MUTUAL FUND INVESTING 101

​To get started and do your own investing I love Mutual Funds. As opposed to investing in individual stocks, investing in mutual funds allows you to pool your money into a fund that is managed by a fund manager and invested into multiple individual stocks. Thus, by investing in a mutual fund you are getting exposure to dozens if not hundreds of individual stocks across a multitude of sectors.  The diagram below illustrates this extremely well:

In addition, mutual funds provide diversification, which effectively means you aren’t putting all your eggs in one basket (i.e. One Company or One Sector). Stocks within different sectors don’t all perfectly correlate when markets go up and down, thus, you want to have money representing multiple sectors to spread your risk.

Now that we have outlined how mutual funds work, let’s look at the 8 key metrics I use to evaluate and filter good funds.  See below definitions for each of these 8 metrics:

1. Minimum Initial Investment - Meaning is exactly how it is spelled out.  Every mutual fund has a required initial investment that ranges from $0 to tens of millions.  
2. Expense Ratio - Is expressed as a percentage and is a cost for investing in the fund.  The people operating the fund have costs and need to pay employees etc.  It is calculated by dividing the operating costs and fees of the fund against the total assets or pool of money in the fund.  
3. Fund Returns - It is the percentage increase or decrease in the value of the fund’s assets under management during a defined period of time (i.e. 3-Yr Return, 5-Yr Return, 10-Yr Return etc).
4. Turnover - Is expressed as a percentage.  Essentially, mutual fund turnover typically measures the replacement of holdings in a mutual fund and is commonly presented to investors as a percentage over a one year period.  In other words, it is measuring the amount of trading activity that the fund is doing each year.  If fund managers are actively buying and selling stocks with the pool of funds the turnover will be higher.
5. Manager Tenure - This is a measure of how long fund managers have been managing the assets/pool of money for that particular fund.  
6. Yield - Expressed as a percentage and is the total amount of dividends/income generated from investments in the fund divided by the fund value.   
7. Load/No Load - Plain and simple a front or back end load mutual fund is a sales charge.  You want to look at funds that are “No Load”. 
8. Fund Diversification - The stock market and the public companies within it are broken into 11 different sectors that within them are broken down further into different industries.  They are as follows:

• Communication Services – 5 industries
• Consumer Discretionary – 11 industries
• Consumer Staples – 6 industries
• Energy – 2 industries
• Financials – 7 industries
• Healthcare – 6 industries
• Industrials – 14 industries
• Information Technology – 6 industries
• Materials – 5 industries
• Real Estate – 2 industries
• Utilities – 5 industries

Now that we have an understanding of the meaning of each of these metrics, let’s look at the targets I apply to these metrics to filter out the best funds.  See below:

• Minimum Initial Investment - This is all dependent on your level of savings and how much you are willing to invest.  I look at funds that have an initial investment between $0-$3,000.  Funds that require a higher initial investment does not mean they bring a higher return over time.  There are plenty of funds that I will outline that have low minimum investment and have solid returns over time.  
• Expense Ratio - Any fund that has a fee of less than 1%.  This does not mean that funds that have higher expense ratios are not good investments.  There are plenty of reasons for this, but I view a fund with a low expense ratio to be efficient and gaining returns without significant trading activity (i.e. Buy and Hold Strategy).    
• Returns - I don’t pay too much attention to more recent fund returns (i.e. Returns within the last 5 years or less).  I look at fund performance primarily over a 10+ year period.  When I invest in mutual funds I don’t intend on selling for a long period of time.  The S&P 500 and Dow Jones are indexes that you see on the news that measure the stock market performance.  Since inception of the stock markets they have averaged around 10% per year.  Therefore, when looking at 10-Yr and 15-Yr Fund returns my rule of thumb is if the returns are at 8% or above during that duration they appear to be a solid investment.    
• Turnover - Turnover ideally would be less than 40%.  For perspective if the turnover is 100% or over, the fund manager has effectively completed a combined value of trades on average (Buying & Selling) that is greater than the overall value of the funds holdings.  
• Manager Tenure - I target an average manager tenure of 10 years.  Some funds have multiple managers.  If the company has good returns and managers that have tenure, that provides me a level of comfort around future performance. 
• Yield - You can make an argument that this target depends on your overall investing strategy, however, I would want a target that has a minimum of 1% yield.  
• Load/No Load - Definitely no load funds are preferred unless the fund’s returns are extraordinary (net of load fees and annual expenses).  
• Fund Diversification - When you google and do research on a fund you are looking at take a look at how many different sectors that they are investing in.  The fund will typically have a breakdown of this.  Check out this link as an example.  Ideally, I like to see coverage across all sectors, and no more than 20% concentration of the assets to one particular sector.

I hope this provides you with some insights into how I approach mutual fund investing.  Keep in mind there is no perfect approach and is just one way of analyzing funds.  In addition, you may like a fund that meets the majority of the criteria, but not all of them.  

If you want to take more risk there are funds that are purely sector focused and a majority, if not all the assets under management are diverted into that sector.  Check out this Vanguard Fund that focuses specifically on the Healthcare sector.

I hope you enjoyed reading this post.  You can employ this approach as you commence your investing independently.  Also, for the folks that are not where they want to be financially or for retirement, I strongly encourage you to take the #htfinance20 challenge.  Start making the incremental changes to your financial future!