Investors who pay attention only to a fund's return are missing out on valuable information. Determining how a fund achieved its returns can be just as important as analyzing the returns themselves. Evaluating a fund properly not only helps you compare it with other funds, but lets you see whether a fund matches your investing needs and how it would complement your other investments. In this three part series we will dive into different components of mutual funds to consider when choosing a mutual fund.
Caution: Before investing in a mutual fund, it's important to analyze and carefully consider a wide range of factors, including the fund's investment objective, risks, fees, and expenses. These can be found in the prospectus available from the fund. Before investing, obtain a copy and read it carefully.
Analyzing a fund's investment objective
For some investors, analyzing a mutual fund basically consists of looking at historical returns. However, any analysis really should start with a fund's investment objective. More than any other factor, this will determine the role a specific fund might play in your portfolio and how well it fits with your financial goals.
There are three basic investing objectives: growth, income, and capital preservation. Growth investments are typically expected to appreciate in value over the long term. Income investments offer regular payments of income--for example, as interest payments. Investments that focus on capital preservation won’t increase much in value, but are the least likely to lose value and typically can be easily converted into cash. Within each category, a mutual fund may have various ways of achieving its objective. A fund also may combine objectives; for example, it might focus on income as a primary objective, with capital preservation as a secondary objective.
Within each of these three broad objectives, there are many subcategories; in fact, the Investment Company Institute compiles data for funds in roughly 40 separate investment objectives.
Considering the type of securities in which the fund invests
A fund's investment objective will determine what type of specific securities it includes. A fund may invest in a single asset class; for example, a stock fund concentrates on stocks, a bond fund on bonds, and so on. Such a fund may be relatively broad-based and invest in a wide variety of stocks or bonds, or it may narrow its focus even further and concentrate on a specific type of stock or bonds.
Tip: Even though a fund may focus on a single type of investment, it may still have multiple investment objectives. For example, a stock fund might attempt to provide both growth and current income by concentrating on companies that have a history of consistent or increasing dividend payments. However, all investing involves risk, and there can be no guarantee that any investing strategy will be successful.
A fund also may invest across asset classes, combining several types of investments in an attempt to use the strengths of each to achieve its investment objective. For example, a balanced fund usually includes both stocks and bonds. Such a combination fund may have a so-called "neutral mix," which represents the percentage or range of percentages that will be allocated to each asset class over time. As a hypothetical example, a fund might have a 55-45 neutral mix of stock and bonds, or a neutral mix of 50-60 percent for stocks and 40-50 percent for bonds, though (depending on the fund guidelines outlined in the prospectus) the fund may also stray from the neutral mix.
Some funds even invest in other funds; a so-called "fund of funds" would be an example.
Learning about investing style and strategy
Even funds that invest in the same type of securities and have a similar investment objective may have different ways of trying to achieve that objective.
One of the key factors in a fund's methodology is whether it is actively or passively managed. A passively managed portfolio attempts to match the performance of a given benchmark index and minimize expenses that reduce an investor's net return. With an actively managed portfolio, a manager tries to beat the performance of a benchmark index by using his or her judgment in selecting individual securities and deciding when to buy and sell them. Each camp has strong advocates who argue that the benefits of its style outweigh the other's; you need to understand which best suits your overall investing strategy.
Another point of differentiation for stock funds is whether its manager leans toward either growth investing or value investing. A growth fund focuses on companies that are growing quickly and that seem to have greater than average potential for appreciation in share price. A value-oriented fund focuses on buying stocks that appear to be undervalued by the market relative to the company's intrinsic worth. Some fund managers blend the two approaches; this is sometimes known as a "growth at a reasonable price" (GARP) approach.
In some cases, a fund's strategy is not only a method for attempting to produce a return but the core of why the fund was created to begin with. For example, a lifecycle or target date fund is a specific type of asset allocation fund that adjusts its mix of stocks, bonds, and cash alternatives over time based on a specific time horizon. A distribution fund's strategy may be designed to produce a specific percentage rate of return each year, or make regular payments of income over time based on how long the portfolio is expected to last. In each case, the strategy is the core of how that specific fund functions.
Note: The target date of a target date fund is the approximate date upon which an investor plans to withdraw his or her money. The mix of investments in a target date fund becomes more conservative as the date grows closer. The principal value is not guaranteed at any time, including at the target date, and there is no guarantee that a target date fund will meet its stated objectives. It's important to note that no two target date funds with the same target date are alike. Typically, they won't have the same asset allocation, investment holdings, turnover rate, or glide path, so it's important for an investor to look beyond the target date to determine if a particular target date fund is an appropriate investment.
You'll also need to analyze the impact of whether a fund is an open-end or closed-end fund. With an open-end fund, you can buy and sell shares directly from the fund itself, and new shares are issued or redeemed constantly based on the flow of assets into or out of the fund. Closed-end funds have a fixed number of shares, determined when the fund is launched. Also, those shares are not redeemed by the fund but must be bought from or sold to other investors, much as shares of stock are. And unlike an open-end fund, the shares of a closed-end fund typically trade at a premium or discount to their net asset value (NAV).
Now, that you’ve learned more about what to analyze when it comes to a fund’s objective, style and strategy, you’re ready for Analyzing Mutual Funds – Part 2. In this second part of the three part series, we look at analyzing metrics.