Jun 12, 2007

Mutual Fund - Definition, How to Invest?

“Past performance is not an indication of future results” – is always written in the fine print on any Mutual Fund prospectus. As an investor that statement used to make me uncomfortable while selecting a mutual fund for my retirement portfolio. That was because I used to look at the historic performance as the criteria to find the fund that can get me better returns for the future. This is called chasing performance and it did not take me too far anyways. But the question still remained. How do I select a fund that can give me a decent return in the long run and does not loose too much value during recession? More generally, How to invest in Mutual funds?

The answer is not very easy because no one single mutual fund can do well during all economic times, and even if it does it can not repeat that performance all the time. So I cannot rely on just one fund that can give me decent return in my retirement fund. (Though there are many new funds like, Freedom funds from Fidelity, which target a particular year for retirement and allocate your money into different mutual funds to achieve the same goal. That can be a different topic altogether.) I will have to carefully select Mutual funds which as a portfolio can do well during most economic conditions (up, down, lateral) and diversify my portfolio with funds based on capitalization (Large, Mid, Small), based on growth or value (Value, Blend, and Growth), based on geography (US based, EAFE, Emerging, etc). It is still not a guarantee that my portfolio will yield splendid results because when the total market moves in any direction, most of the stocks move along with it. And this does not help in achieving true diversification. True diversification is not a topic of the discussion here and let me confine myself to finding a suitable Mutual fund for my portfolio. So I embarked on some research and came up with some homework items that I can do before selecting any Mutual Fund, so that I can increase my chances of better returns.

I came up with a checklist of items that can help me rationalize my selection of Mutual Funds. This way I feel comfortable that my homework behind the selection is logical and is not driven by my emotions. I have discovered that selections based on data have yielded me better returns than when I used to chase performance. These are items for “MY” checklist and you might have to do some more research to find the funds that are more appropriate for your need.

All the items in the checklist are freely available on the internet and particularly on Morningstar.com.

Let me just briefly re-emphasize what a Mutual Fund is. A Mutual Fund is a company (a corporation that receives preferential tax treatment under the U.S. Internal Revenue Code) that combines investor’s money and generally purchases stocks, bonds other securities. A professional manager or a group of professional managers will make purchase decisions of securities on behalf of the investors. Investors in turn pay small fees to these managers.

Mutual Fund Objective & Investment Strategy: One of the main factors to consider is to check whether the objective of the Mutual fund matches that of the individual. The fund may seek long term (usually) capital growth and/or income, and this may not suit the need of an individual. The appropriateness of the funds objectives to individual’s needs has to be considered before any investment. Fund prospectus can give you more information on this. So the investor should compare and ensure that the objectives of the Mutual fund really fit his/her portfolio.

The fund may invest money in common stocks or bonds or real estate, which may be US companies or international companies in order to achieve the fund’s objectives. Based on the securities and the proportion of allocation, the risk/reward ratio of a fund changes. And an investor has to keep that in mind.

Any individual seeking true diversification of his portfolio should focus on the objectives and investment strategies of the new Mutual Fund before bringing it into his portfolio. I compare the objectives of the new fund with my existing portfolio to ensure that no single segment of my portfolio is overly loaded (unless that is by design) or under loaded. Some of the different areas to consider while diversifying are to have adequate exposure to large cap and small cap companies, growth and value companies, bonds and bond funds, foreign companies, emerging markets, Real estate Investment Trusts (REITs), Gold and precious metals, etc. The main idea is to not put all the eggs in the same basket, rather to break down the total money into each one of these segments so that no single debacle in one segment will wipe off our entire portfolio.

Mutual Fund Manager: A fund manager is like a head coach of a basketball team; he might be supported by a team of managers, economists, analysts, statisticians and IT systems. The fund manager with the help of his team looks at the current situation of the economy, analyzes the securities that can benefit from the current state of economy and then invests in securities that conform to the fund’s objectives and strategies. He keeps a good watch on the invested securities to make sure that the fund’s objectives are still met and the fund investor is getting good returns.

As you can guess, so much depends on the Fund manager; he is like the CFO for the fund. If a fund has done well and the manager has been with the fund for long time, then I attribute the high performance to the fund manager and I am more likely to bet on that fund manager again. That is why I look for funds which have manager tenure of more than 3 to 5 years.

Star rating from Morningstar: Morningstar’s star rating compares a fund’s historical returns to its historic volatility and rates each fund from 1 to 5 stars; 5 being the best. The fund with highest return/volatility in its category earns 5 stars. Though Morningstar 5 star rating does not guarantee future results, 5 star rated funds are a good starting point for further analysis.

