A quest for the absolute best stocks and the best mutual funds will always end in wasted effort. The best funds this year will regress toward the middle of the pack next year. The best you can do is find a fund that does a good job of tracking the index, and that has very low fees. Trying to call “tops” and “bottoms” in equity markets will avail you nothing. The best funds are so because they are cheap and track their index well. Use that energy instead to determine the right proportion of stocks, bonds, and other asset classes that provide you with a realistic return for your level of risk tolerance. Unlike most traders are forced to assume, portfolio allocation is not a zero-sum game. All of your investments can simultaneously make you money when markets cooperate. Asset allocation within your portfolio is many orders of magnitude more important than stock picking, fund picking, and market timing. This is a fortuitous state of affairs since your allocation is the only factor affecting fund performance that you have any control over.
Research has shown convincingly that you can enhance your returns by overweighting your portfolio with certain factors. Historically, this could not be recommended because the individual investor would find the process too complicated and expensive. Today, low-cost mutual fund options give investors with a long-term view the opportunity, at least in theory. If you have an IRA and can buy ETFs, you can consider a factor-based portfolio. If you are dealing with a system that will let you choose only mutual funds (and you are not a multimillionaire), you are limited to the size, value, and term premia.
It seems that Vanguard is starting to translate its popular ETFs into mutual funds, but there doesn’t seem to be any hurry (which I interpret as a sign of quality). These tilts come with the addition of higher risk. Because the factor risks tend to be uncorrelated with each other, you can diversify away much of that premium risk by designing a diversified portfolio. Such investments would be considered speculative when taken alone but can be quite sensible as a modest portion of a larger pool of uncorrelated risks.
References and Further Reading
Bender, J., Remy, B., Melas, D., & Subramanian, R. A. (2013). Foundations of Factor Investing. MSCI.
Berkin, A. L., & Swedroe, L. E. (2016). Your Complete Guide to Factor-based Investing: The Way Smart Money Invests Today. BAM Alliance Press.
Last Updated: 6/25/2018