Buying Mutual Funds Part III

In the third part of this series on buying mutual funds we're going to discuss evaluating mutual funds.  There is no doubt that when it comes to publishing information on mutual funds that Morningstar is an industry leader.  Here we're going to help you to better understand the information you're likely to encounter when reviewing performance reports you see from Morningstar and other publishers of mutual fund ratings data.

Selecting Mutual Funds

By understanding these mutual fund performance reports better, you should be more effective at evaluating and selecting a mutual fund.  Specifically, we'll be discussing how to read the following types of mutual fund ratings and analyses:

• Morningstar Ratings
• Historical Returns for Mutual Funds
• Mutual Fund Volatility Ratings

As you'll see, researching a mutual fund is much different than researching stocks.  That's because with common stocks, you can look at earnings growth rates, financial ratios and future earnings projections.  With mutual funds, you're purchasing a bundle of stocks, so those types of measures become somewhat meaningless.

Understanding Morningstar Ratings

The Morningstar rating system started back in 1985 and was immediately embraced by mutual fund advisors as well as investors.  In 2002, Morningstar enhanced their mutual fund rating system by introducing several new peer groups and changing their measure of risk-adjusted return.  The two major components of this new rating system include:

• Category Rankings - Funds are ranked within categories such as large value, large blend, world stock and specialty funds.  By ranking mutual funds relative to peers, investors get a better sense of relative performance.
• Risk Adjustments - Mutual funds are rated for risk with a greater emphasis on downward risk.  That is, there is more emphasis placed on avoiding a negative outcome.

This risk adjustment component is important to understand.  Morningstar uses a risk rating that is based on what is called utility theory.  That theory states that investors are more concerned about possible negative outcomes than unusually high returns.  This means that funds that perform extremely well one year and poorly the next will not be rated as highly as a fund returning moderately positive returns over the same period of time.

Morningstar Five Star Ratings

The highest possible rating in the Morningstar system is a five star rating.  Funds are rated for the trailing three, five and 10-year time period whenever possible.  The overall rating is a composite or weighted average of these time periods.  The exact formula for that weighting is:

Morningstar Rating Formulas

As you can see from the weightings, Morningstar places more emphasis on the longer-term ratings whenever possible.

Five Star Rating Examples

Here is an example of how the above table is used.  If a mutual fund you're evaluating has been in existence for five to ten years.  Then 60% of the rating is based on its five year performance and 40% of the final rating comes from the fund's performance over the last three year.

Distribution of Morningstar Ratings

Finally, it's worth mentioning how these mutual fund ratings are distributed within categories.  Morningstar distributes the stars based on relative performance and the distribution of stars is as follows:

• Five Star Ratings - 10% of mutual funds in that category
• Four Star Ratings - 22.5% of mutual funds in that category
• Three Star Ratings - 35% of mutual funds in that category
• Two Star Ratings - 22.5% of mutual funds in that category
• One Star Ratings - 10% of mutual funds in that category

So if you're evaluating a mutual fund and see a five star rating, that means it has outperformed 90% of the mutual funds competing in the same fund category.  Now that we understand the Morningstar rating system, let's take closer look at how those ratings are derived.

Historical Returns for Mutual Funds

Historical returns for mutual funds are another important piece of information that can be used to evaluate a mutual fund.  Historical performance is usually stated in absolute and relative terms.  That is to say when you see a chart of performance, it will usually show the actual performance of the fund over time, in addition to comparing that performance to peers or an index.

The stock charts and mutual fund charts themselves often show investors what would have happened to an investment over time.  For example, the chart might show what would have happened to a $10,000 investment over a five year span of time.  The chart will also show what would have happened if the investor placed that money elsewhere - usually in an overall market measure such as the S&P 500.

Morningstar might also include a chart of other mutual funds in that same category.  This way, the investor can visualize and compare the relative performance of the mutual fund versus the market and its peers.

Finally, you might also see a % rank in category figure.  You'd want that value to be as high as possible because that number tells you how well that fund did relative to its competition.  For example, a % rank in category figure of 95% means that only 5% of the funds in that category did better than the mutual fund you're evaluating.