I always screen for funds with 5 star rating from Morningstar before I perform any more analysis on the fund.

Performance above the benchmark: Many actively managed funds do not outperform their respective index funds and that is an important factor to consider while choosing a Mutual fund. If an index fund that is not actively managed and that has lower expense ratio (discussed next) can outperform an actively managed fund, then why pay extra expense to buy the actively managed fund? Usually an index fund is considered as a benchmark for each category of funds (the category depends on large/mid/small cap, or growth/value, international/domestic or industry sectors, etc) and actively managed funds should beat these benchmarks in the long run to deserve the extra expense they demand from the investors.

I have used http://www.fundalarm.com/ website for months now to determine if my funds have been at least performing on par with the benchmark for its category. Click on the “data tables” link on the main page of the website and enter your fund ticker. You can see the absolute performance and the comparison with the benchmark. If my fund is not meeting the benchmark’s performance, then I have an option to switch to the benchmark itself. Ideally speaking, I prefer (who doesn’t) that the performance of my fund is as high as possible above the benchmark.

Morningstar also compares each fund against S&P 500 and against the category returns. That compared number will be positive if the fund outperformed the index during the period and negative if the fund underperformed.

Expense Ratio: The cost of owning the mutual fund is represented by the expense ratio and it includes advisory fees, operating fees, 12b-1 distribution fees and other administration fees. With an expense ratio of 1%, the fund will pay itself 1% of the total money in the fund for the year irrespective of the performance of the fund. Usually the expense ratio ranges from 0.2% (index funds) to 3% (International funds). Over time the expense ratios can take a big bite out of the investor returns and hence an investor needs to pay particular attention to these expenses. When Returns after expense ratios are considered, index funds beats most of the funds in the long run and one main reason is that index funds have lower expense ratios.

I usually make sure that I do not pay more than ~1% in expense ratio, but if I have to, then I make sure that the performance of the fund justifies that extra expense. One exception to this is the international funds which usually have higher expense.

Load on the Fund: Some Mutual funds charge sales load that is paid to the brokers and that does not benefit the investor at all. Sales load is called Front load when the load is paid upfront, and is called Back load when the load is paid when selling the fund. Load fees can vary from 1% to 8%. Paying sales load is like starting with negative return on the investment and the load does not buy any special privileges for the investor.

Personally, I am against paying any loads for any mutual fund and I screen for No load funds before I spend any time analyzing them. There are plethora of alternatives for loaded funds that can perform equally well as the loaded funds. I just say “No” to Load funds. Just use top No Load Mutual Funds

Standard Deviation: The risk associated with a mutual fund is seen in the volatility of the performance and standard deviation is used to measure the volatility of a fund. The higher the standard deviation, the higher is the volatility of the fund performance which maybe associated with higher returns. When you are comparing two funds that have same performance, choosing the one with lower standard deviation is better because it is maximizing the returns for the risk taken on. Standard Deviation can run from as low as 1 to as high as 30 or greater.

Most of the time I choose a mutual fund with standard deviation less than 15 and any risk averse investor should do so. Sticking with funds of standard deviation less than 10 is preferred for conservative investments.

Annual Turnover: A funds turnover rate represents the percentage of fund’s holdings that it changes every year. A turnover of 100% or more implies that the entire portfolio of the fund is changed every year. Buying and selling stocks will costs money through commissions and hence higher costs for the fund. Funds that have higher turnover distribute their yearly capital gains to their shareholders and shareholders will have to pay taxes on these capital gains.

I always look for turnover ratio to be less than 25, but I haven’t had much luck to get many non-index funds with turnover ratio less than 20. Typically I have chosen funds with annual turnover to be less than 60%. Sometimes the fund manager will have to sell the securities that are incurring loss in order to compensate for the securities that are sold with capital gains, and hence the turnover ratio can go little up. Though I look for turnover ratio to be less than 25%, I am little lenient with this factor if all others are doing very well.


Price/Prospective Earnings ratio (P/PE): A mutual funds Price/Earnings ratio is based on the P/E ratio of its individual stocks. Usually Funds with low P/E are less risky and produce better returns than funds with higher P/E. P/E of a fund is the ratio of fund price divided by one year per share earnings. However, the P/PE ratio considers prospective earnings for the future year rather than the earnings from the past year.

When I am using P/PE from Morningstar, I look for the P/PE of a fund to be less than 20 and prefer the ones which are lesser than 15. This is a conservative approach for selecting funds for the long run.

There many more points that you need to consider before you finally decide on a mutual fund, but the above ones should generally lead you in the path of higher long term returns.

-Nidhi

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