Today we will begin an examination of mutual funds.
Why my interest in writing about mutual funds?
First, mutual funds are extremely popular and there are many funds in existence. So whether you intend to or not, you will come across funds in your investment travels.
Second, I believe mutual funds, along with exchange traded funds, should form the cornerstone in any investment portfolio. Hopefully, you will come to share that view.
Third, some of the things I read about mutual funds are not entirely accurate. I want to pass on some caveats and considerations for you when assessing funds.
Let us get started.
There are Many Funds to Choose From
The first thing you notice about mutual funds is the huge number that exist in the market.
Fortunately, this means that whatever your investment strategy, you will be able to find a fund that helps achieve your objectives.
Unfortunately, it also means that there are a lot of funds to wade through.
According to the Investment Company Institute’s 2010 Investment Company Fact Book, in 2009, US mutual funds numbered 7691 and were worth $11 trillion dollars. Globally there were 65,735 mutual funds valued at $23 trillion.
Given the sheer volume, how does one pick a fund that is right for his needs?
There are three key ways to reduce your search and find an appropriate fund.
Investment Style
Mutual funds are grouped by investment style or categorization.
Fixed income or equities would be two very broad styles. Likely too general to be useful in practical fund comparisons.
Within a category, funds are often broken down into smaller sub-categories. These are the investment styles that make it easier to find funds that meet your investment strategy.
If you want a fund that invests solely in Japanese equities, you can find a grouping of funds that meet that objective. If you want to invest in high yield (“junk”) bonds from U.S. corporations, you can find a listing of these funds as well.
While there may be almost 66,000 mutual funds out there, those that meet your specific search criteria will be significantly less.
Comparing Performance By Style is Important
Besides reducing the number of funds to research, style is crucial in assessing funds.
As the old saying goes, you must always compare apples to apples, not apples to oranges. So too is it true with mutual funds.
Like any asset, mutual funds have their own risk-return profiles. One style may have lower risk than another. This will result in a lower expected return. If you only compare actual performance, you may invest solely in high risk funds and ignore more secure alternatives.
For example, shares of companies in emerging markets are traditionally riskier than shares from American “blue chip” firms. As they are higher risk, the expected return on emerging market shares should be higher than for “blue chips”.
In comparing two funds, Bluechipfund and EMMAfund, you see that last year EMMAfund experienced an annual return of 12% versus 10% for Bluechipfund. That might cause you conclude EMMAfund is the better investment.
But what if you knew that the risk associated with EMMAfund was 20% versus 5% for Bluechipfund. If you recall our look at investment risk, you will remember that an investment with a 20% standard deviation is significantly more volatile in price, both upwards and down, than one with 5%. That might make you think twice about your decision.
By sorting funds by style, funds within a specific category should have similar risk-return characteristics. That allows for better assessment of true performance by the fund managers.
Rating Agencies
Ratings agencies rank fund performance on a risk-adjusted basis. This assists investors in narrowing choices for their own investment decisions.
Morningstar is the main rating agency, but there are others to consider using, including Lipper. Also, websites, such as TheStreet.com and Businessweek, review and grade funds.
How do agencies rate mutual funds?
Morningstar, for example, plots each fund’s risk-adjusted return for a variety of time periods. These are then compared with other funds on a traditional bell curve. A fund that falls within the top 10% of all funds merits a 5 star rating. If the fund sits in the next 22.5%, it earns a 4 star rating. And so on until the bottom 10% receive only 1 star.
In addition to 3, 5, and 10 year ratings, Morningstar also provides an Overall Morningstar Rating. This is a weighted average of all individual ratings for a fund.
In theory, by choosing funds that are rated as 4 and 5 stars, you are narrowing your options to funds that are in the top third of their style based on risk-adjusted performance.
That should help make better investment decisions.
While ratings help find above average performers, they are not foolproof.
Rankings are based on historic results and not the future. As circumstances change in the marketplace or in the fund itself, future performance may differ from the past.
Also, agencies and reviewers do not cover all available funds. Some are more comprehensive than others. For example, Forbes rates approximately 2600 funds. This is less than half the 7691 available in the US.
Be aware of the limitations in the ratings before investing.
Screening Tools
In assessing funds, there are a variety of tools available to assist you.
These tools allow investors to screen funds by many different criteria.
Most brokers provide screening tools, many with ties to rating agency or internal rankings.
As well, fund rating agencies like Morningstar have their own screeners. And many investment or finance websites (e.g. YahooFinance, Forbes, etc.) have screening tools available.
Different screening tools may allow you to search by slightly different criteria.
However, the key criteria should be the same from tool to tool. These include fund performance over varying periods, investment style, sales charges, annual expenses, etc.
I shall try to expand on some of the above items over some upcoming posts. So if you have questions, hopefully I will address them shortly.
Next up, I will look at a few common investment styles.
I for one quite liked this blog