Quick Mutual Fund Analysis Rules

How to analyze mutual funds

A year ago, most investors I spoke to thought they could make more money buying individual stocks instead of mutual funds. Now, I’d bet most of us are ready to consider funds.

Funds offer several advantages, the most important being fund managers can do a better job of picking stocks than most of us. Why? For starters, it’s their day job, and what’s more, many can tap a research staff to help with the analysis.

You’ll need to spend some time looking at each prospective fund’s portfolio of stock holdings before you make a final selection, but here are a few simple rules I’ve developed to qualify funds worth considering.

Mutual Fund Analysis

I use Morningstar (www.morningstar.com ) for this purpose because it offers all the data we need to do the analysis. Enter your fund’s name or ticker symbol into the entry box near the top of Morningstar’s main page to display the Morningstar Snapshot page for the fund.

Rule #1: Pick no-load funds

The load is a marketing fee, or sales commission, the fund pays someone, maybe a stockbroker or financial advisor, to sell the fund’s shares. The money doesn’t go towards hiring smarter analysts or buying better computers. There is no evidence that load funds perform better than no-load funds.

The load, typically 5.75 percent, is deducted from your total investment. Does it matter? Say you invest $1,000 in a no-load fund and another $1,000 in a 5.75 percent load fund. If the no-load fund achieved a 20 percent return, you would end up with $1,200 in your account after one-year. The load fund would have to achieve a 27.3 percent return for you to end up with the same $1,200.

The fund’s load is listed under “Sales Charge %” in the Fund Details section. If it’s a no-load fund, you’ll see “None” for both Front and Deferred sales charges.

Rule # 2: Make Return/Risk Ratio at Least 2.0

Morningstar calculates risk and return ratings for funds that have been in existence at least three years. Display the ratings by selecting “Morningstar Ratings ” from the menu on the left.

The return rating compares the fund’s return to all other funds in the same category. If it’s a U.S. stock fund, its return is compared to all U.S. stock funds. A rating of 1.0 means the fund’s return was average over the rating period. A return rating of 2.0 means the fund’s return was twice the average fund’s return. Since you buy mutual funds to make money, higher is better. The rating takes the fund’s expenses, loads, and redemption fees into account.

Morningstar’s risk rating measures the fund’s downside volatility compared to all funds in its category. A 0.5 rating means the fund is only half as volatile as average, and a 2.0 rating means that over the period rated, the fund was twice as volatile as the average fund. Lower is better, of course.

The risk and return ratings are calculated for three-, five-, and 10-year periods if the fund has been around that long. Use the five-year ratings, if available.

The optimum risk/return values depend on your investing style. Risk-averse investors, those who give highest priority to conserving their capital, should look for funds with risk ratings no higher than 0.75. Aggressive growth investors should seek funds with return ratings of 2.0 or higher.

All investors should require return ratings at least twice the risk rating. For instance, if a risk-averse investor finds a fund with a 0.75 risk rating, the return rating should be 1.50 or higher. An aggressive growth investor looking at a fund with a 3.0 return rating, would accept a risk rating of 1.5 or less.

Rule #3: Portfolio Price/Earnings Ratio below 30

The P/E of a mutual fund is simply the average P/E (latest stock price divided by annual earnings) of the stocks in the fund’s portfolio. The portfolio P/E is an important risk indicator. I’ve found that funds with P/Es above 30 signal high risk, especially in a weak market. Risk-averse investors should select funds with P/Es of 25 or less. These rules do not apply to industry specific funds such as technology or healthcare funds. Those types of funds tend to carry higher P/Es. You’ll find the fund’s portfolio P/E in the Portfolio section under Style Box Details.

Rule #4: Manager Tenure Three Years Minimum

The Morningstar risk and return ratings measure the fund’s past performance. Using past performance to predict the future seems to work for mutual funds because a manager with a track record of picking market-beating stocks is likely to continue his or her winning ways. Conversely, an underperforming manager will most likely continue to underperform. A change in fund management means the historical data used to calculate the risk and return ratings no longer applies.

The Manager Start Date is listed in the Fund Details section of the Snapshot page. Do not use risk and return ratings based on time spans that extend further back than the manager’s start date. Avoid funds with managers with less than three years on the job because you have no way of calibrating the manager’s performance.

Rule # 5: Expense Ratio Below 1.75 Percent

The cost of running a mutual fund including salaries, office rents, advertising and other expenses are deducted from the returns paid to the funds’ shareholders. You might see a variety of expense categories listed, but the Expense Ratio includes all fees and is the only number you have to watch. It is listed in the Fund Details section on the Snapshot page.

Here’s an example of how the expense ratio affects your returns. Your return would be 19.5 percent if your fund earned a 20 percent return on its investments, and its expense ratio was 0.5 percent (20.0 minus 0.5). But your return would drop to only 18 percent if the fund’s expense ratio was 2.0 percent instead of 0.5 percent (20.0 minus 2.0).

Sticking with funds with expense ratios of 1.75 percent or less, and lower is better.

These simple rules don’t guarantee you’ll pick market-beating funds, but they are a big step in the right direction.