Fund selection: How do advisers and CIOs choose funds?

Many investors start choosing a fund by looking for the highest recent returns, the strongest rating or a place at the top of a performance table. These can be useful starting points, but they do not tell you whether a fund suits the needs and risk profile of a particular portfolio.

Before comparing funds, clarify the investment objective, risk tolerance, investment horizon and existing portfolio structure. Professional fund selection then centres on one question: What role should this fund play in the overall portfolio?

Financial advisers, fund selectors and Chief Investment Officers (CIOs) therefore assess funds in context rather than in isolation. A CIO oversees the overall investment strategy and portfolio positioning. Professional fund selection combines an assessment of portfolio fit with a structured review of performance, risk, the fund management team, the investment process and fund size.

The key fund selection criteria can be grouped into five questions:

• What role should a fund play in the portfolio?
• How should fund performance, benchmarks and risk be assessed?
• When are ETFs or active funds the better fit?
• How should the management team, investment process and fund size be evaluated?
• Why does fund selection continue after the initial investment?

Every fund should have a clearly defined role within the wider portfolio. Only then can you judge whether its strategy, risks and costs are appropriate.

Why does portfolio fit matter?

A fund may provide exposure to a particular asset class or sub-asset class, reduce concentration or complement the portfolio's risk/return profile. With an active fund, investors may also expect independent investment decisions to contribute additional returns or deliver a more favourable risk profile.

The aim is not to find the "best fund" in isolation. A fund can look compelling on its own and still be unsuitable if it amplifies existing risks or duplicates a role already fulfilled by other holdings.

Owning several funds with different names does not automatically create diversification. They may invest in the same large companies, share similar value or growth biases, or carry comparable currency, liquidity and concentration risks.

The central question is: What does this fund add beyond what the existing holdings already provide?

What should you check first?

An important first step is to compare the fund with an appropriate benchmark. An equity fund should be assessed against a suitable equity index, and a bond fund against a relevant bond index. The benchmark must reflect the fund's investment universe and strategy.

Relative performance is only part of the assessment. Absolute returns, volatility, potential losses and behaviour across different market conditions also matter. An unsuitable benchmark can distort the picture.

Information about the fund management team and investment process should also be available early on. Without reliable details about the decision-makers, their experience and their record of implementing the strategy, an informed assessment is difficult.

A limited track record may also be a reason to rule a fund out. The key question is whether the team has previously implemented the same strategy in another fund or mandate, or has experience using the same quantitative methodology.

Three to five years of performance history can provide useful context, but this is not a fixed minimum requirement. The market conditions covered by that history are more informative. A record spanning rising markets, falling markets and periods of stress may reveal more than a longer history built in broadly uniform conditions.

Fund performance only becomes meaningful when considered alongside the benchmark, investment style and risks taken. The question is not simply how much the fund returned, but what drove those returns and what risks were involved.

Why do rankings and peer groups only tell part of the story?

A fund ranking shows how a fund performed over a particular period under a particular methodology. It does not establish whether the fund fits the portfolio or whether its results appear repeatable.

A peer group is only useful if its members are genuinely comparable. Funds in the same category can differ substantially in their investment universe, investment style, concentration and risk budget.

Meaningful fund comparisons therefore require comparable strategies, a suitable benchmark and similar risk profiles.

Ratings and rankings can help identify funds for closer analysis. Assessments that consider return and risk together, rather than just a brief market period, are more informative. Even so, they do not replace an appropriate benchmark or a review of the team, investment process and portfolio fit.

What is driving a fund's performance?

Analysing the sources of returns, often called performance attribution, helps identify what contributed to a fund's results. These contributions may come from broad market movements, a particular investment style, individual large positions, timing or active decisions by the fund management team.

Returns attributable to market beta reflect broader market movements. A style bias is a persistent tilt towards, for example, value, growth, large-cap, mid-cap or small-cap stocks. When markets favour that style, some outperformance may be explained by favourable conditions for those factors.

Alpha is the portion of returns that, within the chosen benchmark and risk model, is not explained by broad market movements or the systematic factors included in that model. Positive measured alpha does not establish that a manager can deliver repeatable results over time. What matters is whether the performance can be plausibly linked to the investment process.

