Evaluating Mutual Funds

Evaluating Mutual Funds
All mutual funds may be created equal, but some are more equal than others.

You may be looking for a mutual fund to help diversify your portfolio or meet a specific objective, such as long-term growth or current income. With several thousand funds to choose from, how do you narrow the choice?

Evaluating A Fund

The important elements in any mutual fund evaluation include:

The cost of investing in a fund has a predictable effect on the fund’s performance. The higher the fund’s expense ratio, which is the percentage of your account’s value that you pay in annual fees, the lower your long-term return. That’s because every dollar you pay in fees reduces both the present value of your account and the amount available for reinvestment.

Turnover rate is a measure of how frequently the fund buys and sells investments. Funds with a high turnover rate tend to have high transaction costs, which are paid out of the fund’s income, and therefore reduce its return. Frequent selling can also produce short-term capital gains, which may mean you realize taxable investment income that you hadn’t planned upon.

Past performance shows the fund’s returns in previous years. While this measure doesn’t guarantee future returns, it does tell you where the fund has stood in relation to comparable funds and appropriate benchmarks and whether its returns have been consistent or erratic. Performance is affected by the general direction of the markets and what’s in the fund’s portfolio, which reflects the thinking and the skill of the fund management. Before you invest in a strong-performing fund, it pays to check if the managers responsible for that performance are still at the helm. If they are, you have a better sense of what may happen in the future than if they’ve left.

One measure of risk is a fund’s volatility, or the variation in its return — above and below — its average return. The amount of risk you’re comfortable with will depend in large part on your time frame for holding the fund.

A Detailed Roadmap

You can find much of the information you need to evaluate a fund all in one place. The Securities and Exchange Commission (SEC) requires all mutual funds to publish a prospectus and provide a copy to potential investors before they purchase shares or along with the confirmation of an initial investment in a fund.

In addition to stating the fund’s objective and explaining the way it invests, the prospectus explains the fund’s fees, past performance, after-tax returns, and risk profile. It lists the portfolio holdings, identifies the fund manager, and, if there is a sales charge, explains the cost of choosing different classes of shares.

Funds also provide supplementary materials, such as the annual Statement of Additional Information (SAI), which details the fund’s policies on leverage, brokerage commissions, and other financial data. Most fund companies also have extensive websites that provide a great deal of information about their funds.

The work of independent professional analysts is another important resource in evaluating funds. In addition to detailed analyses of the funds they cover, independent research firms, such as Standard & Poor’s, Morningstar, and Lipper, also rate or rank mutual funds. A rating is based on how well a fund meets a specific set of criteria. A ranking is the relative standing of a fund when compared to funds in the same category.

For example, Standard & Poor’s ranks funds on their three-year Sharpe Ratio, which is the fund’s return minus the return on 3-month Treasury bills, divided by the fund’s standard deviation. Standard deviation is a measure of volatility, or the extent to which the fund’s return varies above and below its average return.

The top 10% of funds within a category receives a 5 STARS rank, the next 20% receives 4 STARS, the next 40% receives 3 STARS, the next 20% receives 2 STARS, and the bottom 10% receives 1 STARS. In addition, each fund is assigned a numerical position in the hierarchy of all funds.

In contrast, Morningstar, which also uses a star system, rates funds based on risk-adjusted total return, combining performance and risk in one evaluation.

Lipper evaluates funds on the strength and consistency of their success in meeting their investment objectives and identifies the strongest as Lipper Leaders.

Of course, rankings and ratings don’t tell the whole story. But if you understand the basis for the evaluations, they can provide a useful starting point.

These and other research firms provide some analyses on their websites, and you can also subscribe to receive more detailed reports. If you work with a broker or financial adviser, he or she may provide this research. You can also check to see if your public library carries any of these research reports.

Transparency Issues

Most actively managed mutual funds trade frequently but publish a list of holdings quarterly. This means you really don’t know, at any given time, what the fund owns — since changes could be made as soon as the new quarter begins. In contrast, the holdings of an index mutual fund or an index-based ETF that replicates the index it tracks are fully transparent at all times. Some investors consider this clarity a major advantage in constructing their portfolios.