Key Factors for Evaluating Mutual Funds
Go beyond performance when choosing investments.
If you're currently saving for retirement--or looking to get started saving--you might be wondering how to assess the quality of mutual funds or exchange-traded funds.
There are a few main areas that form the foundation of Morningstar manager research analysts' evaluations of funds, known as the Morningstar Medalist ratings. We'll walk you through all these Pillars--Process, People, and Parent--and we'll show you a quick and easy tool you can use to see how your fund picks work together in a portfolio.
How Has the Fund Performed?
Performance may be the first thing many people look at when evaluating a fund, but it’s not the most important consideration and it certainly shouldn't be the only one. For one thing, a fund's trailing returns won’t tell you much about what role a fund could play in a portfolio. And they also won't tell you too much about how the fund will perform in the future.
By clicking on "expanded view" on the Performance tab, you can take a closer look at how a fund has performed during different market conditions. The Performance chart also helps you put returns into context by showing performance relative to both a benchmark index and Morningstar Category peers, which are other funds that invest in a similar way.
You can find more helpful information on a fund’s Risk tab. A fund’s Morningstar Risk score can tell you how volatile a fund’s returns have been relative to category peers. (A fund must have three years of performance history in order to receive a Risk score.) The score assesses the variations in a fund's monthly returns (with an emphasis on downside variations--the ones that keep investors up at night) in comparison to similar funds. The greater the variation, the larger the Risk score.
You can pair a fund’s Risk score with its Morningstar Return score, which is an assessment of the fund's excess return compared with category peers. (Again, funds with less than three years of performance history do not receive a Return score.)
Funds with Low Risk scores and High Return scores have earned higher returns than peers while taking on much less risk. You can find a visual representation of how a fund’s Risk and Return scores compare to peers on the Risk tab.
What Is the Strategy, and How Well Have the Managers Executed It?
Morningstar analysts evaluate a fund’s performance in the context of its strategy, and you should, too. When you select a fund, it’s important to understand how it invests and what type of performance profile you can expect from it. When you look at the fund's past performance, see if it jibes with what you would expect from the fund's stated objective.
For example, you would expect an aggressive growth fund to outperform in strongly rising, growth-favored markets. You would expect a fund that plies a defensive strategy, either by investing in stocks with a more-defensive profile or by allocating a portion of assets to bonds or less-volatile asset classes, to protect capital better during market sell-offs. But that defensive fund might look pretty dull in red-hot markets, and that growth fund probably looks abysmal when stocks take a nosedive. Understanding how funds invest and behave in different markets, as well as the different roles they play in a diversified portfolio, will help you maximize your wealth-building potential. (More on that later.)
Morningstar analysts thoroughly evaluate a fund's strategy when they rate a fund's Process, which is one of the three Pillars, along with People and Parent, that determine a fund's Medalist Rating. The ratings, which are a feature of Premium Membership, are forward-looking and express how much conviction our analysts have in a fund's or ETF’s ability to outperform its peers in the future. Analysts give higher ratings to funds whose performance objective and investment process (for security selection, risk management, and portfolio construction) are sensible, clearly defined, and repeatable. The process must also have be implemented effectively; in this context, trailing returns can be informative.
Who's Running the Fund?
You should also give consideration to the team running a fund. This includes not only the managers' tenure and demonstrated skill in executing the strategy, but the analyst team supporting those managers.
We've found that mutual funds and ETFs run by high-quality management teams tend to outperform their benchmark and peers. To evaluate an investment’s management team (the People rating), Morningstar analysts assess the fund managers’ and analysts’ experience and ability; their workload; and the depth of direct and indirect resources that support them.
Analysts consider other factors, too, such as whether fund managers invest alongside investors and whether their pay incentives are aligned with investors’ interests. Prospective investors can check publicly available SEC filings to see how much each fund manager has invested in the fund; this is a way to ascertain whether the managers' interests are truly aligned with shareholders'.
The parent fund company's behavior also matters. Morningstar analysts ask a lot of questions to determine whether a fund company is a good steward of investor capital (the Parent rating). For example, is the fund firm dominated by a sales culture or an investment culture? Does the company often launch funds in hot-performing sectors of the market, whether or not they have demonstrated investment expertise in the style? Does the fund company have a history of closing strategies after a periods of strong returns and frothy inflows? Fund closures can be a sign of a shareholder-friendly fund parent--one that doesn't prioritize asset-gathering at the cost of sacrificing current shareholders' future returns.
How Much Does It Cost?
Price is one of the best predictors of a fund's future returns. That’s because a fund’s costs come right off the top of its total return.
As explained in this article, you can use Morningstar to check a fund's price and see whether it's a good deal relative to other funds that invest the same way.
How Well Do Your Investments Work Together?
Not all great funds work well together. The ideal portfolio is diversified among across a variety of sectors, asset classes, investment styles, and world regions. Here you can find some guideposts for ensuring that your retirement portfolio's asset allocations are in the right ballpark.
To check under your own portfolio's hood, try out our free Instant X-Ray tool. It's a great way to identify, at a glance, whether your funds (or any funds you are considering adding to your portfolio) are clustered in a particular part of the market or whether they're well diversified across a variety of sectors, asset classes, investment styles, and world regions. (Here's a sample X-Ray report.) When you're done entering your investments, you can save your Instant X-Ray holdings as a portfolio and continue to monitor it on Morningstar.com.
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