How to Tell if a Fund is All it Claims to Be – ValueWalk Premium
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How to Tell if a Fund is All it Claims to Be

One of the hats I wear is as a professor of practice in the personal financial planning department at Texas Tech University, where I teach the graduate wealth management class. Join me in class as I lecture about mutual funds.

There are thousands of mutual funds that offer to select stocks and bonds for your portfolio. But which ones are right for you?

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Wealth Management Class: Good morning, Professor Evensky,”

HE: Good morning, class. Are you ready to talk about the exciting topic of mutual fund selection?

[Enthusiastic cheers from the students sitting in the front row. The students sitting in the back look up from their smart phones.]

Can anybody tell me what the assignment was?

Michael: The assignment was to evaluate a particular mutual fund that’s being promoted as the only stock fund you need for your portfolio.

Elizabeth: Professor Evensky, is this going to be on the test?

Clay: The ad read “It’s the only domestic stock fund actively managed by professionals with performance that ranked it in the top 10 percent for the past one, three, five, ten, and fifteen years and below average risk.”

HE: Thank you, Michael and Clay. So let’s review some of the terms we’re using here. Elizabeth, what is an actively managed fund?

Elizabeth: Hmm, sorry. I think I was out the day we covered that.

HE: Lisa?

Lisa: “Actively managed” refers to a fund where the manager actively trades the investments with the goal of outperforming an index return benchmark.

HE: And how is an actively managed fund different from an index fund?

Clay: Unlike the actively managed fund, an index manager makes no decisions about what stocks or bonds to buy. He simply wants to own all of the investments listed in the index. If the index drops a stock and adds a new one in its place, the index manager will sell the stock that was dropped and the one that had been added to the index.

HE: So where did you start your evaluation? Anybody?

Cagla: I started with the three Ps: Philosophy, Process, and People, and I was impressed. Management seems to have a credible philosophy, a thoughtful process, and experienced people, although I noted that current management has only been in place for about two and a half years. [See Chapter 13, “The Three Ps of Investing,” for more information.]

HE: You’re on a roll. Who’s next?

Kristin: Well, having passed the three Ps, we then need to evaluate performance. Our clients can’t get yesterday’s returns, but if past performance is good and the fund passes the three Ps, our clients stand a chance of enjoying good performance in the future.

HE: Okay, how would you go about evaluating performance? And performance compared to what?

Lisa: I would begin by determining what sandbox the manager is playing in and select appropriate investable indexes to compare the fund to.

Elizabeth: Excuse me, um, “investable indexes”? HE: Who can explain what an investable index is?

Lisa: It’s a mutual fund or Exchange Traded Fund (they’re called ETFs), available to public investors that have the goal of earning the return of a market index at low cost. For example: the iShares Core S&P 500 ETF seeks to track the results of the S&P 500 that measures the performance of large-capitalization stocks in the United States stock market. The annual fund cost is only 0.07 percent.

HE: Very good. Now, what’s a “sandbox”? How are you going to determine which sandbox it is? And why investable indexes?

Lisa: By sandbox we mean the nature of the underlying investments. In this case, the fund is a domestic stock fund, so we need to determine the size of the companies the fund invests in and the manager’s valuation orientation, so we can know the universe of managers to compare its performance to.

Elizabeth: “Valuation orientation”?

HE: Can someone explain valuation orientation? And tell us how we go about determining the universe for comparison.

Kristen: Generally, stocks are categorized as “growth,” “value,” or “core.” Growth companies are ones investors believe will have significantly improving profits. The stock price tends to be relatively high compared to the company’s current earnings, as investors are paying up for those rapidly improving profits.

Value stocks tend to be relatively cheap based on current earnings, as investors do not have great expectations for the firm’s future profits.

Core stocks are those that have mid-range expectations for future profits. Professionals use a variety of metrics to determine what category a stock falls in.

One of the most common is the stock’s price-to-book ratio. That’s simply a number that tells you how much you have to pay for a share of stock to buy $1 of the company’s book value. For example, the stocks that make up the S&P 500 index have a price/book ratio of about 2.6 while the growth stock portion of that index is 3.8 and the value portion 1.9. When we look at a fund that’s investing in S&P 500 kinds of stock, we’ll look to see how the fund’s P/B ratio compares. If it’s in the 1.9 range then we consider it value, in the 2.8 range growth and core in between.

HE: Elizabeth, are you with us on this?

Elizabeth: Not really, sir.

HE: John, define average capitalization for us.

Kristin: Capitalization refers to the financial size of a company. It’s calculated by multiplying the current price of a stock, times the number of shares of the company. So, for example, if a company has 100,000,000 shares outstanding and the stock is trading at $30 it would have a $3 billion capitalization. To give you an idea, the average of stocks in the S&P 500 is more than $60 billion. Although there is no hard and fast rule, generally we would consider stocks with capitalization of less than $2,000,000 small cap; between $2 and $5 billion mid-cap and more than $5 billion large cap.

Read the full article here by , Advisor Perspectives.


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