Mutual Fund Analysis: 10 Things to Analyze (and 3 to Ignore)

What is a balanced mutual fund?
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Mutual fund analysis does not need to be as complex as most financial media sources and some investment advisers often communicate. There are hundreds of data points to research and analyze. However, you only need to know the best things to research and analyze and to ignore the others.

Pay Attention to These

  1. Expense Ratio
    Mutual funds do not run themselves. They need to be managed and this management is not free! The expenses to operate a mutual fund can be as involved as a corporation. But all you need to know is that higher expenses do not always translate into higher mutual fund returns. In fact, lower expenses usually translate into higher returns, especially over long periods of time.
    But what expense ratio is high? Which is best? When doing your research, keep in mind average expense ratios for mutual funds. Here are a few examples:
    Large-Cap Stock Funds: 1.25%
    Mid-Cap Stock Funds: 1.35%
    Small-Cap Stock Funds: 1.40%
    Foreign Stock Funds: 1.50%
    S&P 500 Index Funds: 0.15%
    Bond Funds: 0.90%
    Never buy a mutual fund with expense ratios higher than these! Notice that the average expenses change by fund category. The fundamental reason for this is that research costs for portfolio management are higher for certain niche areas, such as small-cap stocks and foreign stocks, where information is not as readily available compared to large domestic companies. Also, index funds are passively managed. Therefore costs can be kept extremely low.
  2. Manager Tenure (for Actively-Managed Funds)
    Manager Tenure refers to the amount of time, usually measured in years, a mutual fund manager or management team has been managing a particular mutual fund.
    Manager tenure is most important to know when investing in actively-managed mutual funds. Managers of actively managed funds are actively trying to outperform a particular benchmark, such as the S&P 500; whereas the manager of a passively-managed fund is only investing in the same securities as the benchmark.
    When looking at a mutual fund's historical performance, be sure to confirm the manager or management team has been managing the fund for the time frame you are reviewing. For example, if you are attracted to the 5-year return of a mutual fund but the manager tenure is only one year, the 5-year return is not meaningful in making the decision to buy this fund.
  3. Number of Holdings
    A mutual fund's holdings represent the securities (stocks or bonds) held in the fund. All of the underlying holdings combine to form a single portfolio. Imagine a bucket filled with rocks. The bucket is the mutual fund and each rock is a single stock or bond holding. The sum of all rocks (stocks or bonds) equals the total number of holdings.
    In general, mutual funds have an ideal range for the total number of holdings and this range depends on the category or type of fund. For example, index funds and some bond funds are expected to have a large number of holdings, often in the hundreds or even thousands of stocks or bonds. For most other funds, there are disadvantages to having too few or too many holdings.
    Typically, if a fund only has 20 or 30 holdings, volatility and risk can be significantly high because there are fewer holdings with a larger impact on the performance of the mutual fund. Conversely, if a fund has 400 or 500 holdings, it is so large that its performance is likely to be similar to an index, such as the S&P 500. In this case, an investor may as well just buy one of the best S&P 500 index funds rather than hold a large-cap stock fund with hundreds of holdings.
    The fund with very little holdings is like the small boat at sea that can move quickly but is also vulnerable to the occasional large waves. However, the fund with too many holdings is so big it may not be harmed as much by shifting waters but it can't move away from a glacier that can rip its hull and sink like the Titanic.
    Look for a fund with at least 50 holdings but less than 200. This may assure the "just right" size that is not too small or too large. Remember the apples-to-apples rule and look at the averages for a given category of mutual fund. If the fund you are analyzing is much lower or higher in the total number of holdings than its respective category average, you may want to dig deeper to see if this fund is good for you.
    Also, you will want to see if the fund you are analyzing fits with the other funds in your portfolio. A fund with only 20 holdings can be risky on its own, but it may work as one part of a diversified mix of mutual funds within your own portfolio.
  4. Long-Term Performance
    When researching and analyzing investments, especially mutual funds, it is best to look at long-term performance, which can be considered a period of 10 or more years. However, "long-term" is often loosely used in reference to periods that are not short-term, such as one year or less. This is because 1-year periods do not reveal enough information about a mutual fund's performance or a fund manager's ability to manage an investment portfolio through a full market cycle, which includes recessionary periods as well as growth and it includes a bull market and bear market. A full market cycle is usually 3 to 5 years. This is why it is important to analyze performance for the 3-year, 5-year and 10-year returns of a mutual fund. You want to know how the fund did through both the ups and the downs of the market.
