Mutual Fund Analysis
By - Joseph Perrotta

Four Factors To Consider When Investing In A Mutual Fund

Last week, I wrote an article discussing Why Vanguard Sucks

While I believe the post was one of the more insightful pieces I have written (despite the fact I was vilified by several other advisors and investors, who as the article discusses have been brainwashed and are beyond saving), it left a large, unanswered question with regard to investment selection:

How do I select an appropriate mutual fund to invest in?

While most wealth managers and investment professionals attempt to make this process much more complicated than it needs to be, I believe the following four criteria are most important, and should be used to analyze all potential mutual fund investments.

And yes, these are the main criteria that I use when analyzing potential investments for clients.

  1. Fund Mandate

    2. Every mutual fund has a mandate that spells out how it will invest its assets, and in which types of investments it may allocate those assets to.

    While this sounds basic enough, most investors do not fully understand the limitations (better said freedoms), and risks, most mutual funds have.

    For example, let’s look at one of the more popular mutual funds, PIMCO’s total return fund (symbol PTRAX).

    If I asked you what this fund invested in, you would probably say bonds. PIMCO is primarily a bond fund manager, right?

    While that is true, your answer would be far from correct.

    According to the prospects for PIMCO’s total return fund, dated 12/13/2011:

      “The Fund may invest, without limitation, in derivative instruments,
      such as options, futures contracts or swap agreements, or in
      mortgage- or asset-backed securities…”

    Wait a second. PTRAX can invest in mortgage-backed securities!? You mean those things that played a huge role in the financial meltdown we saw in 2008 and 2009?

    Yes, that is correct.

    Now, I am not saying that the fact that this fund can invest in mortgage-backed securities is bad, or good, for that matter. I am sure that they play an important role in diversifying that fund and generaing a return, or else PIMCO would not have elected the option to invest in them.

    What I am saying is that it is important to understand what a fund may or may not be able to invest in BEFORE investing in it, so that you are 100% knowledgeable and comfortable with the investments you may own.

  2. Management Tenure

    3. Management tenure is, to me, the most important determinant when choosing a mutual fund.

    There are two reasons for this.

    1. Continuity

      2. When you invest in a fund that has a long management tenure, you have a much better idea of how that manager performs and reacts to certain economic conditions than you would if a fund manager started last year.

      While a new manager may be great, you have little idea of knowing that beforehand. And on the flipside, he could have no clue what he is doing. Wouldn’t a few years of performance statistics help in making that decision?

      Of course

      While short management tenure may not necessarily be bad, there is much more predictability with longer management tenure.

    2. Historical Reference

      3. Let’s say mutual fund XYZ has returned 10% per year for the past 20 year.

      Amazing, you may say. I want to invest in THAT mutual fund.

      Why not, right?

      While this may be true, what if the manager who had managed that fund over the past 20 years just retired?

      Do you think the fund will grow at 10% per year for the next 20 years?

      Maybe, but there is much less certainty around a new manager without a proven track record.

    It is very important to keep up to date with changes in management prior to making (or even in the midst of making) an investment in a mutual fund.

  3. Alpha

    4. Okay, I am going to assume that most people don’t know what alpha is.

    Alpha measures the risk-adjusted performance of a mutual fund relative to its benchmark. (Piece of cake)

    When making any investment decision, risk-adjusted returns provide far more insight than absolute returns.

    To illustrate what we mean by risk-adjusted, let’s look at the following example:

      Investment 1 – Annual Return 10% – Standard Deviation 10% (I’ll get to standard deviation in a minute)
      Investment 2 – Annual Return 8% – Standard Deviation 5%

      Which investment is better?

      Well that depends.

      While the absolute return of investment 1 is better (10% versus 8%), the risk-adjusted performance of investment 2 is better.

      Here’s why:

      Standard deviation, as we all remember from statistics class, is a measure of the deviation of a return from its mean (average).

      The higher the standard deviation, the higher the the volatility, the higher the risk.

      So investment 1 had a higher return, but at the expense of higher risk.

      But what if they had the same risk?

      For the purposes of this analysis, if the standard deviation of investment 1 was cut in half, it would equal 5%, which is the standard deviation of investment 2.

      Following the financial theory of risk and return, if the standard deviation was cut in half, the return would also be cut in half.

      This would provide the risk-adjusted return of the investment, and would look like this:

      Investment 1 – Annual Return 5% – Standard Deviation 5%
      Investment 2 – Annual Return 8% – Standard Deviation 5%

      So while the absolute return of investment 1 is higher, the risk-adjusted return of investment 2 is higher.

    Alpha is a measure by which we can analyze a funds performance, taking into account the risk-adjusted performance of the fund.

  4. Expenses

    5. No analysis of a mutual fund would be complete without a look at its expense ratio.

    While we would all appreciate it if the intelligent (loosely used) folks at most mutual fund companies provided their services for free, this is unfortunately not the case.

    Mutual funds charge expenses, the same as any other professional service.

    Note that the fees mutual fund managers charge are in addition to the fees a wealth manager may charge for his/her financial planning services

    The fees that mutual funds charge vary from manager to manger, but are typically charged as a percentage of the assets that are invested with that fund.

    Just as risk-adjusted performance statistics are important when analyzing a fund, so are expense-adjusted performance numbers.

    If a mutual fund generated a 10% return last year, but charged 2% in fees to do it, then you’re really left with only 8%.

    It is also important to note that most performance numbers are reported as gross numbers, which means prior to fees being taken out.

    But are high fees bad?

    As I discussed in my Vanguard post referenced above, high fees are not always bad.

    Yes, they do detract from the net-performance (after fees) of a fund, but if a funds performance is substantially above that of its peers and/or benchmark, those fees may be justified.

    It is not prudent to simply look for the fund with the lowest expenses.

While mutual fund research and analysis can be a time-consuming and arduous process, at the end of the day, it can make a substantial difference in the outcome of your investment performance.

Next time you’re reviewing your portfolio, or speaking with your advisor, be sure to review these principles to ensure that your funds are the most appropriate for what you’re looking for.