Analyse funds like the pros

Here are five questions to ask when looking at a fund and how to find the answers in our analyst reports

David Kathman, CFA 28 August, 2009 | 0:00
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Morningstar has expanded into many different investment-related businesses, but we're still best known for analysing funds, and fund analysis remains central to what we do. As Morningstar analysts, we talk to hundreds of fund managers on a regular basis and spend much of our time thinking and writing about funds.

Much of what goes into our fund analyses comes from our conversations with managers and other proprietary sources, but we also do plenty of research using data that's widely available. In fact, it's usually possible to get a pretty good idea of a fund's merits just by looking at the information found on, as long as you know what to look for and how to use it. Here are five key questions that Morningstar analysts ask when we start to analyse a fund an

d where we look for the answers, with an emphasis on data found on

1. How have returns been under the current manager?
Most investors are looking for high returns, so if you're investigating a fund, it's natural to want to know how it has performed in the past relative to similar funds. The Morningstar Rating for funds (the star rating) is a quick and popular way to measure a fund's relative performance, but it has its limitations, as we've pointed out in the past. Directly examining a fund's percentile ranking within its category over a long-term period, such as five or 10 years, is also a good start, but a fund's past history doesn't always reflect its current situation.

We're typically most interested in how a fund has performed since the current management team took over. If a fund has a great 10-year record but the manager responsible for that record has recently left, we'll tend to be more cautious than we would be if the manager were still in place. Conversely, though less commonly, a fund with poor or mediocre long-term returns may look more promising if a new manager with a good track record has recently come on board. You can find the start date of the current manager(s) in the lower right part of the fund's Quote page on (click here for an example) and then you can create a customised chart showing the fund's relative performance since that date, using the new Chart feature.

2. How risky has the fund been in the past?
In the financial world, risk is often equated with volatility, measured in terms of standard deviation or something similar. The problem with standard deviation is that it doesn't mean much without a context, because some types of funds are inherently more volatile than others. One quick and easy way to put a fund's volatility in context is to look at its Morningstar risk, which you can find on its Risk & Rating page on (click here for another example). This measures not standard deviation, but a similar measure that penalises downside variation more than it rewards upside variation. We categorise each fund's Morningstar risk in one of five groups, from "high," for the riskiest 10% in the category, to "low," for the least risky 10%. (This article has more discussion of standard deviation.)

Most investors are less concerned with a fund's overall volatility than with its downside volatility--how likely it is to blow up or dramatically underperform its peers. The fund's annual percentile rankings, which can be found under Performance Analysis at the bottom of our fund reports, can give you some idea of this. If a fund has landed in the bottom decile of its category in the past, you should be prepared for the likelihood that it will do so again at some point.

3. Where is the portfolio most concentrated?
Another thing that Morningstar analysts invariably look at when analysing a fund is its portfolio, including where that portfolio is most concentrated relative to the fund's peers. Each fund's Portfolio page on provides a good overview of the portfolio's characteristics, including its sector weightings relative to its category and the wider market. If a fund is significantly heavy in certain sectors, it can give you some idea of how the fund is likely to perform in certain kinds of markets. A stock fund that's heavy in technology stocks, such as Fidelity Global Special Situations, is likely to do well in growth-led bull markets and poorly in bear markets, while one that holds a lot of consumer staples stocks, such as Janus Global Fundamental Equity, will tend to do poorly in bull markets and relatively well in bear markets. Nearly all funds that are heavy in financials got hammered in 2008 but are doing much better in 2009.

One of the easiest ways to get a good sense of a stock fund's portfolio is to look at its top holdings. If the top holdings are mostly big, easily recognisable stocks like BP, Royal Dutch Shell and Vodafone then you're probably looking at a large-cap fund that's similar to the broad market and would be appropriate as a core holding. If they're mostly smaller names and/or stocks you don't recognise, that fund might be more useful in a supporting role in a portfolio. Also, if those top holdings take up more than about 5% of assets, it suggests a concentrated portfolio, which can be prone to short-term underperformance if something goes wrong with a top holding. One prominent example is Artemis UK Growth, which suffered badly in 2005 when Regal Petroleum, which made up over 5% of its portfolio at the time, slashed its forecast for oil in a controversial Greek field and threatened to restate reserves in other countries.

4. What does the fund's style box look like?
The Morningstar Style Box has long been recognised as a useful tool for summarising a fund's portfolio, and the detailed version found at the top of each stock fund's Portfolio page on is especially helpful. We have built on our traditional style box and recent research reports now show a style box with a dot representing the portfolio's "centroid," which allows for finer distinctions than the traditional style box alone is capable of. This can enable you to recognise the difference between, say, two large-blend funds, if one offering is on the edge of large-growth territory, while another is in large-value territory.

The shaded area around a fund's centroid represents its Ownership Zone, which shows how wide-ranging the portfolio is. A small ownership zone means that the fund focuses almost entirely on stocks in one area of the style box, while a large ownership zone spreading across most of the box means the portfolio is very diverse. This difference can be significant for knowing how a fund would fit into a portfolio; in general, a larger ownership zone means that a fund is more appropriate as a core holding, while a fund with a small, concentrated ownership zone might have to be balanced out with a different type of fund. (See this article for more on ownership zones.)

5. What does the fund cost relative to its peers?
Finally, one of the most important things we consider when evaluating a fund is how much it costs. A fund's Fees page on shows the most relevant fees and expenses--the total expense ratio is what we tend to focus on the most.

It's important to look at a fund's expense ratio in the proper context. That means comparing it not just with funds of the same or similar category, but with comparable share classes. No-load funds (in which shares are sold without a commission or sales charge) usually have lower expense ratios than retail shares of load funds, and among load funds, A shares (which charge a front load) virtually always have lower expense ratios than B or C shares (which charge a deferred or level load). The Fund Screener allows you to screen for all funds in a given category, after which you can rank funds by expense ratio to see where a given fund ranks.
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About Author

David Kathman, CFA  David Kathman, CFA, is a senior fund analyst with Morningstar.

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