When savers want to invest their hard-earned bees and honey into stocks and bonds and so on but lack the time and/or know-how to do so themselves, they often turn to investment funds. Not only do funds allow you to outsource all the hard work to investment professionals, but they also let you diversify your dough across a variety of different assets – even if you’ve only got a modest sum to start with.
An investment fund pools together cash from many such small investors and places it in the hands of a full-time money manager. They then invest that money according to predetermined criteria and objectives. Just about every fund invests in slightly different things and for slightly different purposes – but they’re typically classified according to their target asset class, region, investment strategy (e.g. growth or value), sector, and – for stock funds – company size.
Investment funds are usually structured in one of two ways. In an open-end fund – which includes most US “mutual funds”, European “SICAVs”, and British “unit trusts” – the manager issues as many shares as there is investor interest. When you buy into the fund, additional shares are created to fulfill that demand; if you sell those shares, they’re simply taken out of circulation. The value of an open-end fund therefore matches the value of its underlying investment holdings, also referred to as net asset value (NAV).
A closed-end fund, by contrast, has shares listed on an exchange, just like any other public company. The value of a closed-end fund is accordingly determined by demand for those shares – and it could trade above or below NAV. If you want to invest, you’ll have to find a seller; and when you want to extract your money, you’ll need to find a buyer for your shares. This normally shouldn’t be a problem, but in times of extreme market stress you could find there are no takers…
It’s also important to note that investment funds differ from exchange-traded funds (ETFs) in two main ways. First, investment funds are almost all actively managed: their managers pick specific investments that they think will combine to beat the market. ETFs, meanwhile, tend to be passively managed – they simply aim to replicate the performance of an underlying market index.
Second, ETFs and closed-end funds are listed on traditional stock exchanges, where shares can be bought and sold throughout the trading day. Shares of open-end funds, on the other hand, change hands just once per day – and are typically bought and sold via brokers or specialist “fund marketplaces”.
Before we get into the details of investment fund analysis, it’s worth touching on how to find the relevant data in the first place. You can search for funds – and screen for them based on specific criteria – using free online tools such as Investing.com (a global database), Morningstar.com (US), Morningstar.co.uk (UK, natch), Portfolio Visualizer (US), and Trustnet (European).
These sites allow you to both find investment funds and check out their details – and your first port of call should be the fund’s factsheet. As you can see from this example, the factsheet usually includes detailed performance data, information on the benchmark it’s aiming to beat, a breakdown of the fund’s holdings, and an overview of its investment team. Fund managers sometimes even include performance commentary in the factsheet, which can help put what you’re seeing into context.
Just as you’d research and analyze a stock before investing in it, you should do likewise before investing in a fund. Investment fund analysis can be done “qualitatively” and “quantitatively” – and both techniques are equally important. Going over a fund’s factsheet and reading any accompanying commentary is an example of the former. So what else should you look at when evaluating quality?
Most funds are run by a lead portfolio manager (PM). It’s always worth assessing the PM’s experience, reputation, and track record; ideally, you’d want to be handing your money to someone with strong scores on all three fronts. In terms of judging how much a PM has investors’ best interests at heart, you might want to investigate whether they’ve got some of their own cash in the fund, and if their compensation is tied to performance. Such information is often available in the fund’s prospectus or statement of additional information (SAI).
You can do something similar with the rest of the investment team too. PMs normally oversee a group of analysts whose job it is to research and recommend individual investments. Assess their experience and structure and keep an eye out for red flags like high team turnover – rarely a good sign. This sort of information can be found by searching financial news sites.
Focusing again on the factsheet, it’s worth checking out the weighting of the fund’s top 10 holdings. A fund that’s more than 50% invested in those top 10 positions may be over-concentrated and vulnerable to shocks; if more than 10% is invested in a single position, then that could also be cause for concern. Still, you don’t want a fund that’s too diversified either – one that holds, say, 100 or 150 positions. Not only is it unrealistic to expect a PM to stay on top of so many investments, but an overly diversified fund risks becoming an “index hugger” which merely mirrors the movements of a market index. That’s not what you’re paying an active manager for.
Which brings us to our last qualitative question: cost. At risk of stating the obvious, the lower a fund’s price, the better. This can be assessed in a number of different ways – but the most commonly consulted formula is total expense ratio (TER). A fund always has to disclose its TER, and you can usually find this on the factsheet.
The TER expresses overall running costs in any given year as a percentage of the fund’s assets. This includes management fees (not necessarily including performance bonuses) as well as trading, legal, and other operational expenses. Essentially, a fund with a TER of 1% will lose 1% of its value that year before factoring in investment returns. That means the PM has to beat the market by at least 1% for their fund to outperform – and justify its existence to investors.
Quantitative analysis involves calculating and examining statistics and ratios based on a fund’s historical returns to evaluate performance. The catch, of course, is that past positives are no guarantee of future success. But quantitative analysis remains a very useful exercise: you can assess the return and risk characteristics of individual funds and, crucially, use these metrics to help you choose between several similar options.
