Part Two
Five Questions to Ask before Buying a Fund
You may feel intimidated by the task of picking a mutual fund. With more than 10,000 funds to choose from, it's tempting to buy a magazine or visit a Web site that will tell you exactly which funds you should buy. Or to just pick the fund that's topping the performance charts. Or to throw darts at a list of funds that earn 5-star ratings from Morningstar. Obviously, these aren't the best ways to find the fund that will meet your goals or your investment personality. But after making your way through the Funds 200 Level of our Interactive Classroom, you'll know just what to do. You'll learn how to answer the five questions you should ask before buying a stock fund.
How has it performed?
How risky has it been?
What does it own?
Who runs it?
What does it cost? These questions form the foundation of Morningstar's approach to fund selection. We'll address these questions in-depth in subsequent sessions, but here's a taste of what's to come.
How Has It Performed?
Many would say that a fund that produced returns of 22% per year for the past five years performed better than a fund that returned 20% per year over the same period. That's sometimes the case, but not always. The fund that gained 20% may have beaten competing funds that follow the same investment style by six percentage points, while the 22% gainer may have lagged its competitors by a mile. To really know how well a fund is doing, you can't look at returns in isolation; instead, put a fund's returns into context. Compare the fund's returns to appropriate benchmarks--to indexes and to other funds that invest in the same types of securities. (We'll expand on this question in our next course.)
How Risky Has It Been?
The very act of investing involves an element of risk. But some funds are more volatile than others. Generally, the greater the return of an investment, the greater the risk--and therefore the greater potential for loss. Investors who take on a lot of risk expect a greater return from their investments, but they don't always get it. Other investors are willing to give up the potential for large gains in return for a less bumpy ride. Consider a fund's volatility in conjunction with the returns it produces. Two funds with equal returns might not be equally attractive investments; one could be far more volatile than the other. (There are a number of ways to measure how volatile a fund is. We'll cover four risk measurements that appear on our Quicktake Reports--standard deviation, beta, Morningstar risk ratings, and Morningstar bear market rankings--in Mutual Funds 203 and Mutual Funds 204.)
What Does It Own?
To set realistic expectations for what a fund can do for you, it's important to know what types of securities a fund's manager buys. You shouldn't expect a bond fund to gain 10% per year, but that's not an unrealistic expectation for a stock fund. Don't rely on a fund's name to tell you what it owns. Fidelity Magellan FMAGX is a giant in the fund industry, but does the fund's name give you any idea of the types of securities its manager buys? As we mentioned in our first session, fund managers can buy just stocks, just bonds, or a mix of the two. They can stick with
Who Runs It?
Mutual funds are only as good as the people behind them: the fund managers who make the investments. Because the fund manager is the person most responsible for a fund's performance, knowing who's calling the shots--as well as how long he or she has been doing it--is essential to smart mutual fund picking. Make sure that the manager who built the majority of the fund's record is still the one in charge. Otherwise, you may be in for an unpleasant surprise. (We'll talk more about why fund managers matter in Mutual Funds 209.)
What Does It Cost?
As we pointed out in Mutual Funds 107, mutual funds aren't free. You should pay for professional money management, but paying enormous expenses to invest is like giving money away. That's because every penny that you give to fund management or to brokerage commissions is a penny you take away from your own return. Further, costs are one of the few constants in investing: They'll remain pretty stable year in and year out while the returns of stocks and bonds will fluctuate. You can't control the whims of the market, but you can control how much you pay for your mutual funds. Unfortunately, fund costs are somewhat invisible, buried in shareholder reports and taken right off the top of your return. We provide a detailed breakdown of a fund's costs on our Quicktake Reports. Remember that you may sometimes make money in your mutual funds, but you'll always pay fees.
How to Benchmark Fund Returns
"How much do you bench?" That's a familiar question to any weightlifters out there. The maximum weight that you can lift is often regarded as the definitive statement of your strength. Yet what actually constitutes a "good" bench press depends on the person: A 5'5" man who can bench-press 175 pounds may have a superior strength-to-bodyweight ratio compared with a 6'2" man who can bench-press 250 pounds. The same relativity holds true when examining a fund's performance. What constitutes a "good" return depends on your needs and the type of funds you're investigating. That's where benchmarks become useful.
Your Personal Benchmark
Start with your personal benchmark. In fitness terms, that might mean getting strong enough to carry your three-year-old around town without getting winded or building endurance to climb
Indexes as Benchmarks
The most common type of performance benchmark is an index--a preselected group of securities. But there's no consensus on the single best index to use. The Dow Jones Industrial Average (DJIA) may be the index that heads the stock market report on the evening news, but nobody actually uses it as a performance benchmark for stock mutual funds. Why not? Because it's so narrow: It includes just 30 large-company stocks, which means it isn't all that indicative of the breadth of the overall stock market. The index you'll hear about most often in fund circles is the Standard & Poor's 500 index, which includes 500 major
Peer Groups as Benchmarks
The second type of benchmark you can use is peer groups, or funds that buy the same types of securities as your fund. Compare funds that buy large, undervalued companies with other large-value funds. Or compare those that buy only
Our Approach
When evaluating funds, select several benchmarks. Begin with your personal benchmark, and be sure that any investment you're considering can match your needs. Then compare funds to a widely accepted index, such as the S&P 500, to get a sense of performance on the broadest level. Finally, look to peer-group benchmarks to see if the fund is good at what it does.
