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How to Determine Which Fund is Better?

2/10/2014

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Q. I am looking at several mutual funds and ETF funds, for example, FUSVX, FUSEX, FSTVX, and FSTMX from Fidelity, I wonder how to pick the best fund?

A. The mentioned 4 names are actually 2 funds with 2 classes each.  

2 classes within the same fund typically have the following differences - minimum account balances and expense ratios.  For example, FUSVX and FUSEX both are S&P 500 index funds, but with different minimum account balance requirements and slightly different expense ratios.  The good news is, once your account balance reaches the higher class (lower expense ratio) threshold, you will be automatically moved to that class by Fidelity.

Now, here is the more important question, how do you pick from two or even more different mutual funds, how to tell one mutual fund or ETF fund is better than the others?

The common mistake people make is to only look at at a fund's past performance and then make the decision based on that past record.

Don't make that mistake!

In addition to return, you need to consider risks as well.  This is where it gets complicated, because there are at least 5 major ways to measure a fund's risk.

Alpha
Alpha is a measure of an investment's performance on a risk-adjusted basis. It takes the volatility of a stock or fund and compares its risk-adjusted performance to a benchmark index. The excess return of is its "alpha."  The more positive an alpha is, the better.



However, Alpha is not a good metric use to compare two different types of funds.  Just like you can't say an elementary school student whose math level is several times of average students' level has better Math skills than a math professor whose math skill level is at the same level of his peers.

Beta
Beta is a measure of the volatility, or systematic risk of a security or a portfolio in comparison to the market as a whole.  You can think of it as the tendency of an investment's return to respond to swings in the market. By definition, the market has a beta of 1.0.  Individual security and portfolio values are measured according to how they deviate from the market.  The higher a Beta is, the more volatile the underlying stock or portfolio is.

Unfortunately you can't use Beta alone to judge which fund is better, it measures risk only, you need to incorporate return figures, although typically the higher the risk, the higher the expected return.

R-Squared
R-Squared is a statistical measure that represents the percentage of a fund portfolio's or security's movements that can be explained by movements in a benchmark index.  


R-squared values range from 0 to 100.  It's advised for fund investors to avoid actively managed funds with high R-squared ratios, because you don't want to pay the higher fees for so-called professional management when you can get the same or better results from an index fund.


Again, this is a risk measurement only metric, can't be the solo metric to judge which fund is better.

Standard Deviation
Standard deviation measures the dispersion of data from its mean. In plain English, the more that data is spread apart, the higher the difference is from the norm. In finance, standard deviation is applied to the annual rate of return of an investment to measure its volatility (risk).  The higher standard deviation is, the more risk a stock or fund is.



This is another risk metric that can't be used alone to judge which fund is better.

Sharpe Ratio
Developed by Nobel laureate economist William Sharpe, this ratio measures risk-adjusted performance. It is calculated by subtracting the risk-free rate of return (typically the U.S. Treasury Bond) from the rate of return for an investment and dividing the result by the investment's standard deviation of its return.



The higher the Sharpe ratio is, the better!

The Sharpe ratio tells investors whether an investment's returns are due to smart investment decisions or the result of excess risk. This measurement is very useful because although one portfolio or security can reap higher returns than its peers, it is only a good investment if those higher returns do not come with too much additional risk. 

The bottom line
Sharpe Ratio is the best one for reasons discussed above.  Pick the fund with the highest Sharpe ratio among all your fund options.

Where do you find the above data for a fund?  Please see our next blog post.

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