Mutual Fund Research

The approach to researching mutual funds is similar to that used when selecting stocks.  But since a mutual fund is a pre-packaged portfolio of securities; the process is a little simpler.  The universe of mutual funds is also much smaller than that of common stocks, so there are fewer 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 securities.  Whenever investing in stocks, it's necessary to find eight or more companies to purchase in order to lower the investment's overall risk.  With mutual funds, only a couple of funds are needed to diversify away risk, and satisfy the investor's long-term financial objectives.

Controlling Risk

When buying a single stock, or even a mutual fund, the investor is exposed to market risk.  These are macro-economic factors and / or industry risks such as inflation, interest rates, and overcapacity.  When buying stock of a single company, the investor is also exposed to the risk associated with the company's operating performance.

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; 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, it's possible to lower the risk associated with owning just a single company.  Risk is reduced through the diversification offered by the mutual fund.

Research Strategies

By making some overarching decisions about the investment strategy, researching a mutual fund can be simplified.  For example, while there are many different categories of funds from which to choose, most fall into just three categories:

  • Index Funds:  attempt to mimic an index such as the S&P 500, Dow Jones Industrials or the NASDAQ Composite.
  • Funds Stating an Investment Objective:  offer individuals the opportunity to select from a range of investment objectives.  Funds of this type include aggressive growth, income, value, blend, large cap, mid cap, small cap, and balanced funds.
  • Specialty Funds:  attempt to mimic a specific industry or geography.  This type of fund might include natural resources, commodities, precious metals such as gold, international stocks, and real estate.

Advantages and Disadvantages

It's important to understand the advantages and disadvantages of each of the three fund types listed above.  In the paragraphs below, we're going to briefly discuss each type of fund, then explain how to start the research process.

Index Mutual Funds

One of the big advantages of index mutual funds is the portfolio manager can 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 track 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; the management team is constantly trying to rebalance the portfolio so its holdings remain in the right proportion to the index.  This rebalancing activity drives up trading expenses.

Funds with Specific Objectives

Mutual funds that promise the investor some kind of specific objective can be very useful when it's 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 growth early on and retirement income in the future.

Another group of 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 securities.  This can drive up the fund's expense ratio, and eat into the individual's total return on investment.

Specialty Mutual Funds

Finally, specialty mutual funds 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 the chance to participate in opportunities such as the real estate market or gold with a relatively low cost of entry.

On the downside, specialty mutual funds are exposed to a large amount of industry risk.  Individual stock risk is eliminated by purchasing a mutual fund, but if the technology industry takes a downturn, the investment will suffer too.

Researching Index Mutual Funds

There are only a couple of factors to consider when evaluating an index fund:  mutual fund fees, and the management team.  Since the fund is tracking an index, the management team attempts to assemble a portfolio of stocks that replicate its performance.  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 in line 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 this type of fund.  When comparing index funds from different brokerage houses, the fees should be in the 0.5% range.

It's also important to look at the qualifications of the management team.  All mutual funds will have a prospectus that talks about the fund manager and their background.  Finally, it's a good idea 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 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.

When investing in this type of mutual fund, break down the fund's investment portfolio and take a look at what they are doing in each sector.  In other words, if the fund offers a mix of bonds and stocks, then evaluate the portfolio of stocks and bonds individually.  This is explained further in the following section.

This is perhaps the most complex mutual fund purchase made by investors.  Anyone thinking about purchasing shares in this type of mutual fund should take a look at our series on Buying Mutual Funds.

Researching Specialty Funds

Specialty industries can range from those that invest in tax-free bonds to those focusing on a specific industry, such as gold mutual funds.  When taking this investment approach, the mutual fund is evaluated in a similar fashion to that described in our series on stock research.  Even though that series talks about evaluating a single company, the process can be applied to mutual funds too.

Stock Research Part I explains how to identify exceptional stocks.  The same process would apply to mutual funds.  To summarize the methodology found there:

  • Invest in specialty 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 funds containing stocks with significant brand loyalty.

It may not be possible to find all of these attributes in all of the companies listed in the fund's portfolio, but these attributes should be very common if a fund contains excellent stocks.

Top Holdings

It's also possible to apply the other lessons from the stock research series to evaluate the companies that make up the mutual fund's top holdings.  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, our article on Mutual Fund Ratings also provides insights into the performance of funds.  Pay attention to the usual caveats concerning past and future performance.  For example, don't assume that past performance is an indicator of future returns.


About the Author - Mutual Fund Research (Last Reviewed on June 1, 2016)