Looking at Historical Risk, Part 1
Motorcycle daredevil Evel Knievel enjoys chatting about his record-setting jumps over lines of cars, buses, and other assorted stuff. That's more fun than recalling the time he crashed while jumping across the fountains at Caesar's Palace and broke so many bones, he stopped counting. Investors are just like Evel Knievel: They would much rather talk about the returns their funds generated than the risks they took to achieve those returns. Take Janus Venture JAVTX. No doubt shareholders bragged about their spectacular 141% return in 1999. What they probably didn't reveal to friends and colleagues was that the fund lost 46% during in 2000. Tremendous gains are won only through tremendous risk taking, which often means tremendous ups and downs in short-term returns. That's called volatility. While no single risk measure can predict with 100% accuracy how volatile a fund will be in the future, studies have shown that past risk is a pretty good indicator of future risk. In other words, if a fund has been volatile in the past, it's likely to be volatile in the future. In this session, we'll tackle two common yardsticks for measuring a mutual fund's risk: standard deviation and beta. Both of these measures appear on the Morningstar Fund Report.
Standard Deviation
Standard deviation is probably used more than any other measure to gauge a fund's risk. Standard deviation simply quantifies how much a series of numbers, such as fund returns, varies around their mean, or average. Investors like using standard deviation because it provides a precise measure of how varied a fund's returns have been over a particular time period. With this information, you can judge the range of returns your fund is likely to generate in the future. Morningstar calculates standard deviations for the most recent 36 months of a fund's life. The more a fund's returns fluctuate from month to month, the greater its standard deviation. For instance, a mutual fund that gained 1% each and every month over the past 36 months would have a standard deviation of zero, because its monthly returns didn't change from one month to the next. Meanwhile, a fund that gained 5% one month, 25% the next, and -7% the next would have a much higher standard deviation; its returns have been more varied. But here's where it gets tricky: A mutual fund that lost 1% each and every month would also have a standard deviation of zero. Why? Because, again, its returns didn't vary. Standard deviation is a way of putting a fund's performance swings into a single number. For most funds, future monthly returns will fall within one standard deviation of its average return 68% of the time and within two standard deviations 95% of the time. Let's translate. Say a fund has a standard deviation of 4% and an average return of 10% per year. Most of the time (or, more precisely, 68% of the time), the fund's future returns will range between 6% and 14%--or its 10% average plus or minus its 4% standard deviation. Almost all of the time (95% of the time), its returns will fall between 2% and 18%, or within two standard deviations. Using standard deviation as a measure of risk can have its drawbacks. For starters, it's possible to own a fund with a low standard deviation and still lose money. In reality, that's rare. Funds with modest standard deviations tend to lose less money over short time frames than those with high standard deviations. For example, the range of standard deviations among ultra-short-term bond funds, which are undoubtedly the lowest-risk funds around, is a mere 0.1% to 1.3%, with an average of 0.7%. The bigger flaw with standard deviation is that it isn't intuitive. Sure, a standard deviation of 7% is obviously higher than a standard deviation of 5%, but are those high or low figures? Because a fund's standard deviation is not a relative measure--which means it's not compared to other funds or to a benchmark--it is not very useful to you without some context. So it's up to you to find an appropriate context for standard deviations. We suggest you start by looking at similar funds, those in the same category as the fund you're examining. In May 2002, for example, the average mid-cap growth fund carried a standard deviation of 36%, while the typical large-value fund's standard deviation was 17.5%. You can also compare a fund's standard deviation with a relevant index. The S&P 500, a common benchmark for large-cap funds, for example, had a standard deviation of 21.3%.
Beta
Beta, meanwhile, is a relative risk measurement, because it depicts a fund's volatility against a benchmark. Morningstar calculates betas for stock funds using the S&P 500 index as the benchmark. We also calculate betas using what we call a fund's best-fit index, or the benchmark the fund behaves the most like. For bond funds, we use the Lehman Brothers Aggregate Bond index and best-fit indexes. Beta is fairly easy to interpret. The higher a fund's beta, the more volatile it is relative to its benchmark. A beta that is greater than 1.0 means that the fund is more volatile than the benchmark index. A beta of less than 1.0 means that the fund is less volatile than the index. In theory, if the market goes up 10%, a fund with a beta of 1.0 should go up 10%; if the market drops 10%, the fund should drop by an equal amount. A fund with a beta of 1.1 would be expected to gain 11% if the market rises by 10%, while a 10% drop in the market should result in an 11% drop by the fund. Conversely, a fund with a beta of 0.9 should return 9% when the market went up 10%, but it should lose only 9% when the market dropped by 10%. The biggest drawback of beta is that it's really only useful when calculated against a relevant benchmark. If a fund is being compared to an inappropriate benchmark, its beta is meaningless. When considering the beta of any fund, you should examine another statistic: R-squared, which you can find on a fund's Quicktake Report. The lower the R-squared, the less reliable beta is as a measure of the fund's volatility. The closer to 100 the R-squared is, the more meaningful the beta is. Gold funds, for example, have an average R-squared of just 3 with the S&P 500, indicating that their betas relative to the S&P 500 are pretty useless as risk measures. Unless a fund's R-squared against the index is 75 or higher, disregard the beta.
Looking at Historical Risk, Part 2
Until now, we've focused on risk measurements that you can find on most Web sites or print publications. In this lesson, we'll discuss some only-from-Morningstar yardsticks you can use to get a handle on a fund's risk.
Why does Morningstar offer its own risk statistics when standard deviation and beta already exist as reliable statistics? Those figures give you an idea of how risky a fund is on an absolute level and as compared to an index. But as we pointed out in our last session, no single risk measurement can give you a full idea of a fund's volatility. If you approach risk from various angles--as Morningstar's measures do--you can get a much better picture of how a fund should behave.
You can find all of these measures on the Morningstar Fund Report.
