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5 Questions to Ask
When Evaluating A Fund

  • Introduction
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5 Questions to Ask When Evaluating A Fund

How does one decide between the numerous options available? When selecting a mutual fund, do bear in mind that you are hiring a portfolio manager to do a specific job. Since short-term performance can be very misleading, here is a run-through to help you sift the wheat from the chaff.

How have returns been under the current fund manager?

Most investors are looking for high returns, so it's natural to want to know how it has performed in the past relative to similar funds. The Morningstar Rating for funds (the star rating) is a quick and popular way to measure a fund's relative performance, but it has its limitations, as we've pointed out in 5 steps to decipher past performance. Examining a fund's percentile ranking within its category over a long-term period, such as 5 or 10 years, is a good start, but a fund's past history doesn't always reflect its current situation.

At Morningstar, we're typically most interested in how a fund has performed since the current management team took over. If a fund has a great 10-year record but the manager responsible for that record has recently left, we would tend to be more cautious than we would be if the manager were still in place. Conversely, though less commonly, a fund with poor or mediocre long-term returns may look more promising if a new manager with a good track record has recently come on board.

Why has the fund performed the way it has?

It's not just performance, but the drivers of long-term performance that put a fund's record in context. For example, our analysts look at results during discrete stretches of market stress to add some clarity about the fund's downside risks. In addition, some funds harbor sector-specific or market-cap biases that can cause them to perform differently from peers at times.

Besides looking at the standard 3- and 5-year measures of performance, also consider performance over more meaningful time periods, such as a manager's tenure on the fund, extreme swings in market returns, or a full market cycle.

Value consistency. Strong trailing returns, even over the past 3 or 5 years, could stem from a short stretch of hot performance. More consistent performance tends to lead to better long-term results that are easier for investors to handle.

Our analysts also look for portfolio risks that could, but haven't yet, materialised. Sometimes that will lead us to favour a fund that is more conservative over a fund that has higher returns but may be headed for a big fall. Investors often buy bumpy funds when they're high and sell when they're low. In addition, it's hard for investors to recover from losses. Funds that are prone to large, extended losses have to gain that much more to get back to even.

How risky has the fund been in the past?

Risk is often equated with volatility, measured in terms of standard deviation or something similar. The problem with standard deviation is that it doesn't mean much without a context, because some types of funds are inherently more volatile than others. One quick and easy way to put a fund's volatility in context is to look at its Morningstar risk, which you can find on its Risk & Rating page. This measures not standard deviation, but a similar measure that penalises downside variation more than it rewards upside variation. We categorise each fund's Morningstar risk in one of five groups, from "high," for the riskiest 10% in the category, to "low," for the least risky 10%.

Most investors are less concerned with a fund's overall volatility than with its downside volatility--how likely it is to blow up or dramatically underperform its peers. The fund's annual percentile rankings, which can be found under Performance Analysis at the bottom of our fund reports, can give you some idea of this. If a fund has landed in the bottom decile of its category in the past, you should be prepared for the likelihood that it will do so again at some point.

What is the strategy and how well is it executed?

There's a big difference between having an investment strategy that could add value and one that actually does. Our analysts consider a fund's strategy and assess management's chances in using it to deliver peer-beating returns over the long term. We compare the actions we see in the portfolio with the strategy claimed to follow. We're looking for managers who can stick with their approach and have conviction in their research, rather than those who abandon their strategy when the market disagrees or those who show a lack of confidence in their process.

Our understanding of the strategy also helps us put performance into context and set investors' expectations regarding the risks associated with it. Is it a value fund or an aggressive-growth fund? Does it specialise in a small market niche or cover a broad swath of the universe? Does the fund focus more on relative returns versus a benchmark, or does it value absolute returns and capital preservation? The answers to those questions help us gauge how a fund might fare in different environments and how it might be used in a portfolio.

Where is the portfolio most concentrated?

When analysing a fund, it is imperative to look at its portfolio, including where that portfolio is most concentrated relative to the fund's peers. Each fund's Portfolio page on the website provides a good overview of the portfolio's characteristics, including its sector weightings relative to its category and the wider market. If a fund is significantly heavy in certain sectors, it can give you some idea of how the fund is likely to perform in certain kinds of markets. For instance, a fund that holds a lot of consumer stocks will tend to do poorly in bull markets and relatively well in bear markets.

Look at its top holdings. If the top holdings are mostly big, easily recognisable stocks, then you are probably looking at a large-cap fund that's similar to the broad market and would be appropriate as a core holding. If they're mostly smaller names and/or stocks you don't recognise, that fund might be more useful in a supporting role in a portfolio. Also look at the concentration of the top holdings. A concentrated portfolio can be prone to short-term underperformance if something goes wrong with a top holding.

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Mutual Fund investments are subject to market risks, read all scheme related documents carefully.

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