It’s sensible to begin by running a quick sanity check of the fund’s previous returns. Look at how long these go back – it’s hard to draw meaningful conclusions from meager information. Investigate whether the same PM and core team has been in charge for all that time too; past performance under a different regime will be a particularly unhelpful indication of what lies ahead. And note too whether the historical returns cited are live or “back-tested”, i.e. simulated. It’s not uncommon for newly launched funds, especially those which invest based on mathematical rules, to cite back-tested returns – but you should always take simulated data with a pinch of salt.
Let’s turn now to the hard analysis. The first things you want to measure are the fund’s historical average annual return and the volatility this has exhibited. Investors often arrive at the first number by working out a geometric mean that takes into account the effects of compounding. This compound annual growth rate (CAGR) is calculated using the fund’s current NAV relative to NAV either at inception or some other point in time – say five years ago, if you want to assess the fund’s performance over the past five years. Here’s the formula:
Volatility, meanwhile, expresses a fund’s riskiness based on the extent to which its NAV fluctuates; all else equal, a highly volatile fund carries more risk than one with low volatility. Volatility is best computed using a classic statistical measure: “standard deviation”. To work out the standard deviation of a fund’s historical returns, find the average monthly return across a given time period, subtract this simple mean from each individual monthly reading, square those results, and then find their average. Note that if you’re using monthly returns, you’ll end up calculating monthly volatility – multiply this by the square root of 12 to get annualized volatility.
Focusing on annualized volatility allows us to conduct an apples-to-apples comparison with the annualized return measure (CAGR) we arrived at earlier. And that brings us to another metric that’s very often used to assess investment funds: the Sharpe ratio. This measures “risk-adjusted” returns, calculated as the fund’s CAGR divided by its annualized volatility. It basically tells us how the fund performed per unit of risk. Strictly speaking, Sharpe ratios should subtract the “risk-free rate” – the equivalent CAGR of a super-safe asset like short-term government bonds – from the fund’s own CAGR before dividing by volatility. But for the sake of making simple comparisons between different funds, this can be ignored.
Yet another ratio commonly used to weigh up returns against risk is the information ratio. This tracks the fund’s excess returns beyond the returns of its benchmark – usually a market index – compared to the volatility of those returns.
By way of example, take a fund that invests solely in US stocks. Its benchmark might well be the S&P 500 index. To determine the information ratio, we’d first calculate the top part of the fraction: the fund’s CAGR minus the CAGR of the S&P 500 over the same time period. This gives us the “active return”. For the bottom-part denominator, we’d look at the fund’s historical monthly returns and for each month subtract the S&P 500 equivalent. We can then work out the annualized volatility of those excess returns following the process outlined above to arrive at “active risk”. Divide active return by active risk, and you’ve got the fund’s information ratio.
The better a fund’s done versus its index, the higher its excess returns – and the more consistent these are, the lower the active risk. The resulting information ratio is therefore particularly useful at assessing funds that are explicitly benchmarked against indexes – which includes the vast majority of active funds.
The last quantitative computation we’ll touch on is a really important measure of risk called maximum drawdown (MDD). As illustrated below, this tracks the largest peak-to-trough decline in a fund’s NAV. You should generally stay clear of funds that have experienced large MDDs, as this indicates poor risk management by the PM and their team. And knowing the worst loss a fund has previously experienced can be telling: a 50% drawdown, after all, means the fund would subsequently have to double in value just to get back to where it was!
While all these calculations might seem quite involved, the good news is that most of them can often be found included on the funds’ factsheets, or by using the online tools we mentioned earlier. Nevertheless, only by knowing how they’re worked out and what they represent can you properly interpret them. When comparing several similar funds, you’ll probably want to lean towards those with higher Sharpe and information ratios and lower MDDs. The best approach is to narrow down a list of candidates quantitatively first – and then analyze the remaining few qualitatively to pick the best one or two.
And that’s it. You now have a pretty good grounding in how to not only find information on investment funds, but how to analyze that information both quantitatively and qualitatively in order to assess a fund before buying in. Now get out there and put what you’ve just learned into practice – you might just find your next best investment!
🔹 An investment fund pools together cash from lots of small investors and places it in the hands of a professional money manager.
🔹 You can search for funds using free online tools such as Investing.com, Morningstar, Portfolio Visualizer, and Trustnet. You can also find more information on specific funds by examining their factsheets.
🔹 To qualitatively analyze a fund, examine 1) the reputation, experience, track record, and alignment of interests of the portfolio manager; 2) the investment team’s experience, structure, and turnover; 3) the fund’s holdings; 4) the fund’s cost.
🔹 After doing a quick sanity check of the fund’s track record, you can quantitatively analyze its characteristics by looking at its historical performance, volatility, Sharpe and information ratios (both of which measure risk-adjusted returns), and maximum drawdown.
🔹 When comparing several similar funds, lean towards those with higher Sharpe and information ratios and lower maximum drawdowns. After you’ve narrowed down a list quantitatively, use qualitative analysis to identify the strongest candidates.
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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.