Advisors - November 18, 2019
How To Find the Best Mutual Funds
When putting together an investment portfolio, whether for yourself or on behalf of a client, fund selection is a pivotal exercise.
Investors buy shares of mutual funds to gain exposure to a large pool of individual stocks, to access a fund manager’s proprietary strategy, and/or to take advantage of the diversification benefits that funds can offer.
But with so many mutual funds on the market (there are more than 11,000 on YCharts alone), how is anyone supposed to pick the best one?
Let’s break down the metrics and details to which every fund investor should pay attention. We’ll also show how YCharts supercharges mutual fund research and saves time along the way.
(Disclaimer: This blog is meant for educational purposes only and is not intended to be used as investment advice.)
The best metrics for evaluating mutual funds
The biggest trap to avoid when selecting a mutual fund, or any security, is chasing returns.
Investors chase returns when they invest in a mutual fund (or stock, or ETF, etc.) because it has large historical returns; however, smart, data-driven investors know that past performance is no indication of future results.
Past performance can certainly be one factor that you evaluate when choosing a mutual fund, but be sure to consider other factors as well.
Before diving into the quantitative aspects, you should consider which mutual fund is best for you by considering your own strategy, investing goals, and risk tolerance.
While some mutual funds invest only in technology companies, others focus on emerging economies. Mutual funds differ not only in their strategies, but also with regard to sectors, geographies, and company sizes. You should first decide what category of fund is right for you, then compare funds within that category.
Once your category of choice is determined, here are six of the most important metrics to look at when evaluating a mutual fund:
- Expense Ratio — how much of a fund’s assets are used for administrative and operating expenses such as fund manager compensation and auditing fees; expense ratio represents these costs as a percentage of the fund’s total assets; lower is better
- Turnover Ratio — the percentage of a fund’s holdings that have been replaced in a given year (or other period); because fund managers pay to execute trades, funds with higher turnover ratios incur greater costs, which are passed on to investors; lower is better
- Total Return — the actual rate of return of an investment over a given period of time; total return includes interest, capital gains, dividends, and distributions over that time period; higher is better
- Alpha — a performance measure that indicates the excess return of an investment against a chosen market index or benchmark; higher is better
- Sharpe Ratio — a measure of the risk-adjusted return for a given investment; Sharpe ratio isolates an investment’s profits associated with risk-taking activities; higher is better
- Max Drawdown — an indicator of downside risk over a specified period of time; max drawdown is the maximum observed loss from a fund’s peak to its trough, before a new peak is reached; lower is better
By identifying and understanding the best metrics for evaluating funds, we are one step closer to finding the best funds to invest in.
The Best Mutual Funds in Every Category
Starting in the YCharts Fund Screener, create a list of funds for each category that you want to explore. You can create, then save lists for multiple fund categories by changing only one filter, “Category Name,” in the Fund Screener. For example, we’re looking into the Intermediate Core-Plus Bond category.
From this view in the Fund Screener, you can quickly pivot to any other mutual fund category simply by changing the category filter we just created, to “Large Cap Growth,” for example.
(Note: YCharts uses Morningstar Categories to separate funds by style of composition and to help investors make meaningful comparisons between funds.)
Now we’ll open our list of Intermediate Core-Plus Bond funds in YCharts’ Comp Tables. To see a table of sortable data for each fund in the category, we’ll add the six key metrics for evaluating mutual funds: expense ratio, turnover ratio, total return, alpha, Sharpe ratio, and max drawdown.
We can now compare funds based on any of the six metrics we added, which is helpful for identifying a funds’ strengths and weaknesses. But why evaluate funds on only one metric when you could combine them all to make a single, data-driven score that will streamline your investment decisions?
Below, we use a YCharts feature called Scoring Models to choose the metrics we find valuable and the percent-weight we want to apply to each factor. Scoring Models will combine the key metrics at our assigned weights to arrive at a single numerical score, with 1 being the best-ranking option, for each mutual fund in our list.
In the Scoring Model shown above, Total Return is weighted 30%, while Expense Ratio and Sharpe Ratio are both weighted 20%. While this example strategy emphasizes these three metrics, your own strategy might put more weight on other metrics like Alpha or Max Drawdown.
If you know the metrics you want to use, but aren’t sure which are more important, you can always equally weight every metric in your Scoring Model.
We now know which Intermediate Core-Plus Bond funds are the best fits for our strategy. After looking through the list and scores, we can visually compare some of those top results using Fundamental Charts.
A few of the top results from our Scoring Model were:
The chart below compares our top mutual funds on total return and standard deviation. We can see that the Principal fund has the lowest total return, 12.99%, over the last three years. PICNX’s annualized standard deviation has been consistently trending lower and is currently 2.48%, the lowest of the three funds.
If your investment strategy tries to balance high returns with minimal drawdowns, Principal’s PICNX might be the fund for you. If you’re strategy emphasizes other metrics, Fundamental Charts can plot historical values for more than 4,000 stock and fund metrics.
Getting Started with Data-Driven Research
There’s a lot more to picking the best mutual funds than just looking at historical returns.
That’s why it’s vital for mutual fund investors to take a data-driven approach that evaluates investment options using the key metrics we outlined above.
Additionally, investors should make sure that a fund’s category, objective, and holdings align with their investment objectives. For example, investors with a very high risk appetite might prefer to evaluate growth equity funds instead of the bond funds outlined in this post. (Don’t worry, you can still do that in YCharts!)
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