Comparison of Mutual Funds
A mutual fund is a pool of money contributed by many investors which is managed by a professional money manager. The money manager invests the funds on the investors' behalf, typically in stocks, bonds, cash equivalents such as money markets, or some combination of the above. Most funds have specific investment objectives, such as safety of capital, aggressive growth or to provide a current income for shareholders. Typically, mutual funds will also focus on specific areas of investment markets, such as small-cap stocks, large-cap stocks, foreign stocks or bonds. Other funds, called "asset allocation funds," balance their holdings across two or more asset classes.
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Types
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Mutual funds come in two basic types: passively managed and actively managed. Passively managed funds seek to replicate the performance of an index, such as the Standard & Poor's 500 Index of large-cap stocks, as closely as possible. Typically, they do this by owning an equal percentage of every company in the index, thus replicating the index's weighting, since most indexes are weighted by market capitalization, or the total value of all outstanding stock in the company. Since fees are minimal, index funds have become a popular method of investing in mutual funds.
Actively managed funds have a fund manager who actively researches investments and chooses when to buy or sell. Actively managed funds have a chance of outperforming the index that most closely matches their investment strategy. But because the manager and his or her research staff must be compensated, actively managed funds also have higher expenses, which are passed on to investors and reduce their overall returns.
Benchmarks
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When comparing funds, it's important to understand what index tracks their segment of the market. For a manager's fees to be worthwhile, he should demonstrate an ability to beat his benchmark index over time. Otherwise you could simply purchase an index fund.
The S&P 500 Index tracks the performance of the largest 500 companies on the New York Stock Exchange; the Russell 2000 Index tracks U.S. small cap stocks, the Lehman Bond Aggregate tracks the performance of the U.S. bond market as a whole, while the Wilshire 5000 Index tracks the performance of the entire U.S. stock market.
Compare the track record of mutual funds against their index.
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Expense Ratios
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An expense ratio is the percentage of assets the fund charges in order to pay the management and research team and pay expenses. Some funds may also charge 12(b)1 fees, which offset the costs of marketing and distributing the fund. Generally speaking, the lower the expense ratio, the better. But a few managers have demonstrated a track record of beating their benchmark indexes over time, or delivering lower volatility over time, helping you manage risk. If you believe they can continue to do so, you may wish to pay more for a good fund manager.
Manager Experience
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Look at the performance of a manager over time. If a manager is new at a fund, you may wish to look up that manager's performance at his or her old fund, if they have a track record of fund management. Generally, you want to compare that manager's performance against similar funds and against the closest index. Their track record should be long enough for you to examine how the fund performs in good markets and bad, and ideally five to 10 years or longer.
Alpha
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You can compare manager performance over time using the fund's alpha. The alpha is a measurement of manager performance that cannot be explained by the market as a whole. A manager with an alpha of one, for example, tends to match the index over time. In this case, the manager adds no value that justifies his performance fees. A manager with a negative alpha underperforms the index, while a manager with an alpha above one adds value.
Beta
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Beta is a measure of volatility, or risk. The S&P 500, by definition, has a beta of 1. A fund with a beta higher than one is more volatile than the S&P 500, while a fund with a beta of less than 1 is less volatile than the S&P 500 index. You can find both alpha and beta measurements on mutual fund information databases such as Morningstar.
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