Steps in Selecting a Mutual Fund

15.2 Steps in Selecting a Mutual Fund

Selecting the right mutual fund can feel a bit like navigating a busy marketplace—there are countless choices, each with different flavors, fees, and features. To help you make sense of it all, the steps outlined here reflect best practices rooted in Canadian regulations and industry standards. These guidelines also build on the Know Your Client (KYC) framework described throughout this course, ensuring that every selection is thoughtful, informed, and aligned with your client’s or your own unique financial profile.

Before we dive into the nitty-gritty details, I just want to share a quick personal reflection. I remember when I started investing in mutual funds. I was, to be honest, kind of overwhelmed. There were so many options—bond funds, equity funds, balanced funds, domestic, global, thematic… you name it. So if you ever feel that way, don’t worry; we’ve all been there. The point is: the more methodical and organized your approach, the easier it becomes to cut through the clutter and make the right choice. Let’s take a look at the core steps.

Defining the Client’s Profile and Objectives

It all starts with understanding who you’re investing for—whether that’s a client or yourself. In the Canadian market, CIRO (the Canadian Investment Regulatory Organization) requires financial professionals to gather comprehensive data under the KYC rule. This means obtaining details such as income, net worth, cash flow, investment goals, risk tolerance, and time horizon.

• If you’re working with a client, have an open-ended conversation. Ask about their personal aspirations: Are they saving for retirement? Funding a child’s education? Buying a home?
• Confirm their capacity for risk. Some people don’t mind big ups and downs if it means a chance for higher returns in the long run, while others just can’t sleep if their portfolio fluctuates too much.
• Outline the time horizon. A client investing for a child’s education might have a relatively short timeline, while someone planning for retirement in 30 years likely has a longer runway.

All these details eventually shape the selection of a mutual fund. Think of it as charting a roadmap—before you plan the route, you have to know where you’re starting and where you want to go.

Establishing an Asset Allocation Strategy

Asset allocation is about splitting the total investment into different “buckets”—such as stocks (equities), bonds (fixed income), and cash equivalents—to strike the right balance between risk and reward based on goals and risk tolerance. Modern Portfolio Theory (MPT) can help here; it provides a framework for combining various asset classes in a way that (hopefully) maximizes returns for a targeted level of risk.

It’s common in Canada, for instance, to have “balanced” portfolios that mix bonds and equities. Perhaps you’ll have 60% in equities for growth and 40% in bonds for stability. Or for a more conservative client, that might skew to 30% equities and 70% bonds. The exact mix depends on many factors, and there’s no single “right” answer.

Sometimes I think about asset allocation like packing bags for a trip. If your trip is long and unpredictable, you bring clothes for all sorts of weather. Just like investing—you don’t want to rely solely on one “weather pattern” in the markets.

Conducting an Initial Screening of Funds

Once the client’s profile is set and the asset mix is decided, it’s time to shortlist potential funds. This step often involves using screening tools. In Canada, many advisors (and even DIY investors) look at resources like Morningstar or Fund Library to filter funds based on:

• Category or mandate: Does your client need a fixed income fund, a pure equity fund, or a balanced fund?
• Historical performance: Examine how the fund has performed over 3-, 5-, or 10-year periods. Keep in mind that past performance doesn’t guarantee future results, but it can provide insights into how a fund has weathered different market conditions.
• Fund size and manager track record: Bigger isn’t always better, but a certain scale can indicate stability. Also, a strong manager with a consistent (not just flashy) track record can be an important sign of competence.
• Volatility: A fund’s standard deviation (or other measures of volatility) gives you a sense of how wildly returns might swing from year to year.

People sometimes forget to match the fund’s time horizon to theirs. If you need your money – or your client does – in two years, a heavily equity-focused fund that invests for the long run may not be ideal. This part is where the concept of “investment mandate” comes into play. If the client wants steady dividend income, you look for a dividend fund, not a growth fund.

Assessing Fees, Costs, and Fund Structure

Fund fees can eat into returns, slowly but surely. This is why paying attention to ongoing costs is crucial. Key cost components in Canada include:

• Management Expense Ratio (MER): The most commonly cited all-in cost that includes the management fee, operating expenses, and taxes.
• Sales charges: Front-end loads (when you buy) and deferred sales charges (when you sell) can significantly reduce overall returns. Deferred Sales Charges (DSCs) often apply if you redeem funds earlier than the specified holding period—be aware of those timelines.
• Portfolio turnover: A higher turnover can lead to additional trading costs.

If the client’s investment plan involves holding the fund for a long time, a load waiver or a no-load fund might be beneficial. On the flipside, some funds might have ongoing Series fees or annual distribution costs that add up. In short: always compare fees carefully, because even a difference of 0.5% in annual costs can be huge over many years. I remember hearing a friend laugh off a half-percent difference. Until we did the math, and, well, wow—over 20 years, half a percent can be thousands (or hundreds of thousands) of dollars, depending on the initial investment.