Morningstar Risk
Morningstar Risk describes the variation in a fund's month-to-month return, with an emphasis on downward variation. But unlike standard deviation, which treats upside and downside variability equally, Morningstar risk places greater emphasis on downward variation.
The theoretical foundation for Morningstar risk-adjusted returns is relatively straightforward: The typical investor is risk averse. Morningstar adjusts for risk by calculating a risk penalty for each fund based on that risk aversion. The risk penalty is the difference between a fund's raw return and its risk-adjusted return based on "expected utility theory," a commonly used method of economic analysis. Although the math is complex, the assumption is that investors prefer higher returns to lower returns, and--more importantly--prefer a more certain outcome to a less certain outcome. In other words, investors are willing to forego a small portion of a fund's expected return in exchange for greater certainty. Essentially, the utility function states that investors are more concerned about a probable loss than an unexpectedly high gain.
Like beta, Morningstar risk is a relative measure. It compares the risk of funds in each Morningstar category. For example, a fund in the large-cap growth category is compared only with other funds in the same category. Likewise, a municipal-national short-term fund is compared only with offerings in the same category. This apples-to-apples comparison allows investors to evaluate the historical risk of funds that are likely to be considered for the same role in a broader portfolio.
Within each category, we rank each fund's risk penalty--the difference between raw and risk-adjusted returns--from highest to lowest. Intuitively, a fund with greater variation in month-to-month return would be assessed a larger penalty than a fund with lesser variation. The level of risk is assigned based on the ranking for funds in the category: The top 10% of funds are High risk, the next 22.5% are Above Average risk, the middle 35% are Average risk, the next 22.5% are Below Average risk, and the bottom 10% are Low risk.
When using Morningstar risk, remember that it is relative. You can't compare Morningstar risk of funds from different categories, as you can their standard deviations. For example, an intermediate-term bond fund with High Morningstar risk may be more volatile than other intermediate-term bond funds, but it could be--and, due to the nature of stock funds, probably is--less risky than a small-cap value fund with Below Average Morningstar risk.
Bear-Market Rankings
Bear-market rankings compare how funds have held up during market downturns over the past five years. This measure is unlike the others presented thus far, because it examines performance only during the times in which investors may face the largest potential for losses—during downturns, or corrections, in the market.
A bear market is officially defined as a sustained market correction, but for the purpose of these rankings, Morningstar identifies "bear-market months" that have occurred in the past five years. For stock funds, we consider any month in which the S&P 500 index lost more than 3% to be a bear-market month. For bond funds, we count any month in which the Lehman Brother Aggregate Bond Index lost more than 1%.
To generate our current bear-market rankings, we simply total each fund's performance during bear-market months and separate them into 10 groups. Funds with ranks of 1 or 2 withstood bear-market months better than those with ranks of nine or 10. If a stock fund receives a rank of 10, its performance during the bear-market months was among the bottom 10% of all stock funds. A bear-market rank of 1 indicates that a fund ranked among the top 10% of all stock funds during these bear-market months. These scores can help predict which funds will hold up well should the market undergo another correction.
Bear-market rankings have two major drawbacks. First, these measures let you know how a fund performed only during certain time periods. Although it's helpful to know how your fund performed during these market downturns, it could certainly lose money--lots of it--during a market upturn. Gold funds, for instance, often earn decent bear-market ranks, but they lose money at other times and are not considered low-risk investments.
The second drawback to bear-market rankings is that not all bear markets are the same. The next market correction may be caused by different economic forces than those that led to the previous one. Hence, funds that held up well in one bear market may not do so well in the next. Conversely, funds that were pummeled the last time around might shine in the next bear market.
All of the risk measurements we've discussed are based solely on past performance. By definition, they fail to account for any potential future risks a fund might harbor. For example, a fund that used to own mostly low-key large-company stocks may now be heavily invested in smaller companies, and therefore it may be taking on more risk than its historical measures show. Given this limitation, remember that statistical risk measures are a good way to begin understanding a fund's risk, but they’re not guarantees of safety. (We'll show you how to examine a fund's portfolio for hidden risks in later courses.)
Gauging Risk and Return Together, Part 1
Up until now, we've focused on yardsticks that tell you either how good or how volatile a fund's returns have been. But we shouldn't neglect the measures that treat performance and risk together: risk-adjusted performance measures. We'll cover two of the more-common yardsticks, alpha and the Sharpe ratio, in this session. You can find both of these figures on the Morningstar Fund Report.
Alpha Defined
In a nutshell, alpha is the difference between a fund's expected returns based on its beta and its actual returns. Alpha is sometimes called the value that a portfolio manager adds to the performance. If a fund returns more than what you'd expect given its beta, it has a positive alpha. If a fund returns less than its beta predicts, it has a negative alpha. As you'll recall from our first session on risk, beta tells you how much you can expect a fund's returns to move up or down given a movement of its benchmark. For example, if the ABC Fund has a beta of 1.1 in comparison with the S&P 500 and the S&P 500 returns 30% for the year, you would expect ABC Fund to return 33%. (30% x 1.1 = 33%.) Since mutual funds don't necessarily produce the returns predicted by their betas, alpha can be helpful to investors. To calculate a fund's alpha, first subtract the return of the 90-day Treasury bill from the fund's raw return (the idea being that the return of a mutual fund should, at the very least, exceed that of a risk-free investment). That gives you a fund's excess return. From that, subtract the fund's expected return based on its beta. What's left over is the alpha. Because a fund's return and its risk both contribute to its alpha, two funds with the same returns could have different alphas. Further, if a fund has a high beta, it's quite possible for it to have a negative alpha. That's because the higher a fund's risk level (beta), the greater the returns it must generate in order to produce a high alpha. Just as a teacher would expect his or her students in an advanced class to work at a higher level than those in a less-advanced class, investors expect more from their higher-risk investments.
