How to Use Morningstar to Research Mutual Funds

Morningstar.com is my choice for mutual fund research because it provides a broad array of data for me to analyze a fund in cost, return, and risk. This post is to discuss what kind of information I will consider when evaluating a mutual fund.

If you already have a specific fund on your mind and want to find more about your target, then Morningstar’s mutual fund page is a great resource for your research (you will need to use other tools to screen the funds if you don’t know what to invest). Here I use Vanguard 500 Index (VFINX) as an example to show what I check when I research mutual funds. Entering the symbol at the homepage and you will see a screen as below.

Load

Before I look anything else, I want to make sure the fund doesn’t carry a load. Mutual fund load is nothing but fees paid for brokers to sell the fund and has nothing to do with fund’s performance. There are many great funds out there for me to get direct access and I don’t need a broker to help me select a fund and sell it to me.

Expense Ratio

Expense ratio is what we pay for the fund manager to manage the fund and do reach on how to invest with our money. For actively managed fund, the ER is usually high since the manager has to keep up with (maybe even try to beat) the benchmark the fund tracks and, thus, has to identify stocks to invest so the fund can offer its investor better return (whether that’s true is another story). On the other hand, passive funds such as index funds require much less involvement and the ER is usually much lower than actively managed funds. Since ER reduces the returns we actually get, I usually prefer funds with ER less than 1%. But if a fund’s return is significant enough to offset the higher ER, I can tolerate the ER to go above 1%. Also specialty (or sector) funds often have higher ER than broad market funds.

Minimum Investment

Besides the above mentioned three items, I also look at the fund manager’s tenure. If the manager just started taking over the fund, then fund’s past performance can’t be used as a tracking record of the fund manager (of course, past performance can never indicate future results). The investment category let me know the fund’s investment style (large-cap, mid-cap, or small-cap, value or growth) and I want to make sure it fits in my overall asset allocation. Finally, the fund’s yield tells me what kind of income I can expect from the fund. A higher yield can bring me more income, but if I plan to hold the fund in taxable account other than tax-sheltered accounts such as IRA and 401(k), a higher yield can also mean a higher tax bill.

Another important measure is the fund’s Morningstar star rating (here’s an introduction on star rating). However, since Morningstar considers many factors when rewarding a fund with stars, a fund with less stars doesn’t necessarily translate to poor performance. Therefore, I don’t want to let the stars get in my way of evaluating the fund, at least not at the very beginning.

Now if you move to the middle section of the screen, you will find the following part of data:

Asset allocation

The asset allocation of the fund itself may not matter too much (unless you have only one fund) and the significance of the fund’s asset allocation should be put into the context of your overall portfolio. But I still look at this part to get an idea of where the fund manager puts the money. For certain types of funds (for example, the asset allocation funds), the asset allocation varies from time to time.

Annual turnover

From time to time, especially for actively managed funds, fund manager has to rebalance (buy certain components while selling others) the fund for various reasons and the trading activity is measured by turnover. The same as when you sell a stock and make a profit, you will pay taxes for the gains, investors of the funds are also responsible for taxes for the fund’s distribution. A higher turnover ratio (my CGM Focus fund has a turnover ratio of 333% in 2006 :(( and distributed $2.92 per share in capital gains. Here’s a topic on mutual fund distributions) usually means higher taxes, which will erode your returns. Unless the fund will be held in a tax deferred account, you should always keep an eye on the turnovers.

Returns

OK, it’s time to take a look how the fund has done over years. Nobody wants to pick up a loser. Click on the “Total Returns” tab on the left and you will see the fund’s past performance. However, instead of the total returns, I am more interested in the investor return which is a more accurate measure on what an average investor will get by investing in the fund at different time (you can find my discussion on total return and investor return).

And how to use the return information? Well, it depends on how you look at it. For passive funds like VFINX, you won’t see much difference between the fund’s return and the benchmark it compares with. For actively managed funds, on the other hand, a long, consistent performance against the benchmark (beat or lag) can serve as a proof of the manager’s ability in finding stocks to invest our hard-earned money, if it all happened under the same manager.

The others

In addition, you can find such information as costs and risks (this article may help you understand the risk measures) of owning the fund and where to make a purchase on Morningstar. I always go to the fund company to purchase the fund I want to invest. The fund may be also available at many brokers and other fund houses, but you may have to pay extra fees if you choose a middle man. You can also find tax-adjusted return of the fund, which can be useful if the fund is part of your taxable investment.

The above information is for each particular fund. Morningstar also has free tools for mutual fund screening (Fund Screener) if you want to find narrow your research to a small number of funds that meet your requirements and for fund ranking if you want to see how a fund is compared against its peers in certain fund category. Once you identy a fund that you want to invest, using their Instant X-ray can help you determine how the fund fits in your portfolio’s overall asset allocation.

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