Reviewing Manager Expertise and Investment Process

Fund managers make decisions about what to buy and sell, so their track record and investing philosophy matter. By checking a manager’s background:

• You can see whether they have a history of sticking to the fund’s stated objectives (e.g., a value investor who consistently looks for undervalued stocks, or a growth investor chasing high-growth opportunities).
• It’s valuable to see if the manager or team invests their own money in the fund. Personal “skin in the game” can align interests with investors.

Ensure the manager’s strategy aligns with your or your client’s values and objectives. For example, if you want a portfolio that focuses on ESG (Environmental, Social, and Governance) investing, you’d look for a manager who emphasizes that approach, not just a manager who invests opportunistically without these considerations.

Analyzing Historical Performance and Risk Metrics

Past performance may not be a crystal ball, but it still helps. Look at consistency. Was the fund in the strong quartile among peers year after year, or did it zoom to the top one year and plummet to the bottom the next?

You might also want to compare the fund’s performance to an appropriate benchmark. For a Canadian equity fund, the S&P/TSX Composite Index is often used. For a global equity fund, the MSCI World Index might be the benchmark. If a fund is consistently underperforming its benchmark, you’ll want to understand why—maybe it has a more conservative posture, or maybe it’s simply not well-managed.

Risk-adjusted metrics like the Sharpe ratio or Sortino ratio can also offer insights into how much volatility a manager took on to achieve returns. If two funds boast similar returns, but one fund took on significantly more risk, you might prefer the other. Another risk measure that’s frequently used is beta; it indicates how sensitive the fund is to overall market movements.

Monitor and Reassess

Once the mutual fund is selected, it’s not “set it and forget it.” You’ll want to periodically review:

• Changes in market conditions. Your once-perfect portfolio might be out of balance after large market swings.
• Ongoing suitability for the client’s evolving goals. Life events such as job changes, new family members, or a shift in retirement plans can mean your strategy has to adapt.
• Fund management or policy changes. If the fund manager changes or the investment philosophy shifts, it might not be aligned with your or your client’s goals anymore.

Rebalancing is the process of adjusting holdings back to the original (or newly revised) target asset allocations. It’s typically done on a scheduled basis (e.g., annually) or whenever major market changes occur. Some people skip rebalancing because it seems tedious, but it can help lock in gains and maintain the desired risk level.

A Visual Overview

The broad overview of these steps can be visualized in a simple flowchart:

    flowchart LR
	    A["Step 1: Define Client Profile <br/> & Objectives (KYC)"] --> B["Step 2: Establish Asset Allocation Strategy"]
	    B --> C["Step 3: Conduct Initial Screening of Funds"]
	    C --> D["Step 4: Assess Fees & Structure"]
	    D --> E["Step 5: Review Manager Expertise"]
	    E --> F["Step 6: Analyze Performance & Risk"]
	    F --> G["Step 7: Monitor & Reassess"]

Think of it as a cycle; you might occasionally loop from Step 7 back to Step 1 when major life or market changes happen.

Glossary

Asset Allocation

The process of distributing investments among different asset classes to optimize returns for a given level of risk.

Management Expense Ratio (MER)

The total annual fees (including management fees, operating expenses, and taxes) expressed as a percentage of a fund’s average assets.

Front-End Load

A sales charge paid when mutual fund shares are purchased.

Deferred Sales Charge (DSC)

A fee paid upon redeeming fund units if they’re sold before a specified holding period.

Investment Mandate

The stated objectives and guidelines under which a mutual fund operates (e.g., growth, dividend income).

Portfolio Turnover Rate

How often a fund’s holdings change within a given period. High turnover can imply additional trading costs.

Official Regulations, Tools, and Resources

• CIRO (Canadian Investment Regulatory Organization) sets proficiency standards for financial professionals and enforces KYC requirements. Learn more at ciro.ca.
• National Instrument 81-102 – Investment Funds: This is a key regulation from the Canadian Securities Administrators (CSA) that lays out how mutual funds in Canada must operate.
• The Canadian Investor Protection Fund (CIPF) protects client assets if a member firm becomes insolvent, ensuring an added layer of security.
• SEDAR+ (replacing the former SEDAR platform) is where you can find publicly filed mutual fund documents—like simplified prospectuses and annual reports—for deeper research.
• Industry data platforms like Morningstar or Fund Library can help with initial fund screening, historical performance charts, and peer-group comparisons.
• For deeper reading on selecting funds:
– “Fundamental Analysis for Dummies” by Matt Krantz
– “Bogle on Mutual Funds” by John C. Bogle

Feel free to explore these resources to expand your understanding. It’s normal to keep refining your selection process. As markets and life circumstances change, so do the steps you take to pick and manage investments.

Selecting a Mutual Fund: 10 Must-Know Steps Quiz