In some ways, mutual funds are more difficult to evaluate than individual stocks. It’s harder to drill down when there’s so far to go (kind of like deepwater drilling as opposed to land drilling – you have to get past all the water first). We rely primarily on Morningstar for our mutual fund research, and the data is updated monthly. We used to review a section of the mutual fund buy list each week (large caps one week, mid caps the next, and so on), but it took too long to rotate through the list, and we wanted to increase our review frequency to match the Morningstar updates. But how do we sift through that mountain of data monthly? I have no objection to hard work, but I like to spend my time wisely, so we came up with a scoring system.
In short, I load a selection of the new Morningstar data into our buy list spreadsheet each month. We look at total return (for the trailing 12 months, 3, 5, and 10 years), the fund’s percentile rank in its peer category, manager tenure, Sharpe ratio, alpha and beta to the best fit index, 3 and 5 year standard deviation, turnover ratio, gross expense ratio, trailing 12 month yield, and correlation (R2) to the best fit index. The spreadsheet extracts some of that data (3 and 5 year category rank, expense ratio, alpha, beta, Sharpe ratio, and manager tenure) and scores it. For example, if a fund’s category rank is in the 50th percentile or higher, it gets 0 points in that column. If it falls between 25th and 50th, it gets half a point, and if it falls in the 1st to 25th percentile, it gets a full point. There are 7 metrics on which a fund is scored, so the highest point value possible is 7, and the lowest is 0. Funds that score between a 5 and 7 are buys, between 2.5 to 4.5 are neutrals, and 2 and below are sells.
This is just a starting point, however. Once the data is entered and the scores are tallied, I spy with my little eye any calculated scores that don’t jive with the current IPC rating. These are analyzed further to see if an IPC review and vote are necessary. Sometimes, a fund can fall from a buy to a high neutral based on a slight decrease in the alpha, for example; further inspection will show that the alpha (though lower) is still positive, the fund’s long-term record is attractive and all the other fundamentals measure up. In a case like that, we might choose to leave the fund a buy. The scoring system really functions as a first pass, a way to flag changes in the funds from month to month and help focus attention on funds that need more in-depth review.
Sarah DerGarabedian, Research and Trading Associate