A good fund does not need to top the rankings in every market environment. Its investment thesis, portfolio holdings and actual performance should be consistent with one another.

Which fund performance and risk metrics matter?

No single metric provides a complete picture of fund quality. Return and risk measures need to be assessed together.

• Volatility and Sharpe ratio: Volatility measures the extent of fluctuations in a fund's value. The Sharpe ratio expresses returns above a risk-free benchmark relative to total volatility.
• Sortino ratio: This uses a risk measure focused on downside deviations below a specified target return.
• Maximum drawdown: This is the largest decline from a previous peak to a subsequent trough. The length of the drawdown and the time taken to recover provide additional context.
• Tracking error: This measures the volatility of the difference between a fund's returns and those of its benchmark.

These metrics are analytical tools, not automatic judgements of quality. What matters is why a fund has those characteristics and whether they suit its intended role in the portfolio.

What can periods of market stress reveal?

Risks can remain difficult to detect during extended rising markets. More challenging conditions help reveal whether a fund behaves as its investment style and stated risks would suggest.

Weaker performance may still be consistent with the investment thesis. An unexpectedly large deviation, however, may warrant closer investigation.

Periods of stress do not reveal every risk in advance. They do provide evidence of whether the investment thesis, portfolio structure and actual performance are consistent with one another.

There is no universal answer to the ETF-versus-active-fund question. Either can be appropriate, depending on its intended role, the market segment, the investment horizon and the wider portfolio.

When might an active fund be suitable?

An active fund may be suitable when its management team can make independent investment decisions within a market segment and demonstrate how its expertise is applied. It should be clear which opportunities the team pursues, which risks it deliberately avoids and where it chooses to deviate from the benchmark.

The potential added value is not limited to higher returns. It may also take the form of a different risk profile, targeted security selection or a portfolio deliberately structured differently from the index.

Costs remain part of the overall assessment. The question is whether the investment process, team and positioning can plausibly contribute to the wider portfolio after costs.

When might an ETF be suitable?

An ETF may be suitable when a broad, well-diversified index provides appropriate exposure to the desired market segment. ETFs can also offer practical advantages for shorter investment horizons or in liquid market segments where the ability to trade quickly matters.

Index construction is crucial. In market-value-weighted bond indices, issuers with more outstanding bonds can receive a greater weight. A large volume of outstanding debt can therefore translate into a large index allocation. This does not make bond ETFs inherently unsuitable, but it is a structural feature worth examining.

Equity indices can also become concentrated when a small number of large companies account for substantial weights. An index that appears broadly diversified is not necessarily balanced across every dimension of risk.

How can you tell how actively a fund is managed?

Tracking error can indicate how much an active fund deviates from its benchmark. For active equity funds, a tracking error of around 3.5% to 4% or higher can serve as a rough indication of more pronounced divergence.

This is neither a universal threshold nor a guarantee of outperformance. Tracking error indicates activity, not quality.

A low tracking error may prompt a closer look at whether the fund's limited divergence from its benchmark is consistent with its stated approach, investment process and fees. The term "closet indexing" is often used for active funds that remain very close to their benchmark. Such a judgement should never rest on a single metric.

An ETF's replication method also deserves scrutiny. A physically replicated ETF holds all or a selection of the index constituents. A synthetic ETF uses a swap structure to replicate index performance. Relevant considerations include costs, including swap costs, transparency, counterparty risk and how readily the structure can be understood.

With an active fund, historical figures only tell part of the story. It is equally important to understand who makes the decisions, how the investment process works and whether the strategy remains workable at the fund's current size.

How should you assess the fund management team?

Clear responsibilities and accountability are essential. It should be possible to identify who makes portfolio decisions, how long the key decision-makers have worked together and how many other funds or mandates they manage.

Team stability, staff turnover, succession planning and key-person risk also matter. A focused team with a small number of clearly identified decision-makers may be easier to assess than an opaque organisational structure. Team size alone, however, is not evidence of quality.

