When meeting with clients to review their portfolio holdings, one of the most frequent questions I’m asked is: “Is this a good fund?”
And at first glance, I’m not always sure.
Funds don’t have feelings or emotions, so ‘good’ isn’t always the right descriptor. Financial products are not inherently good or bad, but how they are used can be either good or bad for your specific situation. When I’m looking at a fund, here are some key indicators that I review to help decide if it’s a ‘good’ investment for you.
Before we jump in, I need to make a few disclosures (to keep the regulators happy). We are going to look at a Morningstar report for the Vanguard Balanced Fund VBIAX. I’m not endorsing or recommending this particular fund for your portfolio, we are just using it as an example since it holds both stocks and bonds.
The information used is current, however, if you read this post in the future, the information will be out of date and not reflective of current market or economic activity. And, finally, we are not looking at all the details, just some that I deem important for decision making.
My descriptors will likely be simplified, but that’s the point, isn’t it? Other advisors may have different views or a different perspective on how to review this report.
So let’s get started, shall we?
We’ll begin by answering a simple question, that may be at the top of many of your minds:
What is Morningstar?
Morningstar is a top provider of independent investment research in the United States and abroad. You can use this site to research and evaluate the quality of mutual funds and other investments.
Ratings
When it comes to reviewing a Morningstar report, there are two ratings that you’ll want to look at: the Star Rating and the Analyst Rating.
The Star Rating is a mathematical measure that rates how well a fund’s past performance has compensated shareholders for the amount of risk it has taken on. An important thing to note is that the Morningstar fund analysts don’t assign the ratings, nor do they add subjective input — meaning they don’t add stars to funds they like or subtract them from others they don’t.
The rating is a measure of a fund’s risk-adjusted return, relative to similar funds. Funds are rated from 1 to 5 stars, with the worst performers receiving a single star and the best receiving 5 stars.
Think of this as backward looking analysis of how the fund performed in the past.
The Analyst Rating rates the People, Process, Parent, Performance, and Price — and is the summary expression of Morningstar’s forward-looking analysis of a fund. Morningstar analysts assign the ratings on a scale with three positive ratings of Gold, Silver, and Bronze, a Neutral rating, and a Negative rating.
These ratings are more subjective and, while not predictive, can be used to consider how the fund may perform in the future.
Learn more: Morningstar Two Ratings for Assessing a Fund
Performance
As investors, we all want funds that have historically performed well — even though past performance is no guarantee of future returns. This is because funds that perform well tend to stay in business, while underperforming funds may close, which may create an unforeseen tax issue within your portfolio. Even large, well-respected firms close down their funds for a variety of reasons.
There are a number of indicators of a fund’s performance that can be found on a Morningstar report, here are a few that you’ll want to pay attention to.
Trailing Returns
A trailing return looks backward from a particular date for a fund’s annualized return over a specific time period — usually ending on the last day of the most recent month, quarter, or year.
If you pull up any mutual fund quote page on Morningstar.com and click on the Performance tab, you’ll see a chart of the fund’s trailing total returns for various time periods, from one day to fifteen years, as well as how it compares with market benchmarks and other funds in its category.
For example, as of the most recent quarter ending March 31, Vanguard Balanced Index Fund Admiral Shares (VBIAX) posted a one-year trailing return of 8.74%, and three and five-year trailing returns of 6.65% and 8.52%, respectively.
You’ll see that the fund has negative returns for the past one- and three-month periods. Does that mean it is not a ‘good’ fund? Nope. If you look at a multitude of balanced funds, many of them have negative returns for the same time period. It’s just the way the market is performing right now.
Fees & Expenses
This is the number everyone wants to know. We all want low fees, but sometimes you get what you pay for. The lowest fee does not always indicate the best fund. It’s more important to look for value than for low cost.
Gross Expense Ratio:
The Gross Expense Ratio is the percentage of the fund’s assets that are used to pay for interest and operating expenses, as well as management fees. The operating expenses typically include fees for things like accounting, administration, advising, audits, distribution (12b-1), legal, reporting, and the like.
While this is a long list, the expense ratio does not reflect brokerage costs, investor sales charges, or other annual fees charged by your investment advisor.
Don’t get fooled by thinking that the lowest cost always makes the best investment. In general, passive index type funds have lower fees than actively traded funds because these funds trade less often and require minimal maintenance. However, an active fund may help protect your investment from downside losses, or generate higher returns. If that’s the case, then the fund’s value may be worth the cost.
Risk and Return
A mutual fund’s risk can be measured in a number of ways. The standard deviation is a common method. You also want to look at a fund’s Beta and Alpha numbers and compare them to an appropriate benchmark.
Beta
Beta is the measure of a fund’s sensitivity to market movements.
By definition, the beta of the market is 1.00. Morningstar reports calculate beta by comparing a fund’s excess return over its benchmark, so a beta of 1.20 shows that the fund has performed 20% better than its benchmark index in up markets and 20% worse in down markets.
In contrast, a beta of 0.80 indicates that the fund’s excess return is expected to perform 20% worse than the market’s excess return during up markets and 20% better during down markets.
I look for funds that are taking advantage of the market and try to find those with a beta close to 1.
Alpha
Alpha is often considered the additional return that an active manager generates over and above what might be anticipated given the level of investment risk taken.
A positive alpha figure is indicative of a fund that has performed better than its beta would predict. Conversely, a negative alpha indicates a fund’s underperformance, given the expectations established by the fund’s beta.
