The $50+ trillion world of mutual funds
By: Philip Valenta
Tags: Investing, Money, Mutual Funds, Economics, Personal Finance

A real-world application of some key judgment metrics

Let’s look at one narrowly-focused mutual fund and one broad-based one vis-à-vis several key judgment metrics you’ll want to rely upon, at least in part, in analyzing funds (consider the data presented here just a snapshot as of the publication of this story):

Hennessy Gas Utility Fund Investor Class (ticker GASFX), a smaller, rather unique fund dedicated to distribution-focused natural gas companies Vanguard Total Stock Market Idx I (ticker VITSX), a massive fund with the objective of granting the customer exposure to the universe of all equities publicly traded in the United States

(Please note that these funds are not meant to be directly compared. They were selected for illustrative purposes only. For your information, they are open-end, no-load funds.)

Expense ratio: In a word, costs. This metric captures how expensive it is for you to own shares of a particular mutual fund. The costlier the fund, the less bang for your investment buck. It is the percentage of assets held by the fund in question that is lost to operating expenses. Remember that costs of ownership will eat into any returns earned. In order to get the most realistic picture of how costly a fund is to own, be sure to find the sum of all costs and fees, including 12b-1 fees. When deciding between comparable funds, show preference for a fund with a low expense ratio.

GASFX currently has a 1.01 expense ratio, which is below average. Expense ratios can get much lower, though. VITSX currently sports a 0.04 expense ratio, which is industry-defeating low.

Fund lifespan: A fund that has been around a long time is more tried and true than one born yesterday. You don’t want to get caught up in an investment fad. Plus, a longer lifespan means the availability of more performance data. While historical returns never indicate future results — never ever — fund performance data can prove helpful in understanding how certain investments have weathered storms, for instance, and in conjunction with other data points, can help to prove the benefits of diversification, among other things. When deciding between comparable funds, show preference for a fund with a longer lifespan.

GASFX has an inception date of May 10, 1989. It is not a new kid on the block. VITSX has an inception date of July 7, 1997. It has also clearly been around for some time now, which bodes well for the customer.

Management tenure: High management turnover is ordinarily not a good sign under any circumstances in any industry. Avoid funds that seem to have a new captain every year. Otherwise, you may find yourself the investor in a fund with an unclear and inconsistent investment strategy or a fund that is in trouble for other reasons. When deciding between comparable funds, show preference for a fund with low management turnover.

GASFX maintains one fund manager at a time, and they tend to head the fund for years at a time. VITSX has more than one fund manager at the helm, and they tend to stay put for years at a time, as well.

Sharpe ratio: Has the fund performed well and does it have a history of rewarding the investor for taking risk? The Sharpe ratio, otherwise known as the reward-to-variabilty (RTV) ratio, is one metric that can provide us with some insight into that aspect of investment analysis. The Sharpe ratio is a rewards-to-variance ratio that is enhanced by mean variance optimization.

In plain language, we are looking at the expected excess return or performance of a portfolio with respect to how much its historical return has varied, or how volatile it’s been. Specifically, in its most basic form, it is calculated as:

Sharpe ratio = [(expected mean return — risk-free rate) / standard deviation of returns]

This relationship describes how well an investor is being compensated for taking on the additional risk of entering into the investment. Note that this ratio is frequently utilized in constructing and examining portfolios. When deciding between comparable funds, show preference for a fund with a higher Sharpe ratio.

Total assets under management: In short, its size. This is an indication of the popularity of, investor confidence in, and potential staying power of the fund. The shares of a larger fund are also more liquid. When deciding between comparable funds, show preference for a fund with more assets under management.

Turnover ratio: The frequency with which a fund turns over its investments, or how often it trades. It’s measured as the percentage of a fund’s purchases or sales (the smaller of the two) against the average market value of the fund’s long-term investments. The higher the turnover, most likely the greater the expense ratio since trading costs money and those costs get passed on to you, hurting your returns. Plus, passive strategies tend to beat active ones over time. When deciding between comparable funds, show preference for a fund with lower turnover.