The 5 Fundamentals of Fund Investing

Here at Morningstar, we’ve been analyzing mutual funds since the late 1980s. Our analysts evaluate funds based on their long-term potential for superior risk-adjusted performance. We judge each fund’s competitive advantages and disadvantages. In 2011, we introduced our Morningstar Analyst Rating. Our ratings have five levels: Gold, Silver, Bronze, Neutral and Negative.

The ratings reflect a synthesis of each fund’s fundamentals—and it’s our philosophy at Morningstar that to be successful, fund investors must understand a few key fundamentals. We break those fundamentals down into five “pillars”: People, Process, Parent, Performance, and Price. These are the big, fundamental areas that have proved vital to a fund’s long-term success.

Let’s take a look at each pillar that we consider when evaluating funds.

People To understand a mutual fund, investors must understand the people behind them.

There is much more to a fund than its manager. There are the analysts, traders, and other managers who contribute to the process, and we consider all of them when assigning our ratings. We think about what advantages they have over their peers along the lines of expertise, experience, and demonstrated skill. A lot of work goes into assessing the people. We talk with managers on a regular basis, we visit fund companies to meet the people behind the scenes (such as analysts and chief investment officers), and of course we pore through piles of shareholder reports, press interviews with the manager, and SEC filings that show how much a manager has invested in the fund.

We also look at how other funds at the family have done to assess firm-wide expertise. We follow analyst movements at the firm so we know how experienced they are and whether there’s turmoil or stability in the ranks.

A negative People score does not mean we think the manager is dim or disagreeable. It could mean that the firm hasn’t demonstrated expertise in that area, the research bench isn’t sufficient or stable, or the manager has not established a track record.

Process There's an enormous variety of fund strategies even within a category: Decide that you want a large-cap growth fund and you will need to find out whether the manager is taking a momentum-based approach or focusing more on growth at a reasonable price, for instance.

At Morningstar, we drill down to really understand the differences. Competitive advantages are a key way to look at it. Is the manager doing something that anyone can do, or is he or she doing things that are hard to replicate? Is the strategy a proven one or a new, untested formula?

Just as important is how well the process is matched to the managers’ and firm’s skill sets. For example, PIMCO runs some very involved derivatives strategies. While those are not without risks, the firm has the resources and track record to give us confidence. Someone running a three-person office would be a terrible fit for such a strategy. Mutual Series is another example of a family with a strong process. It has a deep fundamental-value strategy that it has had tremendous success with, and everyone at the firm is steeped in that investing outlook. Short of hiring away some people from the firm, it’s not something just anyone can replicate.

Parent When you invest for the long haul, you realize just how important the company behind the fund is.

In our analysis, we look at manager turnover at the firm, investment culture, quality of research, ethics, directors, SEC sanctions, and more. If you hold a fund for 15 years, you want stable management that will be there the whole way through. Failing that, you want a firm with a deep bench with people who can step in and keep the fund going along the right path. What you really don’t want is frequent switches with not-very-talented investors.

You’ll also find that a fund company and the fund board make a number of decisions that have a big impact on the fund. Some clearly pit the company’s short-term profits versus fundholders’ long-term interests. For example, if they are maximizing short-term profits at the firm, they won’t close a fund even if further assets could impair performance and they keep fees higher than necessary. Or they might, to the detriment of shareholders, merge two funds with distinctly different strategies. Firms seeking near-term gains sometimes launch funds that may be hot sellers but aren’t great investments and won’t lead to good investor outcomes. In short, you want a partner you can trust for many years to come.

Performance Performance may seem like the easiest element to evaluate: After all, there are plenty of indexes and categories to compare a fund's performance with.

Investors generally do not evaluate fund performance accurately. At Morningstar, we focus on performance under the current manager to tell us whether he or she has added value. The longer the record, the more predictive it is of future relative performance. Although some investors tend to weight recent returns more highly, it’s really the long-term record of a manager that is most telling.

We spend time trying to understand why a fund performed a certain way, and we link the performance back to its root cause: the strategy and holdings. We care about how a fund has performed in different market environments, its risk profile, and its consistency of returns over time. It’s important to understand what risks a manager took and is taking now to generate the returns. Some higher-risk strategies can enjoy a nice steady ride for a few years before all hell breaks loose.

We’ll also look beyond the fund when necessary and appropriate by considering managers’ records at other funds (current and past) as well as other accounts they may have run, such as separate accounts or hedge funds.

Price Costs are a good predictor of future performance. They aren't everything, but they are a crucial piece in the puzzle. You need to consider fund costs when investing.

At Morningstar, we look at a fund’s expenses relative to its peer group and its sales channel. We also take into context its asset size and in some cases its trading costs if they are particularly high or low. It’s also important to consider a fund’s costs in light of its strategy.