How to Use Alpha
It seems to follow, then, that you would want to find high-alpha funds. After all, these are funds that are delivering returns higher than they should be, given the amount of risk they assume. But alpha has its quirks. For starters, because alpha measures performance relative to beta, any drawbacks that apply to beta also apply to alpha. If a fund's beta isn't meaningful because its R-squared is too low (below 75), its alpha isn't valid, either. Secondly, alpha fails to distinguish between underperformance caused by incompetence and underperformance caused by fees. For example, because managers of index funds don't select stocks, they don't add or subtract much value. Thus, in theory, index funds should carry alphas of zero. Yet many index funds have negative alphas. Here, alpha merely reflects the drag of the fund's expenses. Finally, it's impossible to judge whether alpha reflects managerial skill or just plain old luck. Is that high-alpha manager a genius, or did he just stumble upon a few hot stocks? If it's the latter, a positive alpha today may turn into a negative alpha tomorrow.
Sharpe Ratio Defined
The Sharpe ratio uses standard deviation to measure a fund's risk-adjusted returns. The higher a fund's Sharpe ratio, the better a fund's returns have been relative to the risk it has taken on. Because it uses standard deviation, the Sharpe ratio can be used to compare risk-adjusted returns across all fund categories. Developed by its namesake, Nobel Laureate William Sharpe, this measure quantifies a fund's return in excess of a guaranteed investment (the 90-day Treasury bill) relative to its standard deviation. To calculate a fund's Sharpe ratio, first subtract the return of the 90-day Treasury bill from the fund's returns, then divide that figure by the fund's standard deviation. If a fund produced a return of 25% with a standard deviation of 10 and the T-bill returned 5%, the fund's Sharpe ratio would be 2.0: (25 - 5)/10. The higher a fund's Sharpe ratio, the better its returns have been relative to the amount of investment risk it has taken. For example, both Monterey PIA Equity MNTEX and AXA Rosenberg U.S. Small Capitalization Fund BRSCX had 3-year returns of 8.5% through August 2002. But Monterey PIA Equity had a Sharpe ratio of 0.12 compared with AXA Rosenberg U.S. Small Cap's 0.23, indicating that AXA Rosenberg took on less risk to achieve the same return. The higher a fund's standard deviation, the larger the denominator of the Sharpe ratio equation; therefore, the fund needs to generate high returns to earn a high Sharpe ratio. Conversely, funds with modest standard deviations can carry high Sharpe ratios if they generate good returns.
How to Use the Sharpe Ratio
The Sharpe ratio has a real advantage over alpha. Remember that standard deviation measures the volatility of a fund's return in absolute terms, not relative to an index (as alpha does). So whereas a fund's R-squared must be high for alpha to be meaningful, Sharpe ratios are meaningful all the time. Moreover, it's easier to compare funds of all types using standard-deviation-based Sharpe ratio than with beta-based alpha. Unlike beta--which is usually calculated using different benchmarks for stock and bond funds--standard deviation is calculated the exact same way for any type of fund, be it stock or bond. We can therefore use the Sharpe ratio to compare the risk-adjusted returns of stock funds with those of bond funds. As with alpha, the main drawback of the Sharpe ratio is that it is expressed as a raw number. Of course, the higher the Sharpe ratio the better. But given no other information, you can't tell whether a Sharpe ratio of 1.5 is good or bad. Only when you compare one fund's Sharpe ratio with that of another fund (or group of funds) do you get a feel for its risk-adjusted return relative to other funds.
Gauging Risk and Return Together, Part 2
Our last session focused on two common measures of risk-adjusted performance: alpha and the Sharpe ratio. But as we pointed out, both of those figures need a context to be useful. Who can say whether an alpha of 0.7 is good? Or whether a Sharpe ratio of 1.3 is good?
That's where Morningstar's proprietary fund rating comes in. Unlike alpha and the Sharpe ratio, the Morningstar Rating for funds puts data into context, making it more intuitive. You can find the Morningstar Rating, also commonly known as the star rating, on the Morningstar Fund Report.
What is the Star Rating?
Let's clear the air immediately: The star rating is a purely mathematical measure that shows how well a fund's past returns have compensated shareholders for the amount of risk it has taken on. Morningstar fund analysts don't assign star ratings and have no subjective input into the ratings. Morningstar doesn't subtract stars we don't like a fund or add stars when we do.
The Morningstar Rating is a measure of a fund's risk-adjusted return, relative to similar funds. Funds are rated from 1 to 5 stars, with the best performers receiving 5 stars and the worst performers receiving a single star.
Morningstar adjusts for risk by calculating a risk penalty for each fund based on "expected utility theory," a commonly used method of economic analysis. Although the math is complex, the basic concept is relatively straightforward. It assumes that investors are more concerned about a possible poor outcome than an unexpectedly good outcome; and those investors are willing to give up a small portion of an investment's expected return in exchange for greater certainty.
Consider a simple example--a fund expected to return 10% each year. Though investors are likely to receive 10%, past variations in the fund's return suggest there's a chance they might end up with anywhere from 5% to 15%. While receiving more than 10% would be a pleasant surprise, most investors are likely to worry more about the downside--receiving less than 10%. Hence, they'd probably be willing to settle for a slightly lower return—say 9%--if they could be reasonably certain they'd receive that amount. On the other hand, if a fund expected to return 10% each year, but variations in its past returns suggested a narrower 8% to 12% range, investors wouldn't want to forego as much of the expected return in exchange for increased certainty.