    Often a long-term investor employs a buy and hold strategy, where mutual funds are selected and purchased but not significantly changed for up to several years or more. This strategy has also been affectionately labeled the lazy portfolio strategy.
    A long-term investor can afford to take more market risk with their investments. Therefore, if they don't mind taking a high relative risk, they may choose to build an aggressive portfolio of mutual funds.
  5. Turnover Ratio
    The Turnover Ratio of a mutual fund is a measurement that expresses the percentage of a particular fund's holdings that have been replaced (turned over) during the previous year. For example, if a mutual fund invests in 100 different stocks and 50 of them are replaced during one year, the turnover ratio would be 50%.
    A low turnover ratio indicates a buy and hold strategy for actively-managed mutual funds but it is naturally inherent to passively-managed funds, such as index funds and Exchange Traded Funds (ETFs). In general, and all other things being equal, a fund with higher relative turnover will have higher trading costs (Expense Ratio) and higher tax costs, than a fund with lower turnover. In summary, lower turnover generally translates into higher net returns.
    Some mutual fund types or categories of funds such as bond funds and small-cap stock funds will naturally have high relative turnover (up to 100% or more) while other fund types, such as index funds, will have lower relative turnover (less than 10%) compared to other fund categories.
    Generally, for all types of mutual funds, a low turnover ratio is less than 20% to 30% and a high turnover is above 50%. The best way to determine ideal turnover for a given mutual fund type is to make an "apples to apples" comparison to other funds in the same category average. For example, if the average small-cap stock fund has a turnover ratio of 90%, you may choose to seek small-cap funds with turnovers significantly below that average mark.
  6. Tax Efficiency (Taxable Accounts)
    This research data point is only for research funds that will be placed into a taxable brokerage account (not a tax-deferred account, such as an IRA or 401k). Mutual fund investors are often confused and surprised when they receive a 1099 form that says they had income from dividends or that they received capital gains distributions.
    The basic mistake here is a simple oversight: Mutual fund investors often overlook how their funds are invested. For example, mutual funds that pay dividends (and hence generate taxable dividend income to the investor) are investing in companies that pay dividends. If the mutual fund investor is unaware of the underlying holdings of a mutual fund, they may be surprised by dividends or capital gains that are passed on to the investor by the mutual fund. In other words, the mutual fund can generate dividends and capital gains that are taxable without knowledge of the investor. That is until the 1099-DIV comes in the mail.
    The basic lesson here is to place funds that generate taxes in a tax-deferred account so you get to keep more of your money growing. If you have accounts that are not tax-deferred, such as a regular individual brokerage account, you should use mutual funds that are tax-efficient.
    A mutual fund is said to be tax efficient if it is taxed at a lower rate relative to other mutual funds. Tax-efficient funds will generate lower relative levels of dividends and/or capital gains compared to the average mutual fund. Conversely, a fund that is not tax efficient generates dividends and/or capital gains at a higher relative rate than other mutual funds.
    Tax-efficient funds generate little or no dividends or capital gains. Therefore, you will want to find mutual fund types that match this style if you want to minimize taxes in a regular brokerage account (and if your investment objective is growth - not income). First, you can eliminate the funds that are typically least efficient.
    Mutual funds investing in large companies, such as large-cap stock funds, typically produce higher relative dividends because large companies often pass some of their profits along to investors in the form of dividends. Bond funds naturally produce income from interest received from the underlying bond holdings, so they are not tax-efficient either. You also need to be cautious of actively-managed mutual funds because they are trying to "beat the market" by buying and selling stocks or bonds. So they can generate excessive capital gains compared to passively-managed funds.
    Therefore, the funds that are tax-efficient are generally ones that are growth-oriented, such as small-cap stock funds, and funds that are passively managed, such as index funds and Exchange Traded Funds (ETFs).
    The most basic way to know if a fund is tax-efficient or not tax-efficient is by looking at the fund's stated objective. For example, a "Growth" objective implies that the fund will hold stocks of companies that are growing. These companies typically reinvest their profits back into the company - to grow it. If a company wants to grow, they won't pay dividends to investors - they'll reinvest their profits into the company. Therefore a mutual fund with a growth objective is more tax-efficient because the companies in which the fund invests are paying little or no dividends.
