How to Research Mutual Funds

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How to Research Mutual Funds
By Mike Rowan, eRollover.com

Today, I’ll follow up with some suggestions about how to research mutual funds for your 401k, 403b, or IRA. You can apply the analysis to funds in your retirement plan, as well as to funds that you’ve uncovered in other ways. Also, I want to stress the importance of asset allocation in your 401k, especially during these volatile times in the market. A GREAT tool for doing this can be found on eRollover.com’s site by clicking here.

Screening Requirements
I suggest looking for no-load funds rated five stars by Morningstar, with Morningstar “low” or “below average” risk ratings, and with three- and five-year historical returns at least as good as the S&P 500 index. I also advise stipulating that the same manager has to be running the fund for at least five years. Finally, I suggest specifying that passing funds should have minimum initial purchase requirements consistent with your specific needs in your 401k, 403b, or 457 Plan.

I’ll assume that the funds you are researching meet those requirements, with the possible exception of the five-year historical return and five-year manager tenure. Specifying five-year returns and manager tenure disqualifies newer funds. While funds with five-year track records are desirable, I’ll leave it up to you whether you want to allow funds with only a three-year history.

Morningstar is the only site I know of with all of the data needed to do the analysis I’m going to describe. However, eRollover.com does have a mutual fund screener that can suit your needs by clicking here. Start by entering your fund’s name or ticker symbol on Morningstar’s homepage (www.morningstar.com) to see the Snapshot report for the fund.

If Not From Screen
If the fund didn’t come from my screen: confirm that your fund is rated five stars by checking the Morningstar Rating in the Key Stats section. Also, in the Key Stats section, confirm that the fund is no load by looking for the word “none” under both “Front-load %” and “Deferred Load %” in the Key Stats. The required minimum initial investment is also listed in under Key Stats. Use the Morningstar Rating report to confirm that the fund’s Morningstar Risk rating is either “low” or “below average,” and the Management report to confirm the manager’s tenure.

Check Returns
For all funds, whether from my screen or not, switch to the Total Returns report to see the fund’s calendar year and trailing returns. Calendar year returns are returns for specific years such as 2004 or 2005. By contrast, trailing returns are the average annual returns for periods ranging from one to 10 years, if the fund has been around that long. The trailing returns are computed through the previous market day, and thus, are more current than the calendar year returns.

Morningstar also compares the fund’s performance to the S&P 500 index for each period. That figure will be positive if the fund outperformed the index during the period and negative if it underperformed.

The most important figures are the fund’s trailing 3- and 5-year returns vs. the S&P 500. Look for funds that outperformed the S&P by at least 5%, ideally over both the three- and five-year periods. If you decide to waive the five-year check, require at least 8% outperformance vs. the S&P 500 over the past three years.
Also check the fund’s one-year returns vs. the S&P index. Since, one-year is a relatively short timeframe for evaluating fund performance, require only that the fund match the S&P’s return. Ignore year-to-date and the shorter timeframe’s listed by Morningstar.

Finally, in the return section, note the 2002 calendar year returns. That was the year the S&P 500 dropped 22 percent, making it the worst year in recent memory. By noting a fund’s 2002 calendar year’s results, you can see how it performs during a bad year.

Absolute Risk Measure
Next, we’ll consider risk, using Standard Deviation, which you can find in Morningstar’s Risk Measures report. Unlike Morningstar’s risk rating, which compares a fund’s volatility only to other funds in its same category (e.g. small-value, banks, tech stocks, etc.), standard deviation measures historical price volatility on an absolute basis. It’s the price volatility that keeps shareholders awake nights and incites them to sell just when a fund has touched bottom.
Standard deviation values run from as low as 1 to has high as 30, and sometimes higher. The higher the number, the more volatile the fund. Your maximum acceptable standard deviation depends on your risk tolerance. Risk averse investors should avoid funds with standard deviations above 10, and all investors should rule out funds with values above 20.

Another Risk Check
Our final risk measure is price/earnings ratio. You may be familiar with the price/earnings ratio of a stock, which is its recent share price divided by one-year’s per share earnings. A mutual fund’s price/earnings ratio is the based on the average P/E of its individual stocks. Morningstar does some extra data manipulation that results in lower P/Es than you’d get by simply averaging a fund’s individual stock P/Es (typically 60 percent to 75 percent of the simple average).
Research has found that low P/E mutual funds are less risky and produce better returns than high P/E funds. Using Morningstar’s numbers, risk averse investors should avoid funds with P/Es above 15 and all investors should avoid funds with P/Es above 22.

I think that is is a great way to navigate your way through the universe of 20,000+ Mutual Funds. Just remember, getting consistent returns in your 401k isn’t about timing the market. It is achieved through coming up with a solid plan and investing for the long term.

Please visit our site for more Retirement, 401k, and Insurance details:
www.erollover.com

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