This concept is the basis for how Morningstar adjusts for risk. A "risk penalty" is subtracted from each fund's total return, based on the variation in its month-to-month return during the rating period, with an emphasis on downward variation. The greater the variation, the larger the penalty. If two funds have the exact same return, the one with more variation in its return is given the larger risk penalty. Funds are ranked within their categories according to their risk-adjusted return (after accounting for all sales charges and expenses), and stars are assigned such that the distribution reflects a classic bell-shaped curve with the largest section in the center. The 10% of funds in each category with the highest risk-adjusted return receive 5 stars, the next 22.5% receive 4 stars, the middle 35% receive 3 stars, the next 22.5% receive 2 stars, and the bottom 10% receive 1 star.
For multi-share-class funds, each share class is rated separately and counted as a fraction of a fund within this scale, which may cause slight variations in the distribution percentages. This accounting prevents a single portfolio in a smaller category from dominating any portion of the rating scale.
Funds are rated for up to three periods--the trailing three, five, and 10 years--and ratings are recalculated each month. Funds with less than three years of performance history are not rated. For funds with only three years of performance history, their three-year star ratings will be the same as their overall star ratings. For funds with five-year records, their overall rating will be weighted as 60% for its five-year rating and 40% for its three-year rating. For funds with more than a decade of performance, the overall rating will be weighted as 50% for the 10-year rating, 30% for the five-year rating, and 20% for the three-year rating.
If a fund changes Morningstar categories during the evaluation period, its historical performance for the longer time periods is given less weight, based on the magnitude of the change. (For example, a change from a small-cap category to large-cap category is considered more significant than a change from mid-cap to large-cap.) Doing so ensures the fairest comparisons and minimizes any incentive for fund companies to change a fund's style in an attempt to receive a better rating by shifting to another Morningstar category.
Caveats
Like all backward-looking measures, the star rating has limitations. It is critical to remember that the rating is not a forward-looking, forecasting tool. The rating won't predict short-term winners. The star rating is best used as an initial screen to identify funds worthy of further research--those that have performed well on a risk-adjusted basis relative to their peers.
The star rating is a strictly quantitative measure--a high rating doesn't imply the approval or endorsement of a fund by a Morningstar analyst. Additionally, if a management change occurs, the ratings stay with the fund, not with the portfolio manager. Therefore, a fund's rating might be based almost entirely on the success of a manager who is no longer with the fund.
Also, because funds are rated within their respective categories, it's important to note that not all 5-star funds are equal or even interchangeable. A 5-star sector fund, for example, might have the best risk-adjusted return within its specific category, but it's probably far riskier than a highly rated diversified fund.
Rather than buying funds based on their ratings, investors should first decide on an overall portfolio strategy and then seek the best funds for each portion of their portfolio.
Examining a Stock Fund's Portfolio, Part 1
Most of us wouldn't buy a new home just because it looked good from the outside. We would do a thorough walk-through first. We'd examine the furnace. We'd check for a leaky roof. We'd look for cracks in the foundation.
Mutual fund investing requires the same careful investigation. You need to do more than give a fund a surface-level once-over before investing in it. Knowing that the fund has been a good risk-adjusted performer in the past isn't enough to warrant financial risk. You need to understand what's inside its portfolio today--or how it invests.
Such information, which tells you how your fund will behave, helps you set realistic expectations for your investment. A fund manager who quickly buys and sells a compact portfolio of high-priced, fast-growing companies will produce different results from a manager who owns 300 stocks of larger companies with lower earnings but cheap prices. Further, unless you know what a fund owns, you can't determine what role the fund fills in your portfolio. For a fund to fill the large-cap growth portion of your portfolio, you need to know that it actually invests in large-growth companies. Finally, examining a fund's portfolio can tip you off to risks the fund may be harboring--risks that might not have surfaced yet.
For
The Style Box Defined
The Morningstar style box is a nine-square grid that gives you a quick and clear picture of a fund's investment style. The style box classifies funds by whether they own large-, mid-, or small-capitalization stocks, and by whether those stocks have growth or value characteristics or land somewhere in between.
We'll look first at the stock size and growth and value dimensions, then see how they come together in the style box.
Company Size. Every month, Morningstar classifies all stocks in its database according to their market capitalizations, or the total market value of all outstanding stock shares. Take supermarket chain Winn-Dixie Stores WIN. Its 143.1 million shares go for $18.17 apiece (as of
Of course, we also want to know how Winn-Dixie's size stacks up against other companies. Does a market capitalization of $2.6 billion mean that Winn-Dixie is big? Small? In between? To find out, Morningstar ranks all U.S. stocks by their market capitalizations each month, classifying the companies that make up the top 72% of the domestic U.S. market as large capitalization ("large cap") stocks, the next 18% as mid-cap, and the smallest 10% as small-cap. As of April 2002, stocks with market caps of more than $8.85 billion are considered large cap; companies with market caps between $1.56 billion and $8.85 billion are considered mid cap; anything less than $1.56 billion is classified as small cap. That makes Winn-Dixie a mid-cap stock.
Growth and Value Metrics. Morningstar determines a fund's style--whether it invests in "growth" or "value" stocks--by applying a set of five growth metrics and a set of five value metrics to each individual stock the fund holds. These characteristics are compared with other stocks within the same capitalization band and are scored from zero to 100 for both value and growth.
We begin measuring the "value" aspects of a stock by comparing the price of one share of a stock to the company's projected earnings per share. Divide Winn-Dixie's $18.50 stock price by its projected earnings per share for next year of $1.08 and you get a forward price-to-earnings (P/E) of 18. In other words, investors are paying $18 for every $1 in earnings that Winn-Dixie generates. This metric is ranked against other stocks, and the result makes up 50% of Winn Dixie's value score.
