I’ve been investing in index funds for about a year now. I’m ready to branch out beyond Schwab’s Total Stock Market Index (SWTSX). How do I go about analyzing mutual funds?
When looking at a total universe of around 30,000 mutual funds, including many share classes of the same fund, the task can obviously be quite overwhelming. At Henssler Financial, we begin with a very basic screening technique, but unfortunately, this can only be accomplished by using fairly expensive software.
Still, it is possible for the average investor to look for the same attributes we do when analyzing mutual funds. First of all, you have to make sure the fund is actually open to new investors, because you won’t be able to buy shares of a closed fund in the first place. Sometimes a fund closes because it has too many assets under management, and it could affect their investing strategy. Say a Small-Cap fund’s assets have ballooned to $100 billion. It’s going to be difficult for that portfolio manager to buy or sell stocks without moving share prices significantly. Because Small-Cap stocks tend to be low-volume, 1% of the fund’s assets may be half of the stock’s entire market cap.
Secondly, you need to check the minimum initial purchase constraints to make sure you can afford to buy shares. Some funds carry initial investment amounts of $100,000 or more for the less expensive institutional share classes. We generally look at funds with a minimum initial purchase of $10,000 or below so that most of our smaller clients can buy shares.
Next, we look for a Morningstar rating of at least three stars so that its risk-adjusted returns are average to above average, at a minimum, relative to the fund’s peer group. Obviously, past performance has no bearing on future returns, but it’s still good to know that the fund’s managers have proven to be capable investors at some point.
After passing the rating test, you want to make sure the fund’s portfolio manager is responsible for that performance. Say you’re looking at a Morningstar 5-star ranked fund over the last 10 years, but the fund has a new portfolio manager. That new manager is not responsible for the performance and they may not employ the same investing techniques. As a rule of thumb, we like for a manager to have at least five ears of performance under their belt.
Beware of style drift, which occurs when a manager begins to invest in areas outside their expertise. Small Caps or emerging market stocks behave very differently from Large-Cap domestic companies.
A high expense ratio will eat away at your returns, so we look for funds with below average expense ratios. Keep in mind though, reported expense ratios don’t include all expenses from taxes to trading costs. Even holding too much cash in a portfolio can create something called cash drag. As stocks move higher, cash stays the same price and can be a detriment to performance.
Lastly, be mindful of funds that have excessive turnover. Studies have shown higher turnover to be negatively correlated with fund performance. More turnover means more transaction costs, and it also means the portfolio manager may lack conviction in the investment decisions he is making.
At Henssler Financial we believe you should Live Ready, and that includes understanding your investments and how they affect your portfolio. If you have questions regarding your mutual fund portfolio, the experts at Henssler Financial will be glad to help. You may call us at 770-429-9166 or email at email@example.com.