Alignment of interests is another consideration: How closely are the managers' financial interests connected with those of their investors? Performance-related remuneration, the managers' own investment and participation in long-term results can provide useful indications.

Specialist asset managers may, under certain conditions, offer strong alignment of interests. This does not mean they are generally superior to larger fund groups. The relevant considerations are the incentive structure, governance, resources and potential conflicts of interest.

How can you test the investment process?

A convincing description is not enough. The investment process should be evident in the fund's actual holdings.

The management team should be able to explain why a significant position is in the portfolio, the investment thesis behind it and how its weighting was determined. Earlier decisions should also remain understandable when reviewed in retrospect.

These checks help establish whether the process is applied in practice. Discussions over time allow fund selectors to assess whether the managers' explanations, portfolio holdings and historical behaviour are consistent.

Overconfidence, an excessive emphasis on short-term success and weak explanations for earlier decisions can be warning signs. The purpose of a manager meeting is to test the robustness of the investment process, not the persuasiveness of the presentation.

When can fund size become a problem?

Fund size needs to be assessed in relation to the strategy. Fixed costs can weigh on a very small fund, while a very large fund may lose flexibility.

This is particularly relevant in less liquid market segments, small-cap investing and concentrated strategies. Large inflows can alter the portfolio structure and make the original approach harder to implement.

Changes in the number of holdings, overall concentration or the combined weight of the ten largest positions can all be useful indicators. They are not necessarily negative, but they may point to changes in how the strategy is being implemented.

A soft close, which limits new inflows, may indicate that the fund provider is taking capacity constraints seriously. It is not a guarantee of quality in itself. The key question remains whether the investment process can still be implemented as described at the fund's current size.

Fund selection does not end when an investment is made. Ongoing monitoring tests whether the original investment thesis still holds.

What changes should you monitor?

Before investing, document why the fund was selected. This includes its role in the portfolio, expected return and risk characteristics, the assessment of the management team and the assumptions underlying the investment process.

Monitoring should cover changes in the fund management team, investment process, portfolio structure, fund size, ownership, governance and transparency.

Short-term underperformance is not automatically a reason to sell. If a fund behaves as its investment style would suggest, its performance may remain consistent with the investment thesis. Conversely, strong returns are not sufficient reason to retain a fund unchanged when important underlying conditions have shifted.

What does genuine diversification look like?

Diversification is about more than the number of funds in a portfolio. Several funds may depend on the same factors, currencies, market segments or sources of liquidity. These overlaps can go unnoticed in calm markets. Under stress, seemingly different strategies may behave similarly.

A robust portfolio therefore combines different investment approaches, management teams, styles and instruments. Risks specific to a single manager or strategy should not dominate the overall portfolio.

Even global diversification does not eliminate the risk of loss. It can reduce regional concentration, but it does not protect against broad market declines or concentrations within market-capitalisation-weighted indices.

When should you sell a fund?

Professional fund selection includes a clear sell discipline. The decision should not depend solely on whether a fund has recently outperformed or underperformed its benchmark or peer group.

Potential reasons to sell include significant changes to the management team, a change in ownership, insufficient transparency, conflicts of interest or governance problems. Rapid growth in fund size may also call for a fresh assessment if the original strategy can no longer be implemented as intended.

New strategies, or those with exceptionally strong recent performance, should not receive large allocations solely because of their latest returns. Strong short-term performance establishes neither the repeatability of results nor the fund's suitability for the portfolio.

The decision should therefore depend more on whether the original investment thesis remains valid than on a short-term ranking or rating.

Professional fund selection is a structured analytical process. It starts not with the fund that delivered the highest recent return, but with the role the investment needs to fulfil in the overall portfolio.

The next steps are to choose an appropriate benchmark, analyse performance and risk, examine the track record and assess the management team, investment process, incentives and fund size. For ETFs, index construction and the replication method are additional priorities.

Ratings, rankings and historical performance can provide useful information. They are not substitutes for thorough fund analysis.

Choosing and evaluating investment funds requires quantitative measures, qualitative assessment and ongoing monitoring. Good fund selection establishes portfolio fit before investing, then regularly checks whether the team, investment process and original investment thesis still justify the allocation.