The other 50% of the value score comes from four equally weighted historical measures: price-to-sales (P/S), price-to-book (P/B), price-to-cash flow (P/C), and dividend yield. We rank these measures against other stocks in the mid-cap range and their combined rankings go into Winn-Dixie's value score.
The growth score similarly uses one forward-looking measure and four equally weighted historical metrics. Half of the stock's growth score comes from ranking its long-term projected earnings growth rate against stocks in the same capitalization band. Winn Dixie's 6.75% projected growth rate ranks above average (it's in the 65th percentile, with 100 being the highest) among its peers. Next, we rank Winn
We calculate a stock's style score by subtracting its value score from its growth score, resulting in scores that can range from -100 to 100. A stock with a style score of -100 would be a high-yielding, low-growth stock, while one with a score of 100 would have no yield and very high historical and projected growth rates. We classify stocks in the middle as "core" stocks. The dividing lines between value, core, and growth can vary over time with changes in the market, but on average each style will include approximately one third of all stocks in each market-cap range.
Tackling the Funds. Once we have analyzed the stocks, figuring out where a fund's portfolio lands in the style box is easy. First, we calculate the geometric mean of all of the stocks a fund owns. This means that we don't just calculate a straight average of the member stocks' market caps. Instead, the calculation takes the market cap of each stock and the portion of the portfolio that it makes up into account to come up with a number that best represents how the portfolio as a whole is positioned.
We then compare that market cap average with the stocks in Morningstar's domestic stock universe, which accounts for 99% of actively traded stocks in the
To determine the overall style score for a fund, we take the style score for each stock in the portfolio and determine the average weighted score for the portfolio in aggregate. The resulting number can range from 100 (for a fund with nothing but low-yield, extremely growth-oriented stocks) to -100 (a fund emphasizing high-yield, low-growth stocks). A portfolio is classified as growth if the net score equals or exceeds the "growth threshold" (normally about 25 for large-cap stocks). It is deemed value if its score equals or falls below the "value threshold " (normally about –15 for large-cap stocks). And if the score lies between the two thresholds, the portfolio is classified as "blend." (Morningstar classifies individual stocks landing between value and growth as "core.")
Just as with individual stocks, the thresholds between value, blend, and growth funds vary to some degree over time, as the distribution of stock styles changes in the market. However, on average, the three stock styles each account for approximately one-third of each market-cap range.
Putting the Morningstar Style Box to Work
When you look at a fund's Morningstar style box, you immediately get some insight into the manager's investment strategy. A growth portfolio will mostly contain higher-priced companies that the manager believes have the potential to increase earnings faster than the rest of the market. A value orientation, on the other hand, means the manager buys stocks that are cheap, but that could eventually see their worth recognized by the market. A blend fund will mix the two philosophies: The portfolio may contain growth stocks and value stocks, or it may contain stocks that exhibit both characteristics.
Because the style box shows you how a fund actually invests, you can use it to get an idea of what sort of risks the fund harbors today. A fund that owns smaller, more expensive stocks is bound to be more volatile than one holding large, cheap names. And the style box allows you to quickly see where a fund's portfolio lands.
Examining a Stock Fund's Portfolio, Part 2
We've described the Morningstar style box as the "snapshot" of a fund's investment style. It's the best place to start if you're trying to uncover how a fund invests. But don't stop there. A handful of other portfolio statistics reveal additional insights into individual funds--information about a fund's risk and return potential that style boxes don't reveal.
Sector Weightings
Both Smith Barney Aggressive Growth SHRAX and Janus Growth & Income JAGIX land in the large-cap growth square of the style box, yet the funds have different Achilles heels. Smith Barney Aggressive Growth had 51% of its assets in health-care stocks in 2002, while Janus Growth & Income had just 9.6% of its assets invested in that part of the market. If health-care stocks had tumbled, which fund do you think would have been worse for the wear? Smith Barney Aggressive Growth, of course. Welcome to one of our favorite portfolio statistics: sector weightings. Stocks fall into one of three "super" sectors--information, service and manufacturing--which are subdivided into four sectors apiece, bringing the total number of sectors to 12. The information supersector includes the software, hardware, media, and telecommunications sectors. In the service supersector, there are the health-care, consumer services, business services, and financial services sectors. And finally, in the manufacturing supersector, there are consumer goods, industrial materials, energy, and utilities. Morningstar calculates a fund's sector exposure based on the amount of money it has in stocks in each sector. By knowing how heavily a fund invests in a given sector, you'll know how vulnerable it is to a downturn in that part of the market or how much sector risk it's taking on.
Median Market Capitalization
Okay, so median market capitalization is included in Morningstar's style box. But you should examine it anyway because there are small-cap funds and there are really small-cap funds. Take Wasatch Core Growth WGROX and Brazos Microcap BJMIX, for example. Both land in the small-cap value portion of the style box. Yet Wasatch's median market cap at the end of August 2002 was over $1 billion, while
Price/Earnings and Price/Book Ratios
Price/earnings and price/book ratios, too, are included in the style box, but they are worthy of separate consideration. Just as there are degrees of market capitalizations (even within divisions), there are degrees of price multiples. TCW Galileo Aggressive Growth TGMCX and Brandywine BRWIX may both be mid-cap growth funds, but the TCW fund's P/E at the end of August 2002 was 46--versus 23.6 for
Number of Holdings
It's important to know whether a fund holds 20 or 200 stocks. You'd expect a fund with fewer stocks to be more volatile than one with hundreds of names on hand. While that isn't always the case, it often is. So just as you need to be aware of funds that place a large portion of their assets in one or two sectors, you need to know if a fund places a large portion of assets in a small number of holdings. For example, Mosaic Midcap GTSGX and Gabelli Asset GABAX are both mid-cap blend funds, yet the former owns just 29 stocks while the latter stockpiles hundreds of names. Mosaic Midcap is taking on more risk--its performance is dependent on the success or failure of a much smaller number of stocks. (We'll discuss concentrated funds, or funds that own a small number of stocks, more in a later session.)