In addition to a beta of 1, I like to see a positive alpha as well. Index funds don’t provide much alpha at all since they are dependent on the movements of the overall market, which is reflected in their beta. You’ll often see a variety of different alpha numbers in active funds as their performance is dependent on active management.
Portfolio Analysis
A deep dive into the actual fund portfolio can be very telling. While a fund may be performing well (or not), the underlying makeup of the fund tells the story of why.
Asset Allocation Percentages
Asset allocation is the process of dividing an investment portfolio among different asset categories, such as stocks, bonds, and cash — with the primary goal of creating an optimal balance between expected risk and long-term returns.
The Vanguard fund we are looking at is a balanced fund with 58% in US stocks, 39% in bonds, and a smattering of cash, non-US stocks and other investments.
Short Positions
A short position is a speculative form of trading where the seller believes that the price of a security is going to fall and they will be able to buy the security back at a lower price. The % Short in the image above, represents how much of each particular asset type is being shorted.
Why do we care about this? If your fund has a large short position, that means it is highly leveraged. Returns will be amplified, but losses will be as well. I’ve seen bond funds that are leveraged 300%! A bond fund sounds safe and the returns look good, but the fund could have disastrous implications for a portfolio if the market takes a turn.
Top 25 Holdings
A mutual fund’s holdings represent the securities (stocks or bonds) that are held in the fund. Knowing the largest holdings in a mutual fund can show where there is overlap and may help in identifying if your asset allocation is off.
Let’s say you like two similar funds and you want to purchase them both. If the underlying holdings are almost the same, you may well to take the lower priced one and save on fees.
It’s kind of like buying the store brand of cereal instead of the name brand. It’s really the same stuff inside.
Credit Quality
Credit quality, as the name implies, refers to the condition (worthiness or risk of default) of the bonds (adjusted for its relative weighting) within a fund.
Although bonds with a lower credit quality generally carry a higher interest rate, I prefer bonds with a higher credit quality. Remember the ‘junk bond’ crisis of the 80’s? I’d rather not re-live that.
Operations
Have you seen the furniture commercials lately? Most offer same as cash financing for purchases. Now, these companies are not in the business of financing, they are in the business of selling furniture. To make this happen, they incorporate the cost of financing into their products and sell their accounts receivable at a discount. So, if you understand how the company operates, you may be able to save money by paying with cash instead of financing.
The same way, understanding how a fund operates can help you make good choices about which ones are a good value.
Manager Tenure
Manager Tenure represents the number of years that the current portfolio manager has managed the fund. In situations with more than one manager, the average of those years is shown.
Management longevity and consistency can be a plus. Or, if a fund has done poorly, you can see where the management had a turnover which may be a more positive development. Or, if a fund had a manager leave, new and untested leadership may make the fund more volatile. Any time there is a manager change, it’s always a good idea to find out why.
Minimum Investments
Under the purchase tab, the Minimum Investments section outlines a number of key indicators.
- Initial (Investment): the smallest amount a fund will accept to establish a new account.
- Additional (Investment): the smallest additional amount a fund will accept in an existing account.
- Initial IRA (Investment): the smallest investment amount accepted for establishing an individual retirement account. *Note: If none appears, the fund does not have a plan. If the minimum is zero, then $0 will appear.
- Additional IRA: the smallest additional purchase a fund will accept in an existing IRA account. *Note: If the minimum is zero, then $0 will appear.
- Initial AIP (Auto-Invest Program): the smallest amount with which someone can enter into an auto-investment arrangement where the fund takes money on a monthly, quarterly, semiannual, or annual basis.
- Additional AIP: the smallest permissible additional investment a fund will accept in an existing automatic-investment plan account.
This can be critical to know when putting a portfolio together. If you have $18,000 to invest and want a stock fund and bond fund, but you have a $10,000 minimum investment requirement, you might want to find an alternative. Maybe invest in something like the balanced fund we are looking at here, and once your account grows, you can re-evaluate and see if you want to make a change.
Inception Date
The fund inception date is the day when the fund began its operations and was able to begin being sold.
On the report, the inception year is listed first — followed by the month. For example, a fund with an inception date of January 1991, would be listed as 1991-01. The importance of the inception date listing is so investors are able to access the overall performance of funds with long track records.
I tend to like older, more established funds as they have a track record of management and performance. There are lots of newer funds and ETFs and I’m somewhat skeptical of them. I don’t have any idea of how they might perform, the manager’s track record, or if there is even a good market for the fund. I’d rather not buy a fund that will close down in the near future.
Do Your Homework
When it comes to buying a mutual fund or ETF, it’s always important that you look under the hood, kick the tires, and make comparisons to ensure that what you’re purchasing aligns with your long-term goals.
In addition, you should seek out a financial advisor that understands the ins and outs of the market and can help you navigate it all.
If you would like to learn more about how Pathfinder Planning helps investors make sense of their options, click here to schedule an introductory meeting.
Pathfinder Planning LLC provides personal financial planning advice and asset management for a simple fee to young adults and working families in North and South Carolina through group classes, one-on-one planning, and ongoing advice.
Your Financial Mom blog posts are not meant to be legal, accounting or other professional service advice. Content represents the opinion of the author only. Pathfinder Planning LLC is not responsible for the accuracy or validity of content contained in third-party comments.