Analyzing a Mutual Fund

There are a number of mutual funds and fund managers that have performed very well over both long-term and short-term horizons. 

All mutual funds have a stated investment mandate that specifies whether the fund will invest in large caps or small caps, and whether those companies exhibit growth or value characteristics.

It is assumed that the mutual fund manager will stick to the stated investment objective. 

It’s an excellent start to understand the mutual fund’s specific investment mandate, but there is more to fund performance that can only be exposed by digging a bit deeper into the fund’s portfolio over time.

Occasionally fund managers will drift towards certain sectors either because they have more experience within those sectors, or their particular strategy force them into certain industries. A dependence on a particular sector may leave a manager with limited possibilities if they have not broadened their investment net. 

To determine a fund’s sector weight, investors must compare the fund to its relevant indexes to determine where the fund manager increased or decreased their allocation to specific sectors relative to the index. 

This analysis will shed light on the manager’s exposure to specific indexes relative to the benchmark. 

The analysis can be as straightforward as listing the fund and relevant indexes side by side with a breakdown by sector. 

There are managers who have a top-down approach and others that have a bottom-up approach to stock-picking, 

Top-down indicates that a fund manager evaluates the economic environment to identify global trends and then determines which regions or sectors will benefit from these trends and will look for specific companies within those regions or sectors that are attractive. 

A bottom-up approach, a manager will filter the entire universe of companies based on certain criteria, such as valuation, earnings, capitalization, growth or a variety of combinations of these types of factors. A manager will then perform rigorous due diligence on those companies.

To determine whether a manager is actually adding any value to the mutual funds performance based on asset allocation or stock picking, an investor needs to complete an attribution analysis, which uncovers the impact of the manager’s investment decisions with regard to overall investment policy, asset allocation, security selection and activity. 

Attribution analysis can reveal that a manager has placed inaccurate bets on sectors but has picked the best performing stocks within each sector. From this example, this manager should have a bottom-up approach but if the manager’s mandate describes a top-down methodology, this might raise some red flags because we would have discovered that the fund manager has done an inadequate job of asset allocation. 

There are many other factors to consider when analyzing a mutual fund’s portfolio. 

By analyzing the sector weights of a fund and the manager’s attributions to performance, an investor can better understand the historical performance of the fund and how it should be used within a diversified portfolio of other funds. 

An investor can also break down the portfolio to provide valuable insight into a manager’s skill and further enhance the investor’s portfolio construction process. 

If at all possible, an investor would want a mix of superior allocators and first-class stock pickers, as well as fund managers with expertise in various sectors.

Link: http://www.equityscholar.com/library/analyzing-a-mutual-fund/