Evaluating a Mutual Fund “Opportunity”

A mutual fund promising a 6% annual distribution yield (it pays out 6% per year) probably sounds attractive to many investors. In fact, clients of San Diego’s best known financial advisors may find such “opportunities” in their brokerage accounts.

evaluating-a-mutual-fundEvaluating the details of this particular opportunity paints an entirely different picture though, when you factor in more than just the 6% promised yield — things like the fund’s total performance record and brokerage fees, for example. When we evaluate a mutual fund for our clients, here are some of the key factors we consider as we perform our due diligence.

8 Key Factors For Evaluating A Mutual Fund:

  1. Are the costs reasonable? Low expenses are the single best predictor of good future performance. Try to compare the fund to similar investments so that you’re not comparing apples and oranges. For example, balanced or hybrid funds might charge more than bond mutual funds, but less than pure stock funds. Index funds often charge less than 0.2% but actively managed funds are often more than 1.0%.
  2. How long has the fund been around? This can cut both ways. A longer track record (with no management changes) suggests the management team is experienced and knows what it’s doing. However, a fund that’s been in business a long time and grown too big may have a hard time making good investments in the future. This is especially true for funds that focus on small companies.
  3. Has the manager been with the fund for a long time? A new manager will almost always bring changes to the way things have worked in the past. A fund with a decent, long track record but new management could become a completely different fund. Also, personnel turnover can suggest the company doesn’t value talented people or has a toxic culture, and if they don’t value their employees, it’s hard to see how they’ll treat their clients any better.
  4. Has the fund changed how it invests? A fund that changes its strategy frequently can’t be relied upon to do anything particularly well. How can you compare time periods and performance results if the fund keeps doing different things each year?
  5. Does the fund manager invest in his or her own fund? When looking at actively managed funds, we look for fund managers with significant investments alongside their clients – eating their own cooking. For very large funds, the manager should typically have at least a million dollars invested alongside his clients. There are important exceptions, but more is better here.
  6. What is the fund manager’s reputation? Has the firm or the manager been sued by clients or fined or sanctioned by regulators? Cutting corners on the rules or taking advantage of clients is a very bad sign.
  7. Are there obvious conflicts of interest? Do you really want to own an investment with built-in incentives pitting your fund manager’s interests against you?
  8. What are the performance results? Superior past performance is a poor predictor of the future results, but you do want to see some kind of long-term success against a similar benchmark. The fund should look OK against its benchmark AND the benchmark should be representative of what the fund is doing. You can’t compare a stock fund against cash savings accounts because they are entirely different investments with very different risks.

Looking under the hood at the mutual fund “opportunity” above, some of that 6% yield will be return of capital, not income or gains. Also, the total annual expenses of the fund could be more than 3.6%, depending on which share class you can buy. The fund’s management company also owns a brokerage firm — which sells illiquid, high-commission securities to its own fund — and double-dips by collecting brokerage fees for those trades as well as fund management fees. In addition to the high expense ratio, investors may be charged a commission to buy or sell the fund, and are only allowed to sell it once per quarter (not daily like most mutual funds). Finally, the fund is leveraged (they’ve borrowed money to buy extra investments) which increases the risks, generally more than the potential rewards.

After careful scrutiny, this fund doesn’t look attractive at all. At Blankinship and Foster this fund fails our investment evaluation process on multiple levels. We never would have gotten past the self-dealing with the adviser’s own brokerage firm. But the high expenses, leverage and regulatory issues with their associated companies would have sealed it, even before we saw its weak performance record. Sadly, as of February it had collected about $200 million in assets from people who have invested in the fund.

With a little due-diligence, using these 8 Key Factors For Evaluating A Mutual Fund, you can ensure the mutual fund you choose is truly a sound investment. Please contact us at Blankinship & Foster if you have any questions about a specific mutual fund or your own personal investments portfolio.

About Rick Brooks

Rick Brooks, CFA®, CFP® is a partner of Blankinship & Foster LLC and is the firm’s Chief Investment Officer. He is a lead advisor, counseling clients on all aspects of personal financial management. Rick serves on several boards. He is the Chairman of the Board of Girl Scouts San Diego, and also chairs the San Diego Foundation’s Professional Advisor Council. Rick and his family live in Mission Hills. Rick enjoys spending time with his family, theater, cooking, skiing, gaming and reading.

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