Selecting a Mutual Fund

SELECTING A MUTUAL FUND

CONTENT AREAS

  • How Does Volatility Impact Mutual Fund Returns?

  • What Are the Steps in Selecting a Mutual Fund?

  • What Other Elements Should Be Considered When Analyzing and Selecting Mutual Funds?

LEARNING OBJECTIVES

  1. Risk-Return Trade-off:
       - Describe the risk-return trade-off between the different types of mutual funds.
       - List and define the different sources of volatility that impact fund returns.

  2. Steps in Selection Process:
       - List and describe the steps in selecting a mutual fund.
       - Perform calculations related to the different measures of volatility.

  3. Four Elements of Mutual Fund Selection:
       - Analyze the four elements of mutual fund selection: people, philosophy, process, and performance.

KEY TERMS

  • Alpha

  • Assets Under Management (AUM)

  • Beta

  • Canadian Investment Funds Standards Committee (CIFSC)

  • Default Risk

  • Exchange Rate Risk

  • Growth at a Reasonable Price (GARP)

  • Growth Investing

  • Holdings-Based Style Analysis

  • Interest Rate Anticipation

  • Interest Rate Risk

  • Market Risk

  • Momentum Investing

  • Returns-Based Style Analysis

  • Reward-to-Risk Ratio

  • Sector Rotation

  • Sector Trading

  • Security Selection

  • Simple Rate of Return

  • Style Analysis

  • Style Drift

  • Unique Risk

  • Value Investing

INTRODUCTION

  • Financial Objectives: Clients must have financial objectives aligned with their investment choices while considering:
      - Financial circumstances
      - Personal circumstances
      - Investment knowledge
      - Risk profile

  • Asset Allocation Decision:
      - Determines the proportion of each asset class to be held in portfolios.
      - Can be aggressive, conservative, or balanced.
      - Must reflect financial objectives and client's risk tolerance.
      - Emphasis on portfolio diversification.

  • Mutual Fund Selection:
      - Represents the final and critical step in the investment process.
      - Typically involves fund representatives analyzing and recommending funds.
      - Investment decisions should be based on fund’s risk/return profile and performance data.
      - No guarantee of positive returns through any selection method, but past performance serves as a guide, albeit with limitations.

HOW DOES VOLATILITY IMPACT MUTUAL FUND RETURNS?

  • Risk Characteristics of Securities:
      - Different securities have varying risk-return profiles, and mutual funds are no exception.
      - Theoretical understanding dictates:     - Money market mutual funds are less risky than bond funds.     - Bond funds are less risky than equity funds.
      - Funds designed to meet various investor needs contribute to the diverse risk-return profiles in the industry.

  • Graphical Illustration:
      - Figure 15.1 illustrates the risk-return relationship among different mutual fund types.   - Mutual funds exist on a spectrum based on the risk-return characteristics of their holdings.

  • Example Fund Types:   - Short-term bond funds are riskier than money market funds but safer than long-term bonds.   - Preferred dividend funds exhibit risk levels between bonds and equity funds.   - Global mutual funds display variable risk depending on the securities they include.

  • Volatility Relation:
      - The risk/volatility of a fund directly correlates with the risk of underlying securities.
      - Funds of the same category may present different volatility levels due to their unique holdings.
      - Some traditionally viewed low-volatility funds may experience higher volatility (e.g., zero coupon bonds).

  • Sources of Volatility:
      - Price changes in securities are driven primarily by supply and demand dynamics, influenced by new information.

  • Unique Risk:
      - Specific to a security—related to sensitivity to new information, leads to changes in demand and affects pricing.
      - Mitigated through diversification: well-diversified portfolios alleviate unique risks.

  • Market Risk:
      - This is common to all mutual funds - excludes money market funds.
      - Market risk cannot be eliminated through diversification.

SOURCES OF VOLATILITY IN MUTUAL FUNDS

  • Table 15.1 | Sources of Volatility in Mutual Funds:   | Type of Risk | Source of Risk | Ways to Reduce Risk |   |--------------|----------------|-------------------|   | Unique Risk | Sensitivity of price to new information | Diversification |   | Default Risk | Failure to pay bond coupon | Avoid corporate bonds |   | Market Risk | Market fluctuations impacting securities | None |   | Exchange Rate Risk | Changes in currency values | Hedging |   | Interest Rate Risk | Rate changes affecting fixed income prices | Avoid long-term fixed income |

  • The interplay of multiple risk factors contributes to the overall volatility of mutual funds, with mutual funds manifesting varied volatilities based on their component securities.

WHAT ARE THE STEPS IN SELECTING A MUTUAL FUND?

  • Figure 15.2 | Steps for Selecting a Mutual Fund:   1. Refer to sources of mutual fund performance data.   2. Identify funds with suitable investment objectives.   3. Search for funds with strong long-term performance.   4. Review funds showing consistent year-to-year performance.   5. Identify funds with lower volatility among top performers.   6. Evaluate current investment managers' impact on performance.   7. Compare fund facts documents and prospectuses.   8. Examine fees and charges.   9. Analyze fund size.   10. Make the final decision.

RESEARCH THE PERFORMANCE DATA

  • Numerous internet-based sources provide mutual fund performance data, including:   - The Globe and Mail: Biannual mutual fund reviews (February and November).
      - Morningstar Canada: Objective data on performance.

  • Performance data may include key metrics such as:
      - Return indicators
      - Volatility indicators
      - Management Expense Ratio (MER)
      - Performance data through comparisons with appropriate benchmarks.

FOCUS ON APPROPRIATE INVESTMENT OBJECTIVES

  • Funds should be compared amongst similar objectives; it is misleading to compare funds across categories.
      - Example: Comparing a money market fund to an equity fund is inappropriate due to differing expected performance levels.

