Selecting Specific FundsOnce you’ve decided how much of your money to dedicate to each broad asset class, it’s time to decide which specific financial instruments (stocks, bonds, etc.) to purchase within each asset class. This step could be made very complex but the passive investor can quickly cut to the chase. Unlike active investors who convince themselves that they can use convoluted trading rules, select stocks, and beat markets consistently, the intelligent passive investor realizes that consistently successful stock picking is not a realistic aspiration. Instead, the passive investor focuses on the concept we’ve introduced earlier—diversification. Rather than expending time and money on trying to identify a few needles in a haystack, the passive investor buys the whole stack. This provides the ultimate level of diversification, and a virtual guarantee, especially over long period of time, that while the value of some of the pieces of hay in the stack will decline, the majority will prosper. Keeping this in mind, you should now focus separately on each asset class in your allocation scheme. Within each asset class you need to identify well diversified funds that properly represent that asset class. Some funds are specifically designed to mimic particular indexes. An index that represents a distinct asset class is a classic vehicle for the passive investor. Your goal now is to identify low-cost (indexed) mutual fund and exchange traded funds within each major asset class. Identifying FundsYou can use one of the following sources to filter and identify ETFs: Or you can go directly to some of the established providers of ETFs. These include Vanguard, State Street (SPDRs), and Barclays (iShares), among others. You can use one of the following sources to filter and identify mutual funds: In each application, look for a “Screener,” “View,” “Filter” or “Selection” tab or link. This feature will allow you to search for funds meeting particular criteria. For example, large cap stocks in the United States, Bonds in Europe, etc. I find the Morningstar interface to be superior to Yahoo’s, primarily because it’s been easier for me to quickly identify ETF expense ratios on Morningstar. On the other hand, Morningstar’s Screener may take some getting used to if you’ve never used such a system before. You may also be given an opportunity to filter funds based on past performance. This can be extremely misleading, so I highly recommend against it. The issue is less relevant for a passive investor seeking to invest in large indices, as any funds investing in these indices will realize quite similar performance. In fact, if any one fund stands out above the rest, it may be necessary to question whether it has deviated from the index and actually taken on more risk which could come back to haunt an investor later on. Some brokers will provide a list of mutual funds you can buy without transaction fees. But they may charge hefty fees for funds not on their transaction-free lists. You may be able to buy certain mutual funds directly from the mutual fund company by setting up a mutual fund account with them. Theoretically, however, this could mean having to setup multiple mutual fund accounts with multiple fund companies to achieve the asset allocation you seek. Alternatively, and from my perspective, preferably, you can focus on purchasing exchange traded funds instead of mutual funds. With ETFs you pay transaction costs just as you would with a regular stock purchase, but you don’t have to worry about the sometimes convoluted fee structure that accompanies mutual funds. Some of the important indicators you want to look for when seeking index funds are management expense ratios, which reflect the fees you must pay annually to own the fund, and the tracking error, which measures how well the fund tracks the underlying index. In both cases the lower the measure the better. That is, a lower expense ratio is better than a higher one. A low tracking error is desirable, as it indicates the fund tracks the index very closely. Caution: Make sure you write down clearly and accurately the ticker symbol for each investment instrument (ETF or mutual fund) you want to buy. This unique identifier will ensure you purchase the correct instrument. You should get in the habit of confirming this ticker simple a few times before executing an actual trade. Inclusion of a fund in any of the lists below should not be interpreted as endorsement, although I have attempted to identify low-cost funds in each asset class. Selecting Specific Funds
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Passive Investing Steps