    Also, index funds and ETFs are tax-efficient because of the passive nature of the funds are such that there is little or no turnover (buying and selling of stocks) that can generate taxes for the investor.
    A more direct and reliable way to know if a fund is tax-efficient is to use an online research tool, such as Morningstar, that provides basic tax-efficiency ratings or "tax-adjusted returns" compared to other funds. You will want to look for tax-adjusted returns that are close to the "pre-tax returns." This indicates that the investor's net return has not been eroded away by taxes.
    The ultimate objective for the wise investor is to keep taxes to a minimum because taxes are a drag on the overall returns of the mutual fund portfolio. However, there are a few alternative exceptions to this overall rule. If the investor only has tax-deferred accounts, such as IRAs, 401(k)s and/or annuities, there is no concern about tax-efficiency because there are no current taxes owed while holding the funds in one or all of these account types. However, if the investor has only taxable brokerage accounts, they may try to concentrate on holding only index funds and ETFs.
  7. Mutual Fund Category
    When researching for funds, it is important to know which fund type or category you need to begin or complete your portfolio.
    Mutual funds are organized into categories by asset class (stocks, bonds, and cash) and then further categorized by style, objective or strategy. Learning how mutual funds are categorized helps an investor learn how to choose the best funds for asset allocation and diversification purposes. For example, there are stock mutual funds, bond mutual funds, and money market mutual funds. Stock and bond funds, as primary fund types, have dozens of sub-categories that further describe the investment style of the fund.
    Stock funds are first categorized by style in terms of the average market capitalization (size of a business or corporation equal to the share price times the number of outstanding shares):
    The types of bond funds and how they are categorized may be best understood by revisiting the basics of bonds. Bonds are essentially IOUs issued by entities, such as the US Government or corporations, and bond mutual funds are primarily categorized by those entities who want to borrow money by issuing bonds:
  8. Style Drift
    Style drift is a lesser-known potential problem for mutual funds, especially actively managed funds, where the fund manager sells out of one type of security and buys more of another type that may not have been part of the original objective of the fund. For example, a large-cap stock mutual fund may "drift" toward the mid-cap style if the manager sees more opportunities in smaller capitalization areas.
    When doing your research, be sure to look at the history of the fund's style. Morningstar does a good job of providing this information.
  9. R-Squared
    R-squared (R2) is an advanced statistical measure that investors can use to determine a particular investment's correlation with (similarity to) a given benchmark. Beginners do not need to know this at first but it is good to know. R2 reflects the percentage of a fund’s movements that can be explained by movements in its benchmark index. For example, an R-squared of 100 indicates that all movements of a fund can be explained by movements in the index.
    In different words, the benchmark is an index, such as the S&P 500, that is given a value of 100. A particular fund's R-squared can be considered a comparison that reveals how similar the fund performs to the index. If for example, the fund's R-squared is 97, it means that 97% of the fund's movements (ups and downs in performance) are explained by movements in the index.
    R-squared can help investors in choosing the best funds by planning the diversification of their portfolio of funds. For example, an investor who already holds an S&P 500 Index fund or another fund with a high R-squared to the S&P 500, will want to find a fund with a lower correlation (lower R-squared) to be sure they are building a portfolio of diversified mutual funds.
    R-squared can also be useful in reviewing existing funds in a portfolio to be sure their style has not "drifted" toward that of the benchmark. For example, a mid-cap stock fund can grow in size and the fund manager may increasingly buy large-cap stocks over time. Eventually, what was originally a mid-cap stock fund when you bought it is now a fund that resembles your S&P 500 Index fund.
  10. Fund Overlap
    When adding new funds, be sure you are not investing in an area that you already have in your portfolio. Overlap occurs when an investor owns two or more mutual funds that hold similar securities. For a simple example, if an investor owns two stock mutual funds and they both invest in many of the same stocks, the similarities create an effect of reducing the benefits of diversification by increasing exposure to those same stocks -- an unwanted increase in market risk.
    Imagine a Venn diagram with two circles, each representing a mutual fund, overlapping in the center. As an investor, you don't want too much of an intersection between the circles--you want the least amount of overlap possible. For example, try not to have more than one large-cap stock or index fund, one foreign stock fund, one small-cap stock fund, one bond fund, and so on.
    If you prefer to have several funds, or you have a 401(k) plan with limited choices, you can detect fund overlap by looking on one of the best research sites for analyzing mutual funds and look at R-squared (R2).

