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Booknotes: Morningstar Guide to Mutual Funds

November 18th, 2008 at 01:16 pm

When I read a good financial book, I like to take notes for my future reference and for the benefit of others here who might be inspired to go read it. You can see my past entries by clicking on the Booknotes catagory.

I actually read The Morningstar Guide to Mutual Funds several months ago, and just came across my notes -- so the details may be a little rusty. It was well-written, but I find I have a mental block when it comes to reading about investing (very odd considering I'm a bookworm who averages about a book a week.) It took me several libary renewals to get through this one.

This book is the first one I've read that really focuses on the process of how to choose a particular fund, as opposed to generalities of what mutual funds are, and for that I highly recommend it. It explains how to use the information available on Morningstar's website to choose funds.

Questions to ask yourself to check whether you thorougly understand a fund:
* What does the fund own (style, catagory sector)
* How has the fund performed? (3,5,10 year returns, calendar year return, average annualized return, after-tax return)
* How risky has the fund been? (standard deviation, top 10 concentration, Morningstar risk rating)
* Who runs the fund? (fund manager's history)
* What is the fund family like?
* What does the fund cost? (loads, expense ratio)

Know what a fund owns:
* Understand the style box -- this tells you if the fund invests in small, medium, or large companies, and also whether it buys stocks because they are "on sale" (value - a good price compared to history for that stock) or are expected to increase in price quickly (growth) or a combination (blend).
* Check the sector weightings. This tells you how much the fund is investing in different kinds of companies -- say banking, industrial, or high tech
* Check the number of holdings (more stocks = less risk)
* Check the turnover rate (lower is better). If the fund buys and sells a lot, trading fees will decrease the return.

Performance -- things to look at when comparing funds:
* Annualized return
* After-tax return
* Compare the fund's return to the right benchmark

* large cap: S&P 500
* small cap: Russell 5000
* foreign: MSCI EAFE
* taxable bond: Lehman Brothers Aggregate Bond

* Also compare the fund's return to the Morningstar index for corresponding style box
* Look at the long-term history -- the 3, 5, and 10 year returns
* Note how long the manager has been with the fund -- good historical results may have come from a previous manager
* Look at the calendary year returns -- this will tell you if one exceptionally good year is making the other long term results look better than is warranted.

Analyze the Fund's Risk:
* Add up the % invested in the top ten holdings -- how concentrated is the fund in these stocks?
* Style risk: Large-value is the least risky, small-growth has the most risk
* Past volatility: look at the worst calendar year. If it happened again, would you be willing to ride it out or would you feel compelled to sell?
* Standard deviation: this tells how much the fund has varied from the 3 year average. 68% of the time, your return will be within 1 standard deviation. Lower is better (means the fund is more consistent). Compare a fund's standard deviation to the standard deviation of the index.
* Morningstar's risk rating:
* low: least risky 10% of funds
* below-average: next 22.5%
* average: the middle 35% in terms of risk
* above-average: next 22.5%
* high: most risky 10% of funds


Evaluating the Fund Manager
* Look for 10 years experience as an analyst or portfolio manager, with at least 5 of these years as a portfolio manager
* Seek ones who spent their early years at a high-quality firm like Fidelity or American Funds
* Management changes -- consider selling if the management changes and the fund is from a small family has just a handful of fund, or if the fund is the only good one in that family, or if the catagory is small or emerging markets

Analyze Costs
* Growth, small-cap, and international funds will have higher expense ratios because they require the fund to do more research.
* Look for funds charging < 1.25%
* Compare the fund's expense ratio to the following averages:
* large-value: 1.41
* large-blend: 1.24
* large-growth: 1.5
* mid-value: 1.43
* mid-blend: 1.40
* mid-growth: 1.60
* small-value: 1.51
* small-blend: 1.53
* small-growth: 1.64
* Foreign (Europe, Japan, and World): 1.75
* Foreign (emerging markets): 2.19
* Sector funds: 1.72


Portfolio Mix
* Main asset classes are stock, bond, and cash. Some consider foreign, emerging markets, and REITs as separate classes.
* Diversity among the main classes is the most important.
* Diversity among the sub classes (style box, foreign) is useful but not as crucial.

Where to invest money for your short-term goals (plan to use the money in 1-5 years)
* Money-market
* Ultra-short bond funds (bond maturities < 6 months)

Where to invest money for your medium-term goals (plan to use the money in 5-10 years)
* 25% in short-term bond or cash
* 75% in stock funds -- either large-blend or balanced funds
* Shift the money into bonds as you get closer to the goal

Where to invest for long term goals
* I seem to be missing notes for this

Structuring your Portfolio
* Your foundation should be made of a core of funds, comprising 50-80% of your assets. Recommend large-cap domestic fund for the foundation
* Small cap should be < 20% of your portfolio
* Consider having some foreign funds in developed markets (ie Europe and Japan)
* Risk diminishes significantly by owning at least 3 funds
* Above 7-10 funds, risk doesn't diminish
* Watch out for overlap if you own multiple large-cap funds
* Four-corners strategy: invest in large-value, large-growth, small-value, and small-growth
* Check total exposure to each catagory sector -- no more than 30% in any one sector

Write down why you bought each investment.

Understanding the investment strategy of your fund:
Value Styles:
* relative-value: choose stocks that are cheap compared to benchmark such as historical price ratios, industry, or overall market. American Funds Washington Mutual is recommended for this strategy
* absolute-value: figure out what a company is worth, and buy when the stock price is less than that amount. Manager studies the company's assets, balance sheet, and growth patterns. Be prepared to wait out long dry spells.

Growth Styles:
[indent]* earnings driven or "momentum": focus on identifying accelerating earnings. This style has a price risk -- the price of a stock may plunge on bad news. These funds tend to have significant short-term drops.
* revenue-driven: buy stocks that have strong revenues
* GARP (growth at a reasonable price): strike a balance between strong earnings and good value. Fidelity Magellan is a recommended example

I think there may be one or two chapters at the end that I didn't cover...

2 Responses to “Booknotes: Morningstar Guide to Mutual Funds”

  1. Broken Arrow Says:

    Thanks again for a great entry.

    I enjoyed that book, though did not buy it....

    Though MorningStar's tools are great and I use it, it's just that this book uses exclusively MorningStar tools rather than books that try to share the best tools they've found from anywhere.

  2. zetta Says:

    Yeah, that's a downside. What other tools would you recommend?

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