How Do We Choose the Funds We Use? Step Five: Manage the Modifications

Welcome to the final installment of our multipart series on how we choose the funds we use. You may have noticed, the world never stops spinning. The same can be said for evidence-based investing. Over time, how do we sift out and incorporate helpful new best practices, without succumbing to information overload? That’s Step Five.

Step Five: Manage the Modifications

While it’s important to adhere to a long-term investment outlook, even an evidence-based portfolio is expected to evolve over time. For example:

• Harry Markowitz and William Sharpe introduced Modern Portfolio Theory in the 1950s, and Capital Asset Pricing Model in the 1970s, respectively. Their insights set the stage for moving from individual stock speculation to diversified portfolio construction.
• In the 1990s, the Fama/French three-factor pricing model helped us understand the importance of capturing global returns from multiple sources.
• Since then, we’ve explored ways to incorporate other, potentially persistent factors—such as profitability, investment, and momentum.
• Most recently, we’ve also started applying factor investing in additional markets, such as alternative lending and reinsurance, which may offer discrete sources of expected returns.

In short, new studies can change or add to our existing assumptions, with portfolio construction models evolving accordingly. Benchmarks and indexes improve over time as well, sharpening our ability to track and compare relative performance. Enhanced technologies can eliminate inefficiencies, making it possible to pursue expected sources of return that simply weren’t accessible to us in the past.

Reputable product providers heed such updates—or sometimes develop them themselves—and build them into new or existing solutions. We, in turn, must weigh the advantages and disadvantages of incorporating them into your portfolio.

Even if a new and improved fund hits the market, what are the tax ramifications of your investing in it? Even if it is a solid solution, does it fit into your greater financial goals? How can investment management (such as adding new assets or rebalancing your portfolio back to plan) help us incorporate the latest, greatest opportunities, without incurring excessive costs? These are a few of the many questions that factor into your optimal investment selections.

Fund Selection Built to Last

So, how do we choose the funds we use? The answer depends on how to best extract the most dependable returns out of highly efficient markets. It depends on heeding practical improvements as they arise. It depends on determining how these forces are expected to impact you, and your one and only investment experience.