Analyze Funds Like the Pros
Here are five questions to ask when looking at a mutual fund.
Morningstar has expanded into many different investment-related businesses, but we're still best known for analyzing mutual funds, and fund analysis remains central to what we do. As Morningstar analysts, we talk to hundreds of fund managers on a regular basis and spend much of our time thinking and writing about mutual funds. In addition to our analyses of individual funds, we've frequently provided more general tips for making sense of funds and the fund world in The Short Answer, as well as in Fund Spy columns and elsewhere.
Much of what goes into our fund analyses comes from our conversations with managers and other proprietary sources, but we also do plenty of research using data that's widely available. In fact, it's usually possible to get a pretty good idea of a fund's merits just by looking at the information found on Morningstar.com, as long as you know what to look for and how to use it. Here are five key questions that Morningstar analysts ask when we start to analyze a fund and where we look for the answers, with an emphasis on data found on Morningstar.com.
1. How have returns been under the current manager?
Most investors are looking for high returns, so if you're investigating a fund, 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 the past. Directly examining a fund's percentile ranking within its category over a long-term period, such as five or 10 years, is also a good start, but a fund's past history doesn't always reflect its current situation.
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'll 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. You can find the start date of the current manager(s) in the lower right part of the fund's Quote page on Morningstar.com, and then you can create a customized chart showing the fund's relative performance since that date, using the new Chart feature as described by my colleague Katie Rushkewicz here.
2. How risky has the fund been in the past?
In the financial world, 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 Ratings & Risk page on Morningstar.com. This measures not standard deviation, but a similar measure that penalizes downside variation more than it rewards upside variation. We categorize 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%. (This article has more discussion of standard deviation and Morningstar risk, and this document gives all the details about how Morningstar risk is calculated.)
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, found on its Performance page on Morningstar.com, 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. The above-mentioned new Chart tool makes it even easier to see graphically how a fund's returns have varied over time, including when it has beaten or trailed its category or a benchmark.
3. Where is the portfolio most concentrated?
Another thing that Morningstar analysts invariably look at when analyzing a fund is its portfolio, including where that portfolio is most concentrated relative to the fund's peers. Each fund's Portfolio page on Morningstar.com provides a good overview of the portfolio's characteristics, including its sector weightings relative to its category and the S&P 500 index. 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. A stock fund that's heavy in technology stocks, such as Fidelity OTC (FOCPX), is likely to do well in growth-led bull markets and poorly in bear markets, while one that holds a lot of consumer staples stocks, such as Jensen (JENSX), will tend to do poorly in bull markets and relatively well in bear markets. Nearly all funds that are heavy in financials got hammered in 2008 but are doing much better in 2009.
One of the easiest ways to get a good sense of a stock fund's portfolio is to look at its top holdings, which you can find in the "Top 25 Holdings" tab of the Portfolio section. If the top holdings are mostly big, easily recognizable stocks like Wal-Mart (WMT), Microsoft (MSFT), and Coca-Cola (KO), then you're 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 recognize, that fund might be more useful in a supporting role in a portfolio. Also, if those top holdings take up more than about 5% of assets, it suggests a concentrated portfolio, which can be prone to short-term underperformance if something goes wrong with a top holding. One prominent recent example is Oakmark Select I (OAKLX), which suffered badly in 2007 when top holding Washington Mutual, which once made up 15% of the portfolio, collapsed amid the mortgage crisis.
4. What does the fund's style box look like?
The Morningstar Style Box has long been recognized as a useful tool for summarizing a fund's portfolio, and the detailed version found at the top of each stock fund's Portfolio page on Morningstar.com is especially helpful. A red dot represents the portfolio's "centroid," which allows for finer distinctions than the traditional style box alone is capable of. For example, American Funds Fundamental Investors (ANCFX) and Legg Mason Partners Appreciation (SHAPX) are both large-blend funds in the large-blend area of the style box, but their centroids reveal that the American Funds offering is on the edge of large-growth territory, while the Legg Mason fund is almost in large-value territory. (See this article for more discussion.)
The shaded area around a fund's centroid represents its Ownership Zone, which shows how wide-ranging the portfolio is. A small ownership zone means that the fund focuses almost entirely on stocks in one area of the style box, while a large ownership zone spreading across most of the box means the portfolio is very diverse. This difference can be significant for knowing how a fund would fit into a portfolio; in general, a larger ownership zone means that a fund is more appropriate as a core holding, while a fund with a small, concentrated ownership zone might have to be balanced out with a different type of fund. (See this article for more on ownership zones.)
5. What does the fund cost relative to its peers?
Finally, one of the most important things we consider when evaluating a fund is how much it costs. A fund's Expenses page on Morningstar.com shows the most relevant fees and expenses, including sales loads, redemption fees, 12b-1 fees, and the expense ratio. The expense ratio is what we tend to focus on the most, because it encompasses everything shareholders pay except for sales loads.
It's important to look at a fund's expense ratio in the proper context. That means comparing it not just with funds of the same or similar category, but with comparable share classes. No-load funds usually have lower expense ratios than retail shares of load funds, and among load funds, A shares (which charge a front load) virtually always have lower expense ratios than B or C shares (which charge a deferred or level load). The Morningstar.com Fund Screener and Premium Fund Screener both allow you to screen for all funds in a given category, and for no-load funds, after which you can rank funds by expense ratio to see where a given fund ranks.
David Kathman does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.