Turnover Rates
A fund's turnover rate loosely represents the percentage of a fund's holdings that have changed over the past year, and it gives an idea of how long a manager holds on to a stock. Fund accountants calculate a fund's turnover ratio by dividing its total sales or purchases (excluding cash), whichever is less, by its average monthly assets for the year. You can translate this math easily: A fund that trades 25% of its portfolio each year holds a stock for four years, on average.
Despite its seeming simplicity, turnover ratio has its quirks. For instance, a dramatic change in the fund's asset base (the turnover ratio's denominator) can give a false impression of a fund's trading activity. If the manager doesn't change her trading pace, a fund's turnover ratio will decline as assets rise. Conversely, a shrinking asset base can inflate a fund's turnover ratio. Furthermore, if a manager sells a chunk of a fund's portfolio to meet redemptions but doesn't purchase any new securities, her turnover ratio would be zero. Why? Because turnover ratio is calculated by using the smaller figure of either total sales or purchases to divide its average monthly assets for the year, and there are no purchases in the example above. Turnover can give you a sense of a manager's trading activity, but don't read too much into a fund's turnover ratio. Buy-and-hold managers will have lower turnover ratios than managers who trade on short-term factors. And most importantly, very high turnover managers tend to practice aggressive strategies. High-turnover funds tend to be more volatile than other funds in their categories.
Why Knowing Your Manager Matters
Under the watch of head coach Lou Holtz, the Fighting Irish of Notre Dame were a college football powerhouse from the late 1980s through the mid-1990s. During his 11-season tenure, Holtz boasted an admirable .765 winning percentage and led the Irish to a national championship in 1988 (and fell just shy of capturing the crown in 1989 and 1993). But my, how things changed when Holtz departed in 1997. His replacement, Bob Davie, never was able to find a groove as the Irish spun to a virtually unheard-of 25 losses during his five- year stint. Fund investors can learn something from the reversing fortunes of the Fighting Irish. Like college football teams, mutual funds are only as good as the people behind them: the fund managers. Managers are the people who decide what to buy and what to sell, and when. Because the fund manager is the person who is most responsible for a fund's performance, knowing who's calling the shots and for how long is a key to smart mutual fund picking.
Different Manager Structures
Before discussing further why managers are important, let's step back and examine the three ways in which funds can be managed. First, there's the single-manager approach. In this setup, there's one person who takes primary responsibility for making the fund's investment decisions. The manager doesn't do all the research, trading, and decision making without help from others, though. Robert Stansky is listed as the sole manager of Fidelity Magellan FMAGX, but Fidelity's analysts feed him plenty of stock ideas. The single manager is sole decision-maker, not the sole idea generator. Then, there's the management team, popularized by families like American Century, Scudder, and Putnam. Here, two or more people work together to choose stocks. The level of one team member's involvement or responsibilities can be tough to gauge, though. Sometimes there's a lead manager who is the final arbiter (as with some Scudder funds), while other times it is more of a democracy (as with Dodge & Cox). Finally, and most rare, is the multiple-manager system. The fund's assets are divided among a number of managers who work independently of each other. American Funds is the biggest fund family using this approach. Multiple managers are more common with subadvised funds, such as Vanguard Windsor II VWNFX, the CDC Nvest funds, and the American Aadvantage group, in which the fund company hires managers from other companies to run the fund.
Why Managers Matter
We think it is always important to know who a fund's manager is, whether the fund is run by one person or a whole team. Equally important is how long the person or team has been running the fund. Make sure that the manager who built the majority of the fund's record is still the one in charge. Otherwise, you may be in for a surprise. Take
Where Managers Matter Most--and Least
So if you're looking for new investments and find two equally good funds, choose the one with the more-experienced manager. But if the manager of a fund you already own jumps ship, it's not always best to sell the fund immediately. First, you may have to pay taxes on your sold shares, if they appreciated, and what you give up in taxes may not be offset by extra future gains in a different fund. Second, the new manager may do just as well as the old. Finally, some types of funds are simply less affected by manager changes than others. Here are some examples: Index Funds. Managers of index funds are not actively choosing stocks, but simply mimicking a benchmark, owning the same stocks in the same proportion. As such, manager changes at index funds are less important than manager changes at actively managed funds. So if Gus Sauter leaves Vanguard 500 Index VFINX, don't sell. Although Sauter has added incremental return to the fund during his tenure--the fund has been the best-performing S&P 500 index fund over the long term--the fund won't become a complete dog if Sauter leaves. Funds in Categories with Modest
- One-manager funds.
- Funds run by very active managers who've proved to be adept stock-pickers or traders.
- Good funds from families that aren't strong overall, or from fund families that lack other strong fund with a similar investment style.
- Funds in such categories as small growth or emerging markets, where the range of possible returns is very wide.
Disregard managers and manager tenures in the instances outlined above, and you might find yourself much worse off than a disappointed sports fan.
Your First Fund's Qualities
Throughout this level, you've learned how to evaluate funds so that you can answer five key questions: how has it performed, how risky has it been, what's in its portfolio, who's running it, and how much does it cost. Those are questions you need to be able to answer whether you're choosing your first or your thirty-first fund. (Yes, some people own that many.) When selecting your first stock fund, though, you need to focus on a few additional, specific things. Why? Because for some of you, your first fund may be your only fund--or your only fund for awhile. Here are the qualities to look for in your first fund.
