Investing Classroom: What to look for in a fund

Let's be honest: Very few investors are as geeky as Morningstar’s fund analysts. Most people don't have time to fly around the country attending investment conferences and they don't waste their time swapping fund industry gossip. Furthermore, most investors have better things to do than to monitor dozens of funds. Finally, people starting out in investing probably don't have the money to buy more than one fund anyway.

So here's our advice for those searching for their first—and perhaps only—fund.

Index funds
Index funds are about as simple as it gets. Index-fund managers aren't picking stocks in the traditional sense. Instead, they are buying the same stocks in the same proportion as they appear in a particular index. In other words, they don't buy a stock because they like a company's prospects or sell because a firm's outlook has become less than rosy. They simply own the index. They are passive investors.

Index funds have plenty of benefits. Most important, they tend to be low in cost. Because the index-fund managers aren't actively managing their funds—instead of making buy and sell decisions, they're simply doing what the index does—management fees tend to be low.

Index funds are also advantageous because they are fairly predictable. First, they tend to return what the index does, minus their expenses. Second, they always own what the index owns, which means they tend to be style specific. For example, if a fund indexes the FTSE 100, that means it owns large-blend stocks; it'll own those types of stocks today, tomorrow, and the next day. You know what to expect from an index fund. Funds that aren't indexed, also called actively managed funds, might not own the same types of stocks day in and day out. It all depends on the manager's style. He or she may like large companies one day and then see value in smaller firms the next.

Finally, index-fund investors don't have to worry about manager turnover: If the manager leaves, the next manager is likely to do just as well, as long as the fund shop's resources haven't changed. Nor is asset size an issue. Index funds can handle plenty of assets, because they generally don't use fast-trading strategies.

If you only plan to own one index fund for a while, make sure it favours large companies. Some funds hold stocks of all sizes, though larger companies are most heavily represented. Such funds would be excellent choices for one-fund owners.

Funds of funds
Funds of funds are funds that invest in other funds. That may sound redundant, but it's true.

Just as a regular fund offers the skills of a professional manager who assembles a portfolio of stocks or other securities, the manager of a fund of funds will select a portfolio of funds, managed by other managers.

If you have only a small amount to invest each month, a fund of funds allows you access to more funds than you might be able to afford on your own. It also allows investors to avoid the record-keeping and paperwork that comes with owning an assortment of funds.

So what's the catch? Expenses, mostly. The fund of funds structure creates a double layer of costs. First, there are the expenses associated with running the fund of funds itself—management fees, administrative costs, etc. Second, there are the costs associated with the underlying funds—the same sorts of management fees, administrative costs, and so on.

Some fine funds of funds eliminate the double-fee problem by offering funds of funds that invest only in their own funds. The fund families then waive the cost of the funds of funds and you only pay the costs of the underlying funds. Obviously, these funds are a much cheaper option.

Lifecycle funds
First introduced in the early 1990s, lifecycle funds offer investors pre-mixed doses of stocks, bonds, and cash according to their age and risk tolerance. Most fund families offer lifecycle funds in three formulas—aggressive, moderate, and conservative—that you can cycle through as you progress from a young, aggressive investor to an older, more conservative one. Some lifecycle funds are funds of funds, while others own individual securities outright.

All the lifecycle series share the same goal of first growing and then preserving your portfolio, but they vary in their methods. Some track indices and maintain a more or less static mix of assets. Most life-cycle offerings, however, invest more actively. Even Vanguard, which promotes a passive indexing strategy in its Lifestrategy brochure, invests 25% of each lifecycle portfolio in the actively managed Vanguard Asset Allocation.

In the hands of the right manager, such active management can produce good results. But when an active manager concentrates in an asset class at the wrong time, tactical shifts can be deadly. If such manoeuvres make you nervous, then a passive index approach might suit you better.

Check out our Learning Centre for more investment lessons on bonds, funds, stocks and portfolio management.