Mutual funds are a very effective way for small investors to get exposure to financial markets. Rather than investing in individual equities and bonds, a mutual fund investor gets access to a diversified portfolio of securities at a low cost. With diversification in place, a mutual fund allows you to form an effective investment strategy with significant upside potential in terms of capital growth, and dividend income, while having low risk. If you’re not the stock picking type, then mutual funds can be your vehicle of choice for long term investments. However, if you want to think about investing in mutual funds, you need to do a good amount of research as there are plenty of mutual funds available in the market. You will have to focus and understand the key mutual fund performance metrics in order to pick which fund is suitable to your needs and investment objectives.
Let’s look at the various factors you should consider while comparing the performance of various mutual funds:
Past Performance (Fund Returns)
While checking the performance of a mutual fund, the most common information you will come across is the past performance of the mutual fund. For most funds, the past performance is specified in terms of returns over the past 1-, 3-, 5, and 10-years. For a single fund itself, the returns over different time periods can vary drastically. However, with a long-term investment goal in mind, you should consider the 5-year or 10-year returns as a yardstick for real returns. A fund that has good positive returns over a long-term horizon tells us that the fund has an overall positive track record, even if the fund did badly in a particular year.
The returns of a fund are expressed as total returns of the fund. The total returns include the change in the net asset value of the fund, dividend distributions and any distribution of capital gains over a given time horizon.
Comparing the investment returns is definitely an important consideration. However, it is also important to analyse other factors including the fundamental characteristics of the fund and its underlying portfolio.
Once you’re satisfied with the returns performance of the fund, the next thing to look at is the expense ratio of the fund, which is expressed as a percentage of the total assets under management. The expense ratio refers to the total cost to an investor for owning the shares in the mutual fund. This is the cost that the investment company incurs for operating the fund, and includes various costs such as fees paid to the fund managers, administrative costs, taxes, accounting costs, etc. The expense ratio does not include sales fees and other redemption charges that are levied at the time of sale/purchase of fund shares. However, some funds do add a marketing expense to their operating cost, which is referred to as the 12b-1 fee. This is included in the calculation of expense ratio.
Before investing, an investor must carefully look at its expense ratio. The total returns of the funds are expressed net of the fund’s expenses. So, the higher the expense ratio, the more it eats into the total returns of the fund. So, if a fund is earning total returns of 12% but has an expense ratio of 2.5%, you actually earned only 9.5%. The expense ratio can vary widely across funds and generally ranges from 0.25% to 2.50% or higher.
Risk Profile of the Fund
Now that we have looked at the fund’s returns and its expenses, let’s focus our attention on the risk profile of the fund. While doing so, it is important to have an understanding of your own individual risk profile. The risk of a fund is measured in terms of the volatility of its returns. The more volatile the returns, the higher is the risk carried by the fund. Basically, the objective of an investor should be to take the amount of risk that suits his own risk profile, while maximizing the returns on his investment. You can calculate the risk of a fund by computing its standard deviations. Alternatively you can look at the risk ratings provided by sources such as Morningstar that provide a rating of above average, average, or below average risk for every mutual fund. Let’s say you shortlist two funds, both offering 8% returns net of expense ratio. However, fund A has average risk, while fund B has above average risk? Which fund would you go for? (Hint: You want to get maximum returns for the lowest amount of risk).
For advanced users, for equity-based funds the factors to consider for calculating risk are standard deviation and beta. For fixed income funds, the factors will be credit ratings provided by credit rating agencies such as S&P and Moody’s, modified duration, etc.
Last but not the least important, you need to consider the management of the fund. You need to know the past track record of the fund’s manager, which other funds they’ve managed, how have those funds performed, is the fund manager planning to leave the fund and so on… If you’re looking at a new fund manager who doesn’t have a track record, then it’s best to avoid those funds. New funds managers must first prove themselves and you should be looking at fund managers who have served the industry for at least 3-5 years.
It is difficult to assess whether the total returns from a fund are actually good or bad, unless you compare them with a benchmark or peer group. For example, you can benchmark the funds returns to Standard and Poor’s 500 Index, DJ Wilshire 5000 Index, Russell 2000 Index, or any other suitable index. Alternatively you can perform peer comparison by comparing the fund’s performance to its peers, or a peer group. In investment research materials you will often find a fund being compared to a peer group of funds, as well as to a comparable index.
With all the above information, it should be easy to take your pick on the mutual funds you want to invest in. For investment research and fund comparison, you can also use websites like Morningstar that provide excellent screeners that can make your job easy and help you compare and find mutual funds based on multiple criteria.
To summarize, you can follow the following checklist while evaluating the investment quality of a fund:
- Is the management consistent in its investment style?
- What is the fund’s risk-return profile?
- Are the fund’s investment style and its size compatible?
- What is the management structure and what’s the relation between the current manager’s tenure and the fund’s performance during his tenure?
- Does the fund have a low portfolio turnover?
- Does the fund have a reasonable expense ratio?
- How have the fund’s total returns performed compared to its peers and benchmarks?
- What are analysts’ views about the fund?
- What are the current investment conditions?
- Any other comments/observations you have during your research
This due diligence and research can go a long way in ensuring that you get the maximum out of your investments.