Selecting and Monitoring Mutual Funds

Chess Superiority_20090829
Chess Superiority_20090829

Have you ever been to an unfamiliar city and stopped for directions to get to your final destination?  If you were to ask several local citizens, you would likely receive multiple and even different detailed expressions of these directions.  The difficulty then becomes deciphering which “direction” will get us there quickly, and with a minimal number of “wrong” turns.  As investors your destinations are slightly different yet you commonly use similar investment vehicles (mutual funds) to travel this path.  Each of you plan and hope to reach your goals quickly and with minimal risk. In fact, according to the Investment Company Institute, as of December 2007 there were over 8,000 mutual funds with approximately $9 trillion dollars of invested assets.  In addition, 51 million households (88 million individuals) owned on average $50,000 in mutual funds.  These statistics illustrate the popularity of mutual funds within the investment community, and in particular individual investors.  Thus, it is important that investors adopt appropriate evaluation criteria to navigate through this vast universe of mutual funds in order to decipher which are suitable for use within their investment portfolios.  For many investors, this is somewhat of a daunting task.

So as you travel on your financial path, how do you navigate through these investment vehicles to get to your final destination quickly and with the least amount of wrong turns?  Or, how do you best select a mutual fund managed by an ethical management team that performs consistently well when compared with other funds with the same objective and does so with minimal risk?  The answer is, this selection requires a considerable amount of effort and careful due diligence.  Such a task is not, however, an insurmountable one.

If investors prefer to work with a professional advisor who will recommend specific mutual funds to them, they may consider asking the advisor an important question: “Do you follow a similar selection and monitoring process when choosing which funds you’ll recommend?”  The Foundation for Fiduciary Studies in Sewickly, PA recommends that an investor or trustee examine the following eight specific aspects of fund performance and management when monitoring a manager:

1. Evaluate the fund’s performance relative to its peer group—a group of funds with comparable investment objectives

An investor evaluating a manager on a performance basis relative to that manager’s peer group should attempt to choose managers who consistently perform above the median or top half over a complete market cycle—typically considered to be at least three years.

2. Evaluate the risk that the manager is taking relative to the performance that the fund is providing to its shareholders

The Sharpe Ratio, a popular gauge in the investment community, is used to measure a fund’s risk-adjusted return.  Developed by Stanford University Professor William Sharpe, a 1990 winner of the Nobel Prize in Economic Sciences, the Sharpe Ratio is used to compare the relative performance of managers.  In general, the Sharpe Ratio tells us whether the returns of a portfolio come from smart investment decisions or from a result of excessive risk taking by the money manager.  Because it is a relative measure, there is no such thing as a good or bad Sharpe Ratio.  However, within a given peer group, the manager with the higher Sharpe Ratio is preferable.

3. Consider the product’s inception date

Generally, funds with at least a three-year performance history are preferable.  With fewer than a three-year performance history, it is difficult to develop meaningful comparative measures.

4. Correlate a mutual fund’s performance and stability to a peer group

For example, is the mutual fund’s style of investing consistent over time with the peer group characteristics?  When building portfolios, both investment advisors and individual investors will often make selections based on a model or target allocation.  In order to efficiently maintain that allocation, which some consider to be the most critical element in the investment management process—an investor must be confident that the mutual fund’s style will remain consistent.  Otherwise, they will be taking either more or less portfolio risk than they had originally intended.  For example, it would be important to know if a large, growth-oriented US stock fund were purchasing a disproportionate share of companies based in foreign countries.

In addition, a fund that is not highly correlated with its peer group renders the quantitative measures discussed above less meaningful.  Many of these measures of performance and riskiness are reliant upon appropriate and relevant comparisons.

5. Examine the fund’s total assets under management

Funds with total assets in excess of $75 million are considered preferable.  It is felt that at this level the manager will have the buying power and economies of scale to manage the fund cost effectively.

6. Determine if the underlying securities held by the portfolio are consistent with the stated investment style of the mutual fund

The objective here is to identify funds that have at least 80% of their assets in investments that match the stated investment style of the manager.  For instance, if a large growth US stock fund has 35% of its money in cash, an investor could be inadvertently over-weighted in cash and under-weighted in US stocks.

7. Determine the fund’s expense ratio or fee

All mutual funds have an expense ratio that’s charged against the fund’s assets under management.  This expense ratio is hidden from the investor and may be determined by examining the fund’s prospectus.  The fund’s expense ratio has significant impact on the fund’s performance over time.  For example, a fund with an expense ratio that is .75% (3/4 of one percentage point) higher than another comparable fund--all else being the same--will under perform by that amount each year.  When examining fund expense ratios, investors should look for funds with expense ratios that fall within at least the top 75% of their peer group.

8. Examine the stability of the organization

The first seven measures are very much quantitative benchmarks that are fairly easily measured for comparative purposes.  However, the qualitative benchmark of a mutual fund company’s stability is not as easily measured.  The mutual fund industry regulatory scandal from a few years ago is a prime example of why this qualitative measure is so important.  For example, some fund companies made deals with outside investors that allowed them to “time” their funds, thereby generating profits for themselves and diluting profits of long-term shareholders.

In some cases, fund companies allowed outside investors to place trades after the market closed in order to capitalize on news that would likely impact the next day’s prices of securities held in the fund. In the most egregious examples, in exchange for allowing these trading practices, the fund companies received compensation in the form of assets placed in other investment vehicles run by the fund company.  These violations of fiduciary responsibility on the part of such fund families can only be caught through a systematic process of surveying investment industry news, communications, and regulatory environment.  This is a difficult task for the individual investor.

In conclusion, the quantitative measures involve careful evaluation of a fund from a risk and return standpoint relative to its stated peer group.  The qualitative measure involves a vigilant, periodic review of the stability of the organization managing the mutual fund.  Investors not having the time, expertise or resources to carry out the systematic due diligence process may want to work with a professional advisor.  Investors who work with these advisors should then ensure that the professionals giving them advice are themselves following a comparable process of fund selection and monitoring.


Dean Piccirillo offers insurance products through HBK Sorce Insurance LLC. Investment advisory services are offered through HBK Sorce Advisory LLC d/b/a HBKS Wealth Advisors. Mr. Piccirillo is not able to transact business in a state that he is not licensed or registered.