How to Analyze Mutual Funds

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

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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

Let’s say you’re 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: It’s been nothing but a bull market with only a few minor corrections.

As I said in a related story, Why You Should Ignore Mutual Funds’ Five-Year Returns Right Now:

“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

You’d 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, let’s 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 Morningstar’s Basic Mutual Fund Screener reveals at least a dozen funds that have annualized returns at least twice that of the S&P 500’s 10-year return of roughly 8%.

The top-performing mutual fund in my search for 10-year performance was ProFunds Biotechnology UltraSector (BIPIX) with an incredible 22.7% annualized return. And guess which type of mutual funds filled the list of those doubling the S&P 500? Healthcare and biotechnology funds. Even the average healthcare sector fund has a 13.2% 10-year return.

The point here is that it is smart to compare apples to apples. In fact, you can ignore the returns and look at the category ranks instead. A high return is good, but if the fund ranks in the 99th percentile for performance, it’s junk — especially if the poor rank is long-term. Similarly, a poor return is impressive if the performance rank compared to category peers is high.

Give Credit Where Credit is Due: Look at the Manager Tenure

You’ve found a mutual fund with a solid, long-term performance history of consistently beating the category averages.

But what if the manager has only been at the helm for three months? In most scenarios like this, you can throw the performance (and the mutual fund) out the window.

Naturally, manager tenure means almost nothing with passively managed index funds, where established index-tracking mechanisms dictate the fund’s holdings and thus the performance.

But when you buy an actively managed fund, you are doing more than just buying a portfolio of securities — you are hiring a manager. Therefore it is prudent to make sure that the manager you are “hiring” is responsible for the performance, and the respective time period(s), that first caught your attention.

Other Important Factors to Consider

One of the most basic, but vital, things to consider is cost. The best mutual funds are often those with the lowest expense ratios because expenses tend to be a drag on long-term performance.

After looking for low (or at least below-average) expense ratios — again comparing with similar fund types — another basic means of kicking the mutual funds tire is to check its assets under management.

In another previous story, Don’t Ignore Mutual Fund Asset Bloat, I commented thus:

When actively managed funds attract too much money, they have to get bigger to accommodate those assets. If they get too big, they start to perform like an index fund (or worse).

As the assets grow larger, eventually the higher expenses of the actively managed fund make it underperform its benchmark index and the manager fails at his or her primary objective — to show value.

Voila — you have asset bloat.

For example, consider the largest actively managed stock mutual fund in the world, American Funds Growth Fund of America (AGTHX), compared to the S&P 500 Index. The 10-year annualized return is a decent 8.36% for AGTHX, edging out the S&P 500, which put in 7.94% for the same period. But with $141 billion in AUM, would you make a bet that the Growth Fund of America can continue to beat the stock market bogey?

For a hint, in 2014, AGTHX had a gain of 9.3%, whereas the S&P 500 jumped 13.7% — a 4.4-percentage-point underperformance.

Bottom Line

When it comes to analyzing mutual funds, you can start with past performance, but to get an idea of what to expect in the future, be sure to look under the hood and kick the tires by questioning the historical market environment, the apples-to-apples comparison, the manager tenure, the expense ratio, and the assets under management.

As of this writing, Kent Thune did not hold a position in any of the aforementioned securities. Under no circumstances does this information represent a recommendation to buy or sell securities.

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Article printed from InvestorPlace Media, https://investorplace.com/2015/01/analyze-mutual-funds/.

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