10 Easy Ways to Evaluate a Fund’s Temperature

Stocks, ETFs, mutual funds and risk

Exchange-traded funds (or ETFs) and mutual funds are attractive commodities. They do not work the same (ETFs are traded like stocks, mutual funds are not), but they both have a considerable advantage over stocks. They mitigate investment risks by diversification, therefore allowing you to take full advantage of booming market trends without the headache of scrambling to pick the hottest stock out of a hundred possibilities. If you need an analogy to better understand what risk mitigation is, imagine heading to the local racetrack on Sunday to place some bets (after the morning church service of course). If you bet on a single horse, it’s pretty much “win it all or lose it all”. If on the other hand you feel a little more cautious that day and decide to bet on several horses (for a lower potential profit), you’re increasing your odds and lessening your exposure to jeopardy!

As an individual investor, I think it’s best to prefer both ETFs and mutual funds over particular stocks, for the latter are more volatile, and require much more attention and due diligence – not to mention it can (and will) cost you your shirt if the company tanks.

However, just like stocks, some funds are gems, others are dogs. Some cost an arm and a leg, others are cheap to own. So take the time to appraise the 10 following factors when shopping for funds.

1. By dividend

One of the first things I check when scