Finding the right fund – Part 2

Steve Merrell |

Last week I started a three-part series on finding the right mutual fund. As part of the discussion, I highlighted two important principles. First, just because a fund has produced high returns in the past doesn’t mean it is a good investment. Sometimes a fund manager is lucky and sometimes they are just taking higher risk. Second, if the fund invests in things you cannot understand, it is probably not the fund for you.

As if on cue, Monday’s online edition of the Wall Street Journal carried a prominently placed article under the headline “Bankrupt in Just Two Weeks—Individual Investors Get Burned by Collapse of Complex Securities.” I don’t know how many similar articles I have read over the years, but the story is always the same: Normally intelligent people become mesmerized by abnormally high returns, invest their life savings in things they do not understand and end up losing it all. I encourage you to find a copy of the article and try to learn from the mistakes those investors made.

This week I want to share with you some of the metrics I use when evaluating a fund. Not everything important can be quantified, but learning to look at the numbers is a vital step in evaluating any investment. In fact, the more familiar you are with fund metrics, the more likely you will be to find a fund that truly fits your overall portfolio.

I always begin by looking at portfolio manager tenure. Frequent turnover among portfolio managers is a sign of trouble. You also want to make sure the historical numbers you are evaluating reflect the people managing the fund today. If the longest-serving manager has been with the fund for less than three years, set the fund aside and look for another.

I also look at the fund’s operating expense ratio, or OER. Every fund has operating expenses, including management fees, administrative fees and marketing/distribution fees. If you roll these all together and divide by the fund’s net asset value (NAV), you get the fund’s OER.

It is best to compare a fund’s expense ratio with other funds in its peer group. You can easily do this on the free website. From the home page, enter the fund’s ticker symbol in the search box in the top left of the screen. On the fund’s landing page, click on the price tab. There you will find all sorts of information about the costs of the fund. On the bottom left of the page you will see the fund’s OER compared with the average for its Morningstar category each year for the past five years. It is best to stick with funds that have OERs below their category average.

On that same Morningstar page, you will find information about the possible tax consequences of owning the fund. Morningstar publishes something called the three-year Tax Cost Ratio. The Tax Cost Ratio tries to estimate how much an investor’s returns would have been reduced by taxes on capital gains and dividend distributions each year for the past three years. This isn’t an issue if you own the fund in an IRA or 401k account, but if it is in a taxable account, you need to pay close attention to potential tax effects.

You also need to take a careful look at the fund’s risk/return characteristics. Again, Morningstar can help. Click on Morningstar’s risk tab and you will find all sorts of risk-based metrics. We can evaluate a fund’s risk profile in a number of ways, but I like to look at something called capture ratios. Capture ratios come in two flavors: upside capture and downside capture. A fund’s upside capture ratio measures the fund’s performance in up-markets relative to a benchmark index. A ratio greater than 100 means the fund outperformed during up markets. Likewise, a downside ratio greater than 100 means the fund lost more than the benchmark during down-markets.

An index fund will generally have upside and downside capture ratios of 100. However, some funds capture more up-side than down-side. This is one of the primary benefits of so-called low volatility equity funds. Because they have greater upside capture than downside capture, they can produce market-like returns with less overall volatility. Including funds with this characteristic can help strengthen your overall portfolio by buffering returns in falling markets.


Steven C. Merrell MBA, CFP®, AIF® is a Partner at Monterey Private Wealth, Inc., a Wealth Management Firm in Monterey.   He welcomes questions that you may have concerning investments, taxes, retirement, or estate planning.  Send your questions to: Steve Merrell, 2340 Garden Road Suite 202, Monterey, CA  93940 or email them to