. We will be using this criterion for passive funds, because for active funds is only used as a benchmarking.
Currency of the fund.
Region where the fund invests. It can be a wider area like Europe, or a specific country like Germany.
Traded, similar to how common shares are traded. We can also buy traded funds in smaller sizes and with fewer hurdles than non-traded funds, and avoid the special accounts and documentation required non-traded funds. The main disadvantage of traded funds is that they can’t be transferred, so if you want to move your money from one fund to another you have to sell and but, making it less tax efficient.
Pay out refers to the strategy that a fund follows to pay dividends. There are two options: accumulation, reinvests the dividends within the fund, so we don’t get paid but the fund increases its value; and distribution, the fund that will periodically distribute dividends. The accumulation can be more tax efficient, but we lose capacity of using our money for another investments.
Manager, the team that makes the decisions on which shares/bonds the fund will contain along the time. We will only have into account for active funds, as despite there is a management team in passive funds, their decisions are less relevant as they mainly have to replicate the index the fund follows.
Step 5: Fees, a specific criterion that we have decided to put apart because it’s one of the more important things we should be looking at. These costs are deducted from the fund value before the fund price is determined, so you may not be aware of them. Always remember the importance of compounding costs
Front-end load fee, charged upon purchase of the fund.
Management fee, cost of having your assets professionally managed.
Performance fee, payment made to the manager team for generating positive returns
Redemption fee, when shares or bonds are sold from a fund. This fee, also known as an exit fee, market timing fee, or short-term trading fee.
Marketing fee, annual marketing or distribution fee.
Total Expense Ratio, total costs associated with managing and operating a fund. We will use only this for passive funds as it covers all the fees we will be concurring, for an easy selection and comparison with the other fees.
That's all. Now you just need to go to your bank and operate there as we have already explained. Use #imap to track it, and good luck!
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