If you're in accumulation mode--gathering assets for retirement--and looking to identify holdings for your portfolio, or to assess the quality of mutual funds or ETFs you already own, there are a few key things to consider. There are five areas that form the foundation of Morningstar Manager Research analysts' evaluations of funds, known as the Medalist ratings. We'll walk you through all these pillars to see how your fund picks work together in a portfolio.
Performance
Performance may be the first thing many people look at when evaluating a fund, but it certainly shouldn't be the only one. Unfortunately, looking at a fund's trailing return on a yearly basis or even over a longer period can only tell you so much about how a particular fund will perform. For the mathematically inclined, looking at a fund's mean return plus or minus two standard deviations over a certain period can give you a pretty good idea of the range of possible returns you can expect. But if your calculator isn't handy, you can look at a fund's trailing returns during extreme market conditions to get an idea of how aggressive or defensive the strategy is.
Let's look at American Century Equity Income Inv, for example, you can go back quite a while, and see how the fund has performed in a variety of markets. The years 2008 and 2009 can be very instructive, because they marked such a dramatic inflection point. In 2008, the S&P 500 lost 37% amid the financial crisis. In 2009, it rose 26.5%, as the equity market anticipated the economy's eventual recovery. American Century Equity Income lost "only" 20% in 2008. Of course, it's not nothing for a fund to lose a fifth of its value. But it lost less than almost every other fund in the category that year--it ranked in the first percentile.
Fast forward to 2009, when the market soared back from those depths. Again, the S&P 500 gained over 26%, but American Century Equity Income rose a comparatively sleepy 12%. Looking at the fund's annual return pattern, you can get the sense that in more difficult markets, this fund plays very good defense, but it shouldn't be expected to hit the market's high notes. Indeed, this is a fund that gets ahead by losing less--over 10- and 15-year periods, which encompass some more treacherous market periods, it's in the top quintile of the large-value category. However, over the trailing five-year period, which has been marked by strong stock market returns, the fund looks only middling relative to peers.
Of course, an accumulator doesn't need every fund in her portfolio to be a good defensive performer. Depending on your risk tolerance and your risk capacity you may want some more aggressive supporting players to balance out your more steady core holdings.
Process
Performance blends in with the Process piece a bit. Ideally, you want to look for a strategy that you understand and are prepared to stand by, even if it doesn't lead to stellar performance during every market environment. When you look at the fund's performance, see if it jibes with what you would expect from the fund's stated objective. For example, consider PRIMECAP Odyssey Aggressive Growth. The managers follow a disciplined contrarian growth strategy that emphasizes companies with strong growth potential but temporarily depressed valuations, and they're willing to hold on to stocks for a long time waiting for a turnaround. You would expect this mid-cap growth fund to perform well in strongly rising markets, and a closer look at the performance record shows that this has been the case: In 2009 the fund rose 50% and in 2013 it was up nearly 55%. Of course, you shouldn't expect the fund to always deliver such astronomical returns, but it has clearly executed on its stated strategy.
People and Parent
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. You can even look at SEC filings to see how much each manager has invested in the fund; this is a way to ascertain whether the manager's interests are truly aligned with shareholders'.
Stewardship is also an important consideration. Taking a good look at the parent fund company's behavior can help you determine whether it is a good steward of investor capital. For example, is the fund firm dominated by a sales culture or an investment culture? Does the fund company have a history of closing strategies after a periods of strong returns and healthy inflows? It can become more difficult for fund managers to run certain strategies that ply less liquid corners of the market after valuations rise and funds become packed with assets. Fund closures are often a sign of a shareholder-friendly fund parent--one that doesn't prioritize asset-gathering at the cost of sacrificing current shareholders' future returns.
Price
Finally, Price is one of the best predictors of returns. (They come right off the top of a fund's total return.) When assigning our Medalist ratings, fund costs are one thing the manager research analysts consider. The analysts look at a fund's expenses relative to its peer group and its sales channel. They also consider the fund's asset size; ideally, you would want to see a fund's expense ratio decline as it gathers assets under management. In other words, the fund is sharing its economies of scale with investors.
At the fund quote pages on tw.morningstar.com, you can see whether a particular fund's total expense ratio is low, high, or somewhere in between when compared with other funds that invest in a similar asset class and have similar distribution characteristics. That can be a good guide for people who aren't sure whether an expense ratio for a particular fund is cheap or expensive. One thing to note is that index funds or exchange-traded funds tend generally (but not always) to have very competitive costs.
Not all great funds work well together. The ideal portfolio has a mix of exposure to different areas. By selecting different combinations of investments and asset classes that are not perfectly positively correlated, your portfolio is likely to do reasonably well in a variety of different environments, because as one asset is falling, another is likely rising.
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