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How to Analyze Mutual Funds

Finding and buying the best mutual funds is about much more than past performance or future expectations about economic activity and market movements.

Source: ©iStock.com/a-wrangler

While past performance can be a good place to begin. it is crucial for your investing success to dig a bit deeper and find out why the fund has performed well over the given period of time.

As Francis Bacon once said, If a man will begin with certainties, he shall end in doubts; but if he will be content to begin with doubts, he shall end in certainties. Therefore, in one word, the beginning point for analyzing mutual funds is doubt .

Start by Questioning the Performance

Lets say youre a smart long-term investor who knows to focus more on five-year returns than shorter time periods. You then research and find some mutual funds with stellar five-year performance.

But now, look back at the past five years: Its been nothing but a bull market with only a few minor corrections.

It’s common for mutual funds to do well in certain market environments and not so well in others. What if a fund you are analyzing is among the best during growth periods, but among the worst in a bear market? You wouldn’t know by looking at the five-year returns.

Therefore, still assuming you are a long-term investor, a better look-back period for performance may be the 10-year annualized returns. This captures a full market cycle a period from the beginning of 2005 to the beginning of 2015, which includes the end of the previous bull market, the entire subsequent bear market and a full economic recovery.

Did your fund fall off a cliff in 2008? By calendar year, this was by far the worst for stock funds in the past 10 years.

Compare Apples to Apples and Look at Performance Rank

Youd have good reason to be excited about a mutual fund that had a 10-year annualized return that doubled that of the S&P 500 Index. right? Well, lets again begin with doubt:

What kind of mutual fund are you examining? Is the manager a genius? Or can the performance be explained by the fund category or sector in which the mutual fund invests?

For example, a quick search on Morningstars Basic Mutual Fund Screener reveals at least a dozen funds that have annualized returns at least twice that of the S&P 500s 10-year return of roughly 8%.