FOCUS ON BEST LONG-TERM PERFORMANCE

  • Look for funds demonstrating significant long-term returns, noting:   - Return data should include reinvested dividends and net of management fees.   - Limited historical data can pose challenges for performance assessment; ideally, funds should have five or more years of performance data.

FOCUS ON BEST YEAR-TO-YEAR PERFORMANCE

  • Identify funds stable in year-to-year returns;
      - Simplicity of measurement through simple rates of return for consistency of performance.   - Protection against losses in bearish market conditions is critical for conservative investors; consistency in performance is valued.

FOCUS ON LOW VOLATILITY PERFORMANCE

  • Utilize statistical measures of risk such as standard deviation:   - Higher standard deviation indicates increased volatility, indicating greater risk.
      - Prefer lower volatility when return rates among funds are similar.

MEASURES OF VOLATILITY

  • Reward-to-Risk Ratio:
      - Defined as:
        extReward−to−RiskRatio=racextFundReturnextFundStandardDeviationext{Reward-to-Risk Ratio} = rac{ ext{Fund Return}}{ ext{Fund Standard Deviation}}
      - Example calculation demonstrated:     - Fund return: 14%, Standard deviation: 28%       - ext{Reward-to-Risk Ratio} = rac{14 ext{ ext{%}}}{28 ext{ ext{%}}} = 0.5

  • Example Application:
        - ABC Fund:       - Return = 9.8%, Standard deviation = 5.5%
          - ext{Reward-to-Risk Ratio}_{ABC} = rac{9.8 ext{ ext{%}}}{5.5 ext{ ext{%}}} = 1.78

  • Sharpe Ratio:
      - Assesses the compensation for risk taken; used to compare similar funds.
      - Performing against a benchmark's Sharpe ratio indicates outperformance or underperformance.

  • Beta:
      - Compares a fund's volatility against the overall market:     - Beta = 1 indicates equal volatility.     - Beta > 1 implies greater volatility; <1 indicates less volatility.

FOCUS ON FUND MANAGER SUCCESS

  • Analyze whether fund performance can be attributed to the current investment manager's skills.
      - Managers’ sustained performance suggests skill, whereas short-term performance may skew results.

  • Alpha Value Concept:
      - Alpha measures added value from a manager beyond what would be predicted by the fund's beta:     - Positive alpha indicates outperformance relative to risk taken; negative alpha shows underperformance.

COMPARE FUND FACTS AND PROSPECTUSES

  • At the penultimate selection phase, reviews on competing funds to best align with investment goals should be conducted.

  • Fund facts documents should provide comprehensive information on:   - Sales charges, valuation procedures, and investment requirements.

EXAMINE FEES AND CHARGES

  • Management expenses and operating costs factored into performance data; beware of additional charges borne by individual investors.

  • Lower MER (Management Expense Ratio) preferred for long-term investments due to cumulative impact on returns.

ANALYZE THE SIZE OF THE FUND

  • Assess the relative size of funds in the same category:   - Larger funds might face challenges with flexibility and execution due to the size of their portfolios.
      - Smaller, newer funds could offer better performance potential but lack historical data.

MAKE THE DECISION

  • Finalize decisions based on:   - Long-term performance vs. risk profile produced through skillful management.   - Evaluate potential trade-offs across various factors affecting fund selection.

WHAT OTHER ELEMENTS SHOULD BE CONSIDERED?

  • Mutual Fund Categories: CIFSC identifies over 7,000 funds segmented into primary asset classes:
      - Cash, Fixed-Income, Equity, Commodity, Other

  • Qualitative Integrations: A solid foundation for investment decisions incorporates qualitative aspects alongside quantitative data:   - People: Assess asset management firm's personnel, experience, stability, and ethic.
      - Philosophy: Get clarity on investment philosophy alignment with risk profile.
      - Process: Ensure rigorous methodologies optimize fund management.
      - Performance: Focus on consistency of performance, risk consideration, and adherence to investment style.

PEOPLE

  • Key personnel in the investment firm, especially the portfolio manager, are central to success.

  • Portfolio Manager: Experience in managing funds through various market cycles is crucial.

  • Team Analysis: A competent team provides robust support for the manager's efforts.

PHILOSOPHY

  • Documented investment philosophies help in understanding firm strategies, which may include:   - Value investing, Growth investing, Momentum investing, GARP, Sector rotation, etc.

PROCESS

  • Processes should be transparent and verifiable. Importance of a systematic approach to managing funds.

PERFORMANCE

  • Evaluating past performance relative to benchmark consistency and risk consideration provides insight into future potential.

CASE STUDY: SAMANTHA’S OPTIONS

  • Context: Samantha’s conservative portfolio consists of 65% bonds, 30% equities, 5% cash.

  • Assessment: The XYZ US Equity Fund does not match her conservative profile, prompting the recommendation of the LMN US Dividend Fund instead.

  • Criteria for Fund Selection:   - Quality stocks, lower volatility (Beta < 1), stable returns, hedged foreign currency risk

  • Final Note: Consult performance reports (e.g., Morningstar) for confirmation of mutual fund quality and manager track record.

SUMMARY

  1. Risk-Return Trade-Off:
       - The relationship between mutual fund types and their inherent risk/return characteristics.

  2. Selection Steps for a Mutual Fund:
       - Detailed multi-step process for mutual fund analysis and selection.

  3. Elements Influencing Selection:
       - Emphasize the importance of the people behind the fund, its philosophy, management process, and overall performance.

REVIEW QUESTIONS

  • Complete online assessments to reinforce your learning from this chapter.

FREQUENTLY ASKED QUESTIONS

  • Access online FAQs to clarify concepts as required.