The Pareto Principle translates to a skewed 90/10 rule in finance and managed funds, meaning any index is going to be impacted by the small number of stocks that are delivering large returns.
Keep an eye on fees and expenses, and stick to battle-tested funds and proven winners.
Other important factors include fund and manager reputation, sound long-term processes, and tax situations.
The number of options for investing in funds has increased dramatically in the last 10 years. There are currently more than 100,000 mutual funds, 10,000 hedge funds and 5,000 exchange-traded funds in existence.
How do you filter through these options and pick funds and a fund manager that you are happy with? This choice becomes easier when you learn that roughly 90 percent of these solutions fail to deliver attractive returns in all types of markets. According to Arizona State University finance professor Hendrik Bessembinder, "When stated in terms of lifetime dollar wealth creation, the entire gain in the U.S. stock market since 1926 is attributable to the best-performing 4 percent of listed companies."
This means that there are a very small percentage of companies that are providing attractive returns, and most of the specific financial instruments that can be bought and sold will most likely yield poor performance. In addition, the performance results of the majority of funds out there fail to beat a simple index of stocks such as the Dow Jones or the S&P 500 .
The Pareto Principle
We see the Pareto Principle, the 80/20 rule, in all aspects of life. This translates to a 90/10 rule in the world of finance and managed funds. From a statistics standpoint, this is often referred to as positive skew, or fat tail distributions. "Skewness" means that at any given time, the index is going to be impacted by a small number of stocks that are delivering large returns.
This positive skew makes life difficult for active managers. Out of the thousands of possible options in the stock markets, there are only a small number of stocks that will eventually become large winners. Given this environment, what factors should one consider that could result in selecting a fund manager/fund that can provide exceptional returns, given the small number of funds out there today?
More from Straight Talk: Estate plans: Not just for the wealthy Forget FAANG. Invest in these tech trends Nearly every financial plan written has been wrong
1. Fees and expenses
Focus on net returns, which subtract all fees and expenses. Make sure the funds you are evaluating are quoting net returns of all fees and expenses. Would you want a fund that has net returns of 20 percent in a year that included 3 percent of fees and expenses, or one that returns 13 percent in a year but only has 1 percent of fees and expenses?
Most would pick the fund that returns 20 percent. Try to avoid comparing fees and expenses across funds, and spend your time focusing on net returns, because, like most things in life, you pay more for better stuff. Whether that is paying a lot for high potential athletes, employees, clothes or homes, fees and expenses will usually be higher for entities that have more to offer than others that do not.
2. Battle-tested funds
College football rankings often favor teams that are battle-tested. It helps determine how good the team really is, based on how it performed against highly qualified teams compared to mediocre teams. When evaluating a fund, it is better to find those that are battle-tested. Battle testing in the markets is based on how the fund performed in various modes of the market, i.e., bull and bear cyclical markets, economic expansions and recessions. The longer the fund has been in operation, the more likely it has encountered the many flavors of the markets, thereby making longevity a key aspect in your narrowing selection.
3. Concentrated positions in rare winners
Warren Buffett says that "diversification is protection against ignorance," and William O'Neil says that "broad diversification is plainly and simply often a hedge for ignorance." These two legends in finance are making note of the findings Hendrik Bessembinder has observed in the markets. The best fund managers/funds find those rare winners in the stock market and allocate a large concentration of the fund's assets to these winners.
4. A sound process
When Vince Lombardi was asked why he was so successful as coach of the Green Bay Packers, he simply said, "We focused on those things we do well and performed those things on a repetitive basis." The Lombardi power sweep was a clear example of the obsession they had on processes.
The power sweep was introduced, refined and constantly practiced, which resulted in phenomenal success — leading to the legendary win percentages. Funds that focus on improving their processes ultimately lead to better outcomes (better performance). Pay particular attend to those funds that have not wavered that much from their initial launch strategy.
5. Tax implications
Everyone's tax situation is different, so it is really important you understand your tax situation and which type of fund best matches it. For example, if you have a lot of capital losses you are carrying over each year, you can probably tolerate those funds generating large short-term capital gains. Those who want to minimize taxes as much as possible should focus on funds that generate long-term capital gains (i.e., stocks held for more than one year).
6. Reputation of fund manager and firm
Start with the Securities and Exchange Commission and/or the state the fund is registered in, and check for all disclosures and any negative press that has occurred. Research the tenure of the portfolio manager(s), and research not only their SEC and/or state information but also any personal information that is unusual about the manager(s).
Subscribe to one of the many websites that will provide you all historical information about the person/firm, and of course, perform Google searches that contain any aspect of the person's or fund's name. Stay away from managers who display lavish lifestyles. And in the hedge fund world, make sure the fund is registered with the SEC or state and that this registration has been in effect since it was founded.
There are a dizzying array of funds to choose from. Considering the above will help narrow the choices.
(Editor's Note: This column originally appeared at Investopedia.com .)
— By Tom Tresnowski, president and portfolio manager, Vincose Capital Management