Mutual Fund Volatility Measurements

Earlier we told you that Morningstar places more emphasis on downward risk.  The volatility measures for mutual funds will provide you with a good feel for the stability of the fund from year to year.  Typically, when looking at measures of fund volatility you'll encounter:

• Standard Deviations
• Means or Averages
• R Squared versus Standard Index
• Beta versus a Standard Index
• Bear Market Ranking
• Mutual Fund Alpha
• Sharpe Ratios

We're going to finish up this topic on evaluating mutual funds by explaining each of these measures.

Standard Deviation

A fund's standard deviation is simply a measure of the range in the mutual fund's performance.  All you need to remember is that the higher the fund's standard deviation, the greater the fund's volatility.  For example, if you're comparing two mutual funds with the same average return, the fund with the higher standard deviation had greater fluctuations in return from year to year.

Mean or Average

This is simply the mean, or average, return for this mutual fund over the time period stated.  It's the same exact concept you encountered in school.  Averages are usually stated in 3, 5, and 10 year lengths.

R-Squared versus a Standard Index

R-squared measures are usually stated in terms of percentages or values from 1 - 100%.  This measure tells you how useful the beta value will be in predicting the movement of this mutual fund - more on that later.

R-squared versus a standard market measure - such as the S&P 500 Index - tells you how much of the fund's movement can be explained by the movement of the market.  So if a fund's R-squared value is 100%, then that fund moved up and down in-step with the S&P 500.

Beta versus a Standard Index

A mutual fund's beta versus a standard index tells you the relationship between the fund's excess returns (relative to T-Bills) versus the excess return of the standard index. Most equity mutual funds are compared to the S&P 500 index, while bond funds are compared to a bond index.

For example, if a mutual fund has a beta of 1.1, that means the fund has performed 10% better than the S&P 500 index after deducting the T-Bill rate in an up market.  This also means the fund may be expected to under-perform the S&P 500 index by 10% in a down market.

Bear Market Rank

The bear market rank can be useful in evaluating how well a fund performed relative to its peers in a down or bear market.  This figure is based on the total returns for those mutual funds during bear markets and is stated on a percentile basis.

For example, if a fund has a bear market rank of 3 that means the fund was in the top 3% of its peer funds in terms of total return during bear markets.  Mutual funds with a bear market rank of 1 - 5 have withstood bear markets quite well, while a ranking of 95 - 100 means the fund has performed poorly in bear markets relative to its peers.

Mutual Fund Alpha

The mutual fund alpha is a measure of how well that fund performed relative to its expected performance.  In this way, a positive alpha would indicate a fund performed better than the beta would have predicted and a negative alpha would indicate a fund performed worst than the beta would have predicted.

For example, let's say a mutual fund had an alpha of 0.75, an R-squared of 0.95 and a beta of 0.90.  The high R-squared value means the beta value should be fairly accurate.  However, the alpha of 0.75 indicates the fund produced a return that was 0.86% higher than the beta predicted.

Sharpe Ratios

Sharpe ratios are a risk-adjusted measure that was developed by Nobel Laureate William Sharpe.  The Sharpe ratio is a measure of the excess returns for each unit of risk.  The ratio is normally calculated using the past 36 months worth of data.  The Sharpe ratio tells you how much excess return (relative to a risk free investment) is returned for each unit of risk.

For example, let's say you're comparing a mutual fund to its peer category and the fund's Sharpe ratio is 0.50, while its peer category is 0.30.  This means one unit of risk returned 0.50 in excess return for the fund, while the peer group only achieved 0.30 in excess return.  That means the risk-adjusted reward for this fund is lower than its peer group.

Up Next - Mutual Fund Fees and Loads

Just to recap what we've learned so far in this series on buying mutual funds:

• Buying Mutual Funds Part I - in the first part of this series we discussed mutual fund risk and the terms you'll encounter when researching a fund.
• Buying Mutual Funds Part II - in the second edition we talked about how to research a mutual fund.
• Buying Mutual Funds Part III - in this article, the third in this series, we discussed the information you'll encounter when evaluating mutual funds.

This brings us to our final publication where we'll be discussing mutual fund management fees and loads.

About the Author - Buying Mutual Funds Part III

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