Why are open end mutual funds worth reviewing?
First, mutual funds are extremely popular and there are many funds in existence. Whether you intend to or not, you will come across funds in your investment travels. In 2015, 43% of US households owned mutual funds.
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 things I read about mutual funds are not entirely accurate. I want to pass on a few caveats and considerations when assessing funds.
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, whatever your investment strategy, you can find a fund that helps achieve your objectives.
Unfortunately, it also means that there are a lot of funds to wade through to find the good ones.
In 2015, per the Investment Company Institute’s 2016 Investment Company Fact Book, there were 100,494 regulated open end funds globally, valued at USD 37.2 trillion.
In Canada, there were 3283 regulated open end funds in 2015, valued at USD 890 billion.
If you use a common analytical tool like Morningstar, your universe will cover more than 18,000 funds in various classes.
Given the sheer volume, how do you pick a fund that is right for your specific 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 category.
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 specific 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 over 100,000 mutual funds out there, those that meet your search criteria will be significantly less. If not, you will need to refine your criteria to achieve a manageable number.
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, always compare apples to apples, not apples to oranges. So too with mutual funds.
Like any asset, funds have their own risk-return profiles. One style may have lower risk than another. With a lower expected return. If you only compare actual returns, you may invest solely in higher risk funds and ignore more secure alternatives.
For example, emerging market equities are traditionally riskier than American “blue chip” shares. With higher risk, the expected return on emerging market shares should be higher than for “blue chips”.
In comparing two funds, Bluechip and EM, last year EM experienced a return of 12% versus 10% for Bluechip. That might cause you conclude EM is the better investment.
But what if the risk associated with EM is 20% versus 5% for Bluechip? If you recall our look at investment risk, an investment with a 20% standard deviation is significantly more volatile in price than one with 5%.
Comparing blue chip equities with emerging markets is apples to oranges. Instead, you want to compare emerging market funds to other emerging market funds. And blue chip to blue chip.
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.
Note that a potential problem with mutual funds is “style drift”. Where the actual investments (and risk-return profile) differ from the stated investment style. We will cover this shortly.
Rating Agencies
Ratings agencies rank funds on a variety of factors. One is 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.
For disclosure, I tend to use Morningstar raw data feeds in my analysis. Not to say it is the best, but it serves my needs.
Rating Mutual 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.
Do Not Rely Only on Ratings
While ratings may 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. Always an issue with investments. The past is no guarantee of future results.
Agencies and reviewers do not cover all available funds. Some are more comprehensive than others.
Newer funds are often not rated due to limited history.
Different rating agencies, using different methodologies, may come to different conclusions.
Be aware of the limitations in the ratings. I would never rely solely on a fund rating to invest.
Simply because a mutual fund is not rated or is not in the highest bracket does not mean it is a poor investment. There are mutual and exchange traded funds in my top tiers that do not have “official” ratings from Morningstar. Or are ranked lower than I assess.
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 free 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.
Some are free. Some offer limited services for free, with premium upgrades.
For the average, smaller investor, most of the completely free analytical tools will do the job.
Different screening tools may allow you to search by slightly different criteria. However, key criteria are usually the same. These include fund performance over varying periods, investment style, sales charges, annual expenses, etc.
I shall expand on some of the above items in future posts.
Next up, a look at a few common investment styles.