Seek Diversification
Whether you're investing for a goal that's five or 50 years away, your first stock fund should be well-diversified. That means the fund should hold a large number of stocks (100 or more) from a wide range of industries, or sectors. You can find how many stocks a fund owns as well as which sectors it favors on our Quicktake Reports. What's the big deal about diversification? Funds that own many stocks from many different sectors are generally more stable than funds holding few stocks from only one or two industries. For example, the average technology fund carried a standard deviation of 43.4 in Septemer 2002, while the average large-blend fund's standard deviation was a relatively sedate 17.1. While you may own some of these more-concentrated types of funds at some point in your investment life--say, to rev up your returns or to add some variety to your investments--they aren't suitable first-time investments. (We'll talk more about diversification and when you might focus on concentrated investments in later courses.)
Favor Large Companies
Next, focus on funds that buy stocks of large
Go with a Big Family
When buying your first fund, start with one of the larger fund families. Why? Biggies like Fidelity, Vanguard, and T. Rowe Price rarely have truly awful funds. They just can't afford to--it would hurt their reputations too much. Moreover, the media and investors closely follow these families. As such, a poor fund doesn't stay that way for long. It's unlikely their funds will top the charts year in and year out, but they're generally reliable. Going with one of the bigger families has another benefit: Your first fund may not be your last fund, and the big families offer all different types of funds, ranging from
Good First--and Maybe Only—Funds
At Morningstar, we would like to think that everyone's as jazzed about investing as we are. We would like to think that you, too, would fly across the country to attend investment conferences if you could. Or that you'd bypass the latest Stephen King novel for an investment book. That if forced to choose between "Wall Street Week" and "Friends," you'd choose the former. But we know better. Many investors would rather own just one fund or may only be able to choose one fund today. Adding another is a step for the future. So here's our advice for some good types of first--and perhaps only--funds.
Index Funds
Index funds are pretty simple. You might remember from Mutual Funds 209: Why Knowing Your Manager Matters that index-fund managers aren't picking stocks in the traditional sense. Instead, they are buying the same stocks in the same proportion as an index does. In other words, they don't buy a stock because they like the company's prospects or sell because their outlook is less than rosy. They simply own the index. They are passive investors. Index funds have plenty of benefits. Most importantly, they tend to be low in cost. For example, Vanguard 500 Index's VFINX expense ratio is just 0.18% versus 1.02% for the typical large-blend fund. Because the index-fund managers aren't actively managing their funds--put another way, they aren't making buy and sell decisions but simply doing what the index does--management fees tend to be low. Index funds are also advantageous because they are fairly predictable. First, they tend to return what the index does, minus their expenses. Second, they always own what the index owns, which means they tend to be style specific. For example, if a fund indexes the S&P 500, that means it owns large-blend stocks; it'll own those types of stocks today, tomorrow, and the next day. You know what to expect from an index fund. Funds that aren't indexed, also called actively managed funds, might not own the same types of stocks day in and day out. It all depends on the manager's style. He or she may like large companies one day and then see value in smaller firms the next. Finally, index-fund investors don't have to worry about manager turnover: If the manager leaves, the next manager will likely do just as well, considering that neither was actively picking stocks, but just buying the index. Nor is asset size an issue. Index funds can handle plenty of assets, because they don't use fast-trading strategies, frequently changing their holdings. (We'll cover index funds in-depth in a later session.) If you only plan to own one index fund for awhile, make sure it favors large companies. Some funds, including Vanguard Total Stock Market Index VTSMX, hold stocks of all sizes, though larger companies are most-heavily represented. Such funds would be excellent choices for one-fund owners.
Funds of Funds
Funds of funds are mutual funds that invest in other mutual funds. Come again? Just as a regular mutual fund offers the skills of a professional manager who assembles a portfolio of stocks or other securities, the manager of a fund of funds will select a portfolio of funds. If you have only a small amount to invest each month, a fund of funds allows you access to more funds than you might be able to afford on your own. It also allows investors to avoid the recordkeeping and paperwork that comes with owning an assortment of funds. So what's the catch? Expenses, mostly. The fund of funds' structure creates a double layer of costs. First, there are the expenses associated with running the fund of funds itself--management fees, administrative costs, etc. Then, there are the costs associated with the funds that the fund of funds owns--management fees, administrative costs, etc. So even if a fund of funds reports an expense ratio of just 1%, that's still quite a drag on your return, when you consider that you're also paying the expense ratios on each and every fund that the fund of fund owns. Some fine funds of funds eliminate the double-fee problem. Families such as T. Rowe Price and Vanguard offer funds of funds that invest only in their own funds. The families then waive the cost of the funds of funds--their reported expense ratios are 0%--and you only pay the costs of the underlying funds. Obviously, these funds are a much cheaper option.
Lifecycle Funds
First introduced in the early 1990s, life-cycle funds offer investors pre-mixed doses of stocks, bonds, and cash according to their age and risk tolerance. Most fund families offer life-cycle funds in three formulas--aggressive, moderate, and conservative--that you can cycle through as you progress from a young, aggressive investor to an older, more conservative one. Some life-cycle funds are funds of funds, while others own individual securities outright. All the life-cycle series share the same goal of first growing and then preserving your portfolio, but they vary in their methods. Some track indexes and maintain a more or less static mix of assets. Most life-cycle offerings, however, invest more actively. Even Vanguard, which promotes a passive indexing strategy in its Lifestrategy brochure, invests 25% of each life-cycle portfolio in the actively managed Vanguard Asset Allocation VAAPX.
In the hands of the right manager, such active management can produce good results. But when an active manager concentrates in an asset class at the wrong time, tactical shifts can be deadly. If such market-timing makes you nervous, then a passive index approach might suit you better.
