How to Analyze a Fund or ETF

Posted by Alex Frey (@alexhfrey )

You're just starting to get into investing now and have some old "legacy" mutual funds sitting in your account from way back when. What should you do with them?

Your mother calls and asks you whether she should keep the mutual fund that she owns or not. What do you tell her?

To answer both these questions you need to be able to perform a quick analysis of a mutual fund or ETF.

Rather than theorizing about how to accomplish this too much, I am going to take you through the exact mental checklist that I use to analyze a mutual fund or ETF today. I will walk the nine steps using the T. Rowe Price New Era fund as an example. If you are new to investing, this may seem like a long process, but I can now go through it all in a couple minutes or less (most of it subconsciously).

1) What does the fund invest in? Most funds have a mandate to invest in a particular kind of asset. This might be to purchase small-cap US stocks, Asian real estate companies, US Treasury bonds, or even global technology companies. Your first job is figure out what the fund you are analyzing invests in. The name of the fund is usually a pretty good indicator here, but if that fails check the description provided by the fund company. For instance, T. Rowe Price's website says that the objective of the New Era Fund is to "provide long-term capital appreciation by investing primarily in the common stocks of companies that own or develop natural resources and other basic commodities..."

2) Is the fund an asset-allocation fund, a core fund, or a specialty fund? Most funds will fall into one of three broad categories. Asset-allocation funds will own a diversified mix of stocks and bonds that is supposed to be suitable for a particular kind of investor (for instance, a Retirement Date Fund 2040 fund will try to hold a mix suitable for people who plan to retire on or around 2040). What I will call "core funds" will invest broadly in a large asset-class like US Stocks or Treasury bonds. Finally, what I will call specialty funds will invest in a particular region, geography, or type of company (e.g. small-cap companies). The New Era Fund is a specialty fund, since it invests almost exclusively in a particular type of company -- one that produces natural resources. 

3) Given this, is the percentage of the overall portfolio invested in the fund appropriate? If you are following a rational investing approach, you will want to invest most of your money in core funds or appropriate asset allocation funds. Specialty funds might be appropriate for "side bets" or a "play account" that represents a small portion of your overall net worth (in my book I call this a "sandbox"), but they shouldn't be core holdings. Since New Era is a specialty fund, if I had more than about 5% of my net worth invested in it, I would probably want to stop and think about whether this was really a bet that I wanted to be making.

4) Is the fund active or passive? As a rule, funds will either actively select individual stocks or bonds in an effort to do better than the overall market, or they will buy just about every stock in an index in an effort to "match" the market or the part of the market they are tracking. From reading the commentary and objective statement of the New Era fund, it is obvious that it is an actively-managed fund that is attempting to pick stocks that will do better than the overall natural resources sector. If it were a passive fund, its description should have said which index it was tracking. If the fund has "index" in its name, that is also a pretty good tip off that it is a passive fund.

5) What is the fund's expense ratio? The most statistically significant factor in predicting whether a fund will do better or worse than its peers is whether it has a higher or lower expense ratio. Expense ratios are quoted as the percentage of your investment that the fund company will deduct from your account every year. Expense ratios for passively managed funds should be well under .2%, unless the fund invests in emerging markets or some other obscure area that would necessitate somewhat higher costs. The expense ratio for the New Era fund is .68%. This is more expensive than an index fund would be, but about average for an actively-managed fund.

6) What are the explicit costs to buying or selling the fund? If you are analyzing a mutual fund, you will want to know if the fund company charges a "load fee" if you make a purchase. This is a commission that is paid to the person that sold you the fund. You should know exactly what this fee is, if you are paying it. There is usually not a reason to pay one as there are plenty of funds and ETFs that do not charge such loads. The New Era fund, for instance, has no load. Other costs might include a commission that you pay your brokerage account (if you are looking at a mutual fund and you already have an account with that mutual-fund company, this won't apply). To avoid this, you could use a commission-free ETF, if your brokerage offers them (for instance, if you have an account at Vanguard then you can trade that brand of ETFs for free).

7) What are the implicit costs to buying or selling the fund? Whereas explicit costs are direct fees that will be taken out of your investment, implicit costs are costs that you do not see. The largest implicit cost when purchasing an ETF comes from the "bid-ask spread" and is a cost of trading. You might, for instance, be buying an ETF that is worth $24.09 per share, fair value. But in the market right now, the lowest price that someone might be willing to sell you the shares is $24.13. So you will effectively pay a 4 cent per share "implicit cost." To avoid this, you should only invest in funds with adequate market liquidity. You can use the overall net assets in the fund as a proxy for this. Try to fund a fund with many billions in assets as it will generally offer a more liquid market with very small spreads. You can find a direct estimation for the bid-ask spread using the Fidelity ETF tool. Implicit trading costs are less of an issue with mutual funds, because the fund company is mandated by law to issue and redeem shares at fair value. However, this only happens at the end of every trading day, so with a mutual fund the price could change between when you enter the transaction and when it is actually processed.

8) If you already own the fund, are there tax consequences to selling? If you are considering selling a fund that you already own, you should consider whether you have an unrealized capital gain that will be triggered by the sale. This would be the case if the shares have appreciated in price since you purchased them. You may have to pay a tax of up to 20% of the gains.

9) Do the fund's historical performance numbers indicate it has done a good job in fulfilling its mandate? If the fund is actively managed, you will want to look at a five year performance history and compare it to its benchmark (most fund companies should provide this). If it is passive, you can look at how closely it has tracked that benchmark. Looking at New Era's numbers, I see that the fund has fallen behind its peers over the last five years. All else equal, this might make me look for another fund in the category (though chasing performance too much is usually a bad idea).

**KEY OBSERVATION.** Notice that the first four factors did not involve any manager-specific criteria. That is because the most important determinant of a fund's performance is not how smart its manager is. Not even close. Whether a fund manager is any good at selecting investments matters a lot less than what the pool of investments he is selecting from is. In other words, asset allocation trumps all.

To put this differently, it is not a good idea to just try to buy a "good" mutual fund. First it is not exactly clear what a "good" fund even is. But more importantly, it is much more important to set your asset allocation first, and then find relatively low expense funds within the appropriate categories to implement it.


Get our next article delivered to your inbox.

Sign up below and be the first to know about our freshest data-driven thinking on the markets, and investing. We will send you no more than one email a week. This is free.

Ready to start putting this into action?

Take a free two-week trial to IvyVest premium -- our premium subscription service. You'll get access to our rules-based dynamic asset allocation model, tools that will show you exactly what you need to buy in your own discount brokerage account (and when to re-balance) to implement it for yourself, and an insightful monthly newsletter that will keep you on abreast of the most important things going on in the markets. There is no credit card required. Get Started Now!


By Alex Frey