Mutual-fund companies send their customers regular reports composed of marketing blather, regulator-required verbiage and some pearls that you ignore at your peril.
The difficulty facing the typical investor is that the reports contain a lot more noise than signal, said Chris Ryon, a manager of municipal bond portfolios for Santa Fe’s Thornburg Investment Management, a mutual fund company.
“There is a lot of noise because of regulation,” he said. “We have to do certain things to make sure we’re compliant. But there is also some very good information that the retail shareholder can glean very quickly.”
But before you look at any of the material, you should first look at yourself, said Jennifer J. Cole of Cole Financial Consulting in Sandia Park.
You have to understand your financial goals – both short term and long term – and your tolerance for risk, she said. That’s because your examination of mutual-fund reports boils down to making sure the fund is doing what it takes to achieve your goals at acceptable risk.
Thus, the mutual fund’s statement of its goals and risks is a good place to begin your examination of the report.
Vanguard Windsor, for example, one of the biggest and oldest funds, says it is an “aggressive large-capitalization value fund” with a goal “to be ahead of the market, investing in stocks that are temporarily out of favor, but that the fund’s advisers believe will eventually become profitable investments.”
A large capitalization fund invests in the stocks of larger companies. A value fund is one that evaluates the worth of the business that has issued the stock to determine if the share price accurately reflects the value of the company.
The fund managers elaborate on this goal when describing risks associated with an investment in Windsor.
The New Mexico Intermediate Bond Fund that Ryon manages tries to obtain “as high a level of current income exempt from federal and New Mexico state individual income taxes as is consistent, in the view of the fund’s investment adviser, with preservation of capital. A secondary objective is to reduce expected changes in its share price relative to long-term bond portfolios.”
So here are some things to keep in mind when evaluating mutual funds:
Fund managers pursue various investment strategies. Ryon runs what is known as a “laddered fund.” About 5 percent of the fund’s money is invested in bonds of each duration – 5 percent in bonds of one-year maturity, 5 percent in two-year maturities, and so on.
“We do that because we believe that is the best way to run short and intermediate money in a municipal bond fund,” he said.
Other bond-fund managers concentrate their holdings in short-term or long-term bonds. Some buy only high-risk bonds, and some buy only safe government bonds.
Any number of approaches can be good, but the fund you own must suit your own approach or there is no reason to own it, Cole said.
The risks the fund is going to run are also laid out in the report.
The Windsor Fund warns that its approach can lead to “greater short-term volatility because it may take time for the market to recognize a stock’s value. Investors in this fund should have a long-term time horizon and a tolerance for stock-market volatility.”
Ryon said bond funds describe how their managers view things such as credit risk (the chance that a borrower might not pay back the money it owes) and interest-rate risk (the chance that interest-rate fluctuations will affect the value of the fund’s portfolios).
With those strategies and risks in mind, Cole studies the manager’s letter to the fund’s shareholders. There the manager should explain to investors what worked in the past year and what didn’t work.
“Do the reasons for what worked and didn’t work make sense in the context of the long-term objectives of the fund?” Cole said. “If they don’t, that’s a red flag.”
The manager’s letter should describe decisions made in the previous year that are consistent with the risks and strategy the investors were led to expect.
“Is the fund doing what they said they would do?” Cole said. “That, to me, is the most important piece of information I get out of these reports.”
Fund managers make money by charging fees for managing the portfolio. The report tells you what the fees cost you. The question is: Could you get the same performance cheaper from someone else?
You can compare fees for competing funds several ways. Fund evaluation firms like Morningstar and brokerage firms’ online research tools are good places to look.
These numbers tell you how the fund did when compared against its benchmarks. A fund that invests in large-company stocks, for example, will gauge its performance against the Standard & Poor’s 500 index or a similar stock-market measure.
Cole and Ryon both advise caution when looking at performance.
Cole said performance of a fund in any one year isn’t as important as how the fund achieved that performance. A stock fund that does very well when the stock market is soaring may do poorly during a bear market.
So look at five or 10 years of performance to see how well the fund performs in the bad times. It may be that a fund that is less volatile doesn’t perform as well as some other fund in good times. Depending on your investment objectives and your risk tolerance, that may be exactly what you want, Cole said.
Good performance also can blind investors to risks, Ryon said. A fund manager can improve returns through leverage, which means by using borrowed money to purchase investments, he said, but that additional debt has to be paid, adding to the fund’s risk.
Ryon advises you to look at the portfolio’s turnover ratio as well. That is a measure of how much trading the fund’s manager does.
A 100 percent turnover ratio means that every security owned at the beginning of the period covered by the report was sold by the end of the period and replaced with another security.
A lot of turnover can drive up fees, and it can create tax liabilities for the fund’s investors if the sales of securities produce capital gains. That could be just fine if that’s the kind of fund you signed up for.
But if you thought you were investing in a fund that looks for undervalued securities that can be purchased and held for long-term growth, a high turnover ratio should be a warning sign.
Fund reports disclose what the fund owns. It’s a description of “what’s driving the bus,” Cole said. Looking at the holdings is another way of making sure the fund’s investment is consistent with your goals.
“If you’re supposed to be in a diversified fund and your fund has 50 percent of its shares in the technology sector because they made big bets in tech, as a shareholder you need to know you have an outsized investment in a sector maybe you didn’t plan to have,” Cole said.
If a bond-fund investor wants a laddered investment and the report shows the fund owns mostly short-term and long-term bonds and nothing in between, he doesn’t own a ladder, he owns what is called a barbell, Ryon said. It might be time to change funds.
Finding some of the pearls in fund reports requires some sophistication. For example, Ryon advises bond-fund holders to look at the duration of a portfolio, which is a measurement of how long it will be until the cash generated by owning a bond covers the price paid for a bond. That measurement gives you a sense of the price sensitivity of a fixed-income security.
And while Ryon advises fund investors to evaluate the leverage (indebtednesses) of a fund, he cautions that you may have to plow through the footnotes of the fund’s financial statements to find it.
Some investors might want to hire a financial adviser to help them evaluate, understand and choose mutual-fund investments, Ryon said. Everyone else should crack the books.
“Just get educated,” he said.
There a number of good investment guides, including the classic “Security Analysis” by Graham and Dodd, first published in 1934 and regularly updated since then.
The bigger challenge isn’t understanding the footnotes of mutual-fund financial statements. It’s being disciplined, Ryon said. If you choose an investment strategy, can you stay with it? If the stock market crashes, will you panic?
Ryon said anyone can learn the rules of the game.
“The real trick is following the rules,” he said.