Disclaimer: The information on this site is provided for discussion purposes only, and should not be misconstrued as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities.

Ignore These

  1. Net Asset Value (NAV)
    Common mistakes beginning investors make is to confuse price with value and to confuse price with Net Asset Value (NAV). The NAV of a mutual fund is not its price but rather a total value of the securities in the fund minus liabilities, divided by shares outstanding. For practical purposes, however, NAV can be considered "a price." However, a higher price does not indicate a higher value and a lower price does not indicate a poor value or a bargain. Bottom line: Ignore NAV; it has nothing to do with the value or potential of the mutual fund itself.
  2. Short-term Performance
    Most mutual fund investors should ignore short-term performance when doing their research because most mutual funds are not suitable for short investing periods; they are designed for intermediate to long-term (3 to 10 years or more) investment objectives. Short-term, with regard to investing, generally refers to a period less than 3 years. This is also generally true for categorizing investors as well as bond securities. In fact, many investment securities, including stocks, mutual funds, and some bonds and bond mutual funds, are not suitable for investment periods less than 3 years.
    For example, if an investment adviser asks questions to gauge your risk tolerance, they are seeking to determine what investment types are suitable for you and your investment objectives. Therefore, if you tell the adviser your investment objective is to save for a vacation you are planning to take 2 years from now, you would be categorized as a short-term investor. Therefore short-term investment types would be ideal for this savings goal.
    Bonds and bond funds are categorized as short-term if the respective maturity (or more accurately what is called duration)is between 1 and 3.5 years.
    When researching and analyzing investments, especially actively-managed mutual funds, a 1-year period does not provide any reliable insight into a particular fund's prospects for performing well in the future. This is because 1-year periods do not reveal enough information about a fund manager's ability to manage an investment portfolio through a full market cycle, which includes recessionary periods as well as growth and it includes a bull market and bear market.
    A full market cycle is usually 3 to 5 years. This is why it is important to analyze performance for the 3-year, 5-year and 10-year returns of a mutual fund. You want to know how the fund did through both the ups and the downs of the market. Therefore, the short-term (less than 3 years) is not a consideration when researching mutual funds for long-term investing.
  3. Manager Tenure (for Index Funds)
    Yes, your memory is correct: It is wise to analyze manager tenure when researching actively-managed mutual funds, which makes perfect sense. However, it makes no sense to analyze manager tenure for index funds.
    Index funds are passively managed, which means they are not designed to "beat the market;" they are designed to match a benchmark index, such as the S&P 500. Therefore the fund manager is not really a manager; they are simply buying and selling securities to copy something that already exists.

Disclaimer: The information on this site is provided for discussion purposes only, and should not be misconstrued as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities.