by Joe Lan, CFA
Mutual funds have been used by investors for a number of years. By definition, mutual funds are simply an investment vehicle that pools together investor’s money and buys securities. These types of investment vehicles are used in a variety of ways by investors, with some using only mutual funds in their entire investment portfolio and others tapping funds to simply add some diversification to certain sectors of their portfolio. No matter how you want to use mutual funds, it is important, as with all securities, to have a plan for choosing between funds.
With over 26,000 mutual funds at your disposal, the number of fund options now far outweighs the number of stocks for most investors. Here at AAII, we often use screening as our first step when researching stocks. Screening is one of the quickest ways to winnow down a large number of investment options to a more manageable number. Just as with stock screening, mutual fund screening enables investors to target mutual funds that exhibit strong characteristics, allowing you to focus on those mutual funds worth a second look.
The Comparison article in this issue discusses in detail several mutual fund screening options and presents the differences in each. Though most mutual funds screeners are similar, there are still little nuances that make each one unique. This Feature article is the first in a series for the individual investor who is analyzing mutual funds. In this first article, I use Morningstar.com’s Premium Fund Screener, a CI Editor’s Choice, to create screens that target mutual funds with certain characteristics. The Morningstar.com Premium Fund Screener is one of the best available to individual investors. Additionally, Morningstar.com is known for its exhaustive mutual fund data, so after the funds have been identified during the screening process, performing further research is quick and easy.
What to Look For
Naturally, the first step in mutual fund screening is to set up a screen. Before doing this, be sure you have an idea of the characteristics you are looking for in a mutual fund. Oftentimes, mutual funds focus specifically on certain types of offerings. The most popular mutual funds focus on certain market sectors, styles, geographical areas or a combination of the three. For example, a large-cap value mutual fund typically invests in equity stocks that have large market capitalizations and are value-oriented. Alternatively, mutual funds can only invest in bonds or dividend-paying stocks. The possibilities are endless.
When creating a mutual fund screen, I suggest deciding on the type of mutual fund you are targeting and then building a screen to identify these types of mutual funds. Mutual funds focusing on different types of stocks will have different characteristics. For example, small-cap growth funds may have higher returns, higher fees and higher median price-earnings ratios than large-cap value funds. It is important to take these differences into consideration. If you build a generic screen that is applied to the entire universe of mutual funds, you may find that the vast majority of funds passing your screen are of a certain sector or style.
Another area that investors should pay close attention to is fees. A mutual fund may have several different types of fees, including sales fees (or loads), management fees, administrative fees and marketing fees. There are two different types of loads: front-end loads and back-end loads. A front-end load is a sales fee that is deducted when the mutual fund shares are bought, whereas a back-end load takes a fee when the mutual fund shares are sold. Generally, the other fees mentioned represent the expense ratio. Make sure the fees paid on any mutual fund are reasonable. I would suggest staying away from mutual funds charging any sort of load, as these loads are very hard for mutual funds to make up in performance. In addition, redemption fees (back-end loads) can be especially penalizing if you only hold a mutual fund for a short time.
Here, I illustrate how to create two fund screens—a large-cap screen and a small-cap screen. Be sure to have an understanding of what you want to look for before creating a screen.
Screening for Large-Cap Value
Using Morningstar.com’s Premium Fund Screener, the first step is to specify the type of mutual fund you want to target. In this case, the first criterion line is:
Fund Category = Large Value
To choose this criterion, select fund category from the pull-down menu. A window pops up (this same window pops up after you select any data point going forward) allowing you to enter a desired relationship to other criteria (and/or), data, condition (equals, not equal to, greater than, less than, etc.) or value. Simply selecting this one criterion has narrowed the number of options down significantly. Instead of 26,500 or so mutual funds, there are only 1,273 mutual funds that qualify as a large-cap value fund (Figure 1).
Long-term performance is critical for any mutual fund, but for large-cap value funds, I also consider yield and expenses. Therefore, the second criterion, which focuses on long-term performance, is not set to be overly restrictive. The criterion line is:
10 Yr Return % Rank Category <= 40
The Return % Rank Category represents the fund’s total return percentile rank relative to all funds in the same Morningstar category. The highest (or most favorable) percentile rank is 1 and the lowest (or least favorable) percentile rank is 100. The current screen is searching for companies with 10-year returns in the top 40th percentile or better of all funds in their category. As you can see from Figure 2, 4,197 mutual funds pass this individual criterion and 236 funds pass both criteria together.
The third criterion seeks mutual funds that have a year-to-date return in the top 40th percentile. In addition to targeting mutual funds with a strong long-term performance, the third criterion ensures that the mutual funds are also currently performing well. The criterion line reads:
YTD Return % Rank Category <= 40
This criterion allows 10,598 companies to pass, so it is not very restrictive. However, combined with the previous two criteria, the number of passing mutual funds drops to 124.
Because this screen is searching for large-cap value companies, I added a yield criterion. Since the long-term performance filter is not overly restrictive, requiring a decent yield can add some return and ensure that the fund is investing in strong, stable companies. When entering a value for yield, Morningstar provides the cut-off range for each quartile and the average figure for that data point. According to Morningstar.com, the average yield for all mutual funds is 1.47%. I wanted a yield slightly higher since this is a large-cap value fund, so for this criterion, I specify that mutual funds passing the screen must yield at least 2%. This criterion reads:
Trailing 12 Month Yield >= 2
There are currently 7,946 mutual funds meeting this criterion and 31 mutual funds meeting all four criteria set so far.
The next criterion focuses on the expense ratio. With large-cap mutual funds, I suggest keeping the expense ratio low. It is very difficult for a large-cap value mutual fund to make up for a high expense ratio. The current screen searches for mutual funds with an expense ratio of 1% or lower. The screening criterion is:
Expense Ratio <= 1
As you can see in Figure 3, this criterion allows 10,670 mutual funds to pass; together with the other criteria, 19 mutual funds now pass the screen.
Finally, the screen seeks mutual funds with a minimum purchase amount of $5,000 or less, which reads:
Minimum Initial Purchase <= 5000
This ensures that most individual investors are able to invest in the funds that pass this screen. There are now a total of nine companies passing this screen—down from an original universe of over 26,500—a much more manageable number (Figure 4). Figure 5 shows the results of the screen.
Screening for Small-Cap Value
The second screen focuses on small-cap value mutual funds. Generally (this may not always be true), small-cap value companies tend to be more volatile in price than large-cap value companies. To compensate for a higher price volatility (or risk), investors expect a higher long-term return in order to invest in these types of stocks. As you will see in the following screen, the characteristics of these stocks lead to a very different screen.
Just as with the large-cap value screen, the first step is to set the fund category. The process is the same—select Fund Category from the pull-down menu and fill out the appropriate boxes in the window that pops up. The finished criterion reads:
Fund Category = Small Value
As you can see in Figure 6, only 383 mutual funds pass the completed criterion (compared to 1,273 for the large-cap value fund criterion).
Since small-cap value companies are usually more volatile companies, I am more concerned with long-term performance than I was with large-cap funds; higher returns are needed to compensate for the additional price volatility. Therefore, the performance criterion is more restrictive with this screen.
First, I look at short-term performance: As you can see from Figure 7, the screen targets companies that have a year-to-date return in the top 25th percentile in its category. The criterion used is:
YTD Return % Rank Category <= 25
This returns 6,672 mutual funds, and combined with the fund category requirement, the screen now allows 95 mutual funds to pass. At this point, the mutual funds passing the screen are small-cap value mutual funds that have a current year-to-date performance in the top quartile compared to other small-cap value mutual funds.
Long-term performance is scrutinized next. The criterion looks for companies that have a 10-year return that is in the top 30th percentile of its category. The criterion line used is:
10 Yr return % Rank Category <= 30
This line is the most restrictive of our criteria and only allows 3,171 funds to pass, which is about 12% of the universe. This criterion is highly restrictive since it not only looks for mutual funds with strong long-term performance, but also excludes any mutual funds with less than 10 years of performance history. Combined with the previous two criteria, the screen is now down to 19 mutual funds passing.
Finally, the screen seeks funds that do not go over a maximum size, as measured in total assets. This criterion is important for funds that invest in small or even mid-cap companies but almost useless for funds investing in large- or mega-caps. The reason is simple: A fund will run into liquidity issues if it tries to take very large positions in small- and mid-cap companies. As a result, if a small-cap fund has a very high amount of assets under management, it will have to spread its assets among a large number of small- and mid-cap companies. Small-cap funds that are very large become, in essence, similar to index funds, since they are forced to hold a very large number of small stocks. The only difference is that these funds still charge active management fees instead of the lower passive management fees charged by actual index funds. From Figure 8, you can see that our screen searches for companies that have total assets of $1 billion ($1,000 million) or less. The final criterion used in this screen reads:
Fund Size (Total Assets in $MM) <=1000
Though this final criterion passes 18,371 funds by itself, combined with the previous criteria, only six mutual funds now pass the entire screen. The results of the screen are shown in Figure 9.
The sheer number of mutual funds available to investors makes it especially important to have a specific approach when analyzing funds. Screening is a great first step to target suitable mutual funds that are worth your time and effort to analyze further. However, you need to understand the type of mutual funds you are targeting and the characteristics they should exhibit.
Just as with stock screening, mutual fund screening is only the first step in the research process. In the next Analyzing Mutual Funds article, I will delve into specific factors to examine when choosing among the funds that are passing your screens.