Mutual Fund Research

Conducting mutual fund research is like conducting stock research, but because mutual funds are pre-packaged portfolios of stocks, the process is a little simpler.  In addition, the universe of mutual funds is much smaller than that of common stocks, so you are starting with a much smaller number of options to evaluate.

Picking Mutual Funds versus Common Stocks

One of the nice features of mutual funds is they offer the investor the ability to create an instant portfolio of stocks.  When you're investing in stocks, you need to find eight or more companies to purchase in order to lower your overall investment risk.  With mutual funds, you only need to pick a couple of funds to diversify away risk, and satisfy your long-term financial objectives. 

Controlling Risk with Mutual Funds

When you invest in a single stock, or even a mutual fund, you are exposed to market risk.  These are macro-economic factors and / or industry risks such as inflation, interest rates, and overcapacity.  When you invest in the stock of a single company, you are also exposed to the risk associated with that company.

For example, Company A might make a poor decision that hurts earnings or even its profitability over the long term relative to its competitors.  This decision does not hurt the industry in which Company A competes, but the earnings problem is isolated to Company A.  Therefore, Company A's stock price will suffer.

Since mutual funds might contain stocks, bonds, and even cash, you instantly lower the risk associated with owning just a single company.  You've reduced your overall investment risk through the diversification offered by the mutual fund.

Mutual Fund Research Strategies

You can simplify your mutual fund research by making some overarching decisions that help to define your desired investment strategy.  For example, while there are many different categories of mutual funds from which to choose, there are really just three types of funds:

• Index Funds - mutual funds that attempt to mimic an index such as the S&P 500, Dow Jones Index or a NASDAQ Index.
• Funds Stating an Investment Objective - mutual funds that attempt to offer individuals an investment objective.  Funds of this type include aggressive growth, income, value, blend, large cap, mid cap, small cap., and balanced funds.
• Specialty Funds - mutual funds that attempt to mimic a specific industry or geography.  This type of fund might include natural resources, commodity mutual funds, gold mutual funds, international stock funds, and real estate funds.

Advantages and Disadvantages of Mutual Funds

It's important to understand the advantages and disadvantages of each of the three fund types listed above.  We're going to help by briefly discussing each type of fund in the paragraphs below, and then provide some information on how to get started researching your mutual funds:

Index Mutual Funds

One of the big advantages of index mutual funds is that the fund managers invest in such a wide range of securities they virtually eliminate all individual stock risk.  In fact, if constructed properly, an index fund will provide the same return as the index it's supposed to mirror or replicate.

Unfortunately, index funds do not always live up to the investor's expectations, and actually under-perform relative to the index they're mirroring.  That's because as fund shareholders buy and redeem shares in the index fund; the management team is constantly trying to rebalance the portfolio so its holdings remain in the right proportion to the index.  This rebalancing activity can drive up trading expenses.

Mutual Funds with Specific Objectives

Mutual funds that promise the investor some kind of specific objective can be very useful when that objective is aligned with the investor's need.  For example, a fund that rebalances the mix of stocks and bonds over time, moving from a more aggressive to conservative portfolio, may be an excellent choice for individuals looking for a fund to provide them with retirement income.

Other investors might be looking to "time the market," decide that small cap stocks are undervalued, and conclude these stocks will be moving up quickly.  Once again, this type of fund can help the investor get into that market in a very efficient manner.

On the downside, some of these funds can be very actively managed.  An aggressive growth fund might be spending a lot of money researching stocks, as well as frequently buying and selling stocks.  This can drive up the fund's expense ratio, and eat into the investor's total return on investment.

Specialty Mutual Funds

Finally, specialty mutual funds can offer the investor the best of both worlds in terms of flexibility and cost.  Since most of these funds have a relatively small set of investment options, research and trading costs can be low.  These funds also offer investors the chance to participate in opportunities such as the real estate market or gold with relatively low cost of entry.

On the downside, specialty mutual funds are exposed to a large amount of industry risk.  You've eliminated stock risk by purchasing a mutual fund, but if the technology industry takes a downturn, and you're holding that specialty fund, your investment will suffer too.

Index Mutual Fund Research

If you've decided to invest in a mutual fund that follows an index, your research is pretty straightforward.  That's because you only need to pay attention to a couple of factors when evaluating the index fund:  mutual fund fees, and the management team.

Since the fund is an index fund, the management team attempts to assemble a portfolio of stocks that replicate the index itself.  As the size of the fund increases (more investors put their money in the fund), the management team needs to purchase additional stock to keep the fund aligned with the index.

The objective of the team should be to purchase these shares as efficiently as possible.  A good indicator of how well they are controlling costs is to look at the fund's management fees.  An index fund is not an actively managed portfolio, so the fees should be as low as possible.  For example, there is very little stock research involved with an index fund.  When comparing index funds from different brokerage houses, you want to make sure the fund fees are low, in the 0.5% range.

You also want to take a look at the qualifications of the management team.  All mutual funds will have a prospectus that talks about the fund manager.  Make sure you are comfortable with that person's qualifications.  Finally, you may want to look at the fund's past performance, it should come pretty close to the performance of the index itself or something is seriously wrong.

Researching Funds with Specific Objectives

This next topic is a tough one for investors because it is very difficult to verify the fund is fulfilling its stated objective.  For example, these mutual funds can have a mix of stocks and bonds to provide a balanced portfolio to the investor.  They can state their objective is aggressive growth or income through the payment of dividends.

If you decide you are going to invest in this type of mutual fund, you need to break down the fund's investment portfolio, and take a very close look at what they are doing in each sector.  In other words, if the fund offers a mix of bonds and stocks, then you need to evaluate each portfolio of stocks and bonds individually.  You need to follow the advice given below to evaluate each portfolio type in the fund.

This is perhaps the most complex mutual fund purchase to make as an investor.  If you're thinking about buying shares in a mutual fund like this, you really need to take a closer look at our series on Buying a Mutual Fund.

Researching Specialty Funds

Specialty industries can range from those that are invested in tax-free bonds to those focusing on a specific industry, such as gold mutual funds.  If you are going to take this approach, then you should be evaluating the mutual fund in a similar fashion to that described in our series on stock research.  Even though that series talks about evaluating a single stock, the same process can be applied to mutual funds; although this can be accomplished by the investor in a simplified manner.

If you followed along in that series, Stock Research Part I helped you to identify exceptional stocks.  The same process would apply to mutual funds.  For example if you are researching a mutual fund that specializes in certain industries, then you can use the advice in that article.  To summarize the methodology found there:

• Invest in specialty mutual funds that are not in commodity-like industries.
• Try to find mutual funds that specialize in industries were there is a lack of capacity.  That is to say, supply has trouble keeping up with demand.
• Invest in mutual funds containing stocks with significant brand loyalty.

You may not be able to find all of these attributes in all of the companies listed in the mutual fund's portfolio, but these attributes should be very common in a mutual fund containing excellent stocks.

Look at the Mutual Funds Top Holdings

You can also apply the other lessons from the stock research series to evaluate the top company holdings of the mutual fund.  Each mutual fund will publish the top 10 to 25 companies that make up the largest proportion of the fund's holdings.  Examine those stocks carefully because they should be a good indicator of the types of companies the fund manager likes to own.

Finally, you can check out our article on Mutual Fund Ratings to complete your mutual fund research.  Make sure that you pay attention to the usual caveats concerning past and future performance of these funds.   For example, don't assume that past performance is an indicator of future returns.

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