Meditations on Money Management

Andrew Silton: A guide to evaluating mutual funds

CorrespondentFebruary 22, 2014 

I’ve been asked repeatedly to write about the appropriate way to select mutual funds. Regular readers of this column know that I’m a proponent of index investing, so fund selection never comes into play. I don’t believe a foolproof system exists. Simply relying on a rating scheme, like the Morningstar Stars, isn’t particularly helpful. While one- or two-star-rated funds might best be avoided, four or five-star funds are no guarantee of superior performance. In fact, many highly-rated funds begin to fall back to earth just as they receive their accolades. Since I spent a significant part of my career trying to select active money managers, I’ll give you my best shot at answering the question of selecting them. Bear with me. It’s going to take two columns to get the job done. In the first part, I’ll lay out my views on evaluating performance, fees, and risk. In my next column, I’ll share my thoughts on gauging the portfolio and the money manager.

Fortunately, mutual funds produce hundreds of pages of information, and firms like Morningstar hoover up this data into digestible bits. However, the best clues aren’t available in one place. Because the prospectus has gotten so long, the SEC now requires mutual funds to produce a summary prospectus. Regrettably, some of the best nuggets aren’t contained in either document, and you’ll have to consult something called the Statement of Additional Information (SAI), which is an appendix to the prospectus. In short, we’re going to take a condensed tour of data sources and regulatory filings in order to kick the tires on mutual funds.

Investment objective

For starters, you’ve got to decide whether you are comfortable with a particular fund’s investment objective. Alas, the official objective at the beginning of a summary prospectus isn’t too helpful. For example, Pimco’s flagship Total Return Fund “seeks maximum total return, consistent with preservation of capital and prudent investment management.” All these attributes are laudable goals but don’t tell you much about the fund. In my view, you are better off reading the section called “Principal Investment Strategies” and consulting a Morningstar summary.

Evaluating historic performance is the next step in the process. Remember that past performance tells you precious little about future returns. You can find the data on many websites or in the summary prospectus. However, be wary of the performance graphs in many summary prospectuses because they show performance for an institutional share class that isn’t available to mere mortals. You should also ignore all the short-term results. You are better off focusing on five and 10-year results, and figuring out if the fund has beaten its benchmark and its universe of competing mutual funds over those longer time periods. In other words, we’re interested in long-term results. If you’ve got a contrarian bent, you might try finding mutual funds with strong long-term performance that have disappointed in the near-term. There’s some evidence that these types of funds may enjoy a bit of a rebound.

Check the fees

Having identified a fund with superior historic performance, it’s time to test the fund. For example, you’ll want to find the fund’s year-by-year returns at Morningstar, Yahoo, or the mutual fund’s website. In looking at the annual returns, you are trying to determine if the fund’s superior performance is due to one or two years of exemplary performance or relatively consistent outperformance. You should lean toward funds that hit singles and doubles, instead of funds that smack the occasional home run but otherwise strike out.

Having found a winning and relatively consistent fund, you need to look at fees. The summary prospectus has decent data on this subject. Total expense, which includes the management fee, 12b-1 fee (marketing), and other fund expense, is the key number. For the most part, you’re looking for below average fees. Unless the fund’s performance is exemplary, the fees need to be as low as possible.

Next you need to get comfortable with the fund’s risk. Every fund has a variety of risks that are listed in the summary prospectus. The fund’s lawyers typically make sure that the list of risks is exhaustive, so you can’t claim that you didn’t know that some combination of markets, inflation, trading, politics, or some other factor could create a loss. You ought to have some idea that you’re taking these kinds of risks. You should also look at a quantitative measure of risk, such as standard deviation or volatility. It’s by no means a perfect measure, but it will give you some idea of how much turbulence you might expect. The idea is to see if the fund’s volatility might either scare or force you into selling a fund when it drops in value.

Standard deviation

Morningstar and other services routinely provide this data. Generally, you’re looking for the standard deviation for the past three to five years. The best way to explain the purpose of the standard deviation is by an example. Let’s suppose a fund has a standard deviation of 20 percent. This means that there is about a two in three chance that the fund will have a 40 percent spread around the fund’s average return. So if the fund has averaged a 15 percent return, there’s a two in three chance in any given year that the fund will be anywhere from a loss of 5 percent to a gain of 35 percent. Stated differently, it’s pretty likely that the fund could produce a modest loss as well as a potentially large gain. More importantly, it’s also telling you that there about a one-in-six (15 percent) chance that you’ll lose more than 5 percent.

Then you should double the standard deviation to see if you’re comfortable with more extreme results. Now we’re talking about 40 percent volatility. If the average return has been 15 percent, this means that there’s roughly a one-in-40 chance (about a 2.5 percent chance) of seeing your investment decline by 25 percent in a given year. Could you stand that bad a result?

You’ve found a fund that has historically achieved consistently superior performance. The fees aren’t too bad, and you’re comfortable with the risk. However, you have more work to do, which I’ll cover in my next column.

Andrew Silton’s Meditations on Money columns can be found twice a month in The N&O’s Work&Money section. He is a retired money manager living in Chapel Hill. He was CIO for the North Carolina Retirement System from 2002-2005. He writes the blog

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