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, based on the fund’s expense ratio and turnover rate
- Its performance history
- Its risk profile
- Its management team
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 return. Frequent selling can also produce short-term capital gains, which may mean you’ll have taxable investment income that you hadn’t anticipated.
Past performance shows the fund’s returns in previous years. While this measure doesn’t guarantee future returns, it does reveal 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 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.
One measure of a fund’s risk is its 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.
The longer you plan to stay invested, the more volatility you may be comfortable with. That’s because you’re more likely to have time to benefit from potential gains and recover from potential losses that result from fluctuating prices.
What is a mutual fund prospectus?
You can find much of the information you need to evaluate a fund all in one place: the prospectus. The SEC requires all mutual fund companies to publish this document for each fund and provide a copy to potential investors 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, aftertax 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 data.
Ratings and rankings
The work of independent professional analysts is another important resource in evaluating funds. In addition to detailed, objective reviews 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 equity 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.
In contrast, Morningstar, which like S&P 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 rating and ranking data on their websites and send more detailed reports to their subscribers. If you work with a broker or investment adviser, he or she may provide this research. You can also check to see if your public library carries any of these research reports.
You don’t have to look very hard to find advice about which funds to buy, but you do have to take a hard look at the quality of the advice and the person providing it. Ask yourself what’s being sold and who will profit.
Guide To Mutual Funds Evaluating by Inna Rosputnia
Wishing you a great week!
Want Your Money To Grow?
Subscribe to get free research, trading lessons, and more insights.
(We do not share your data with anybody, and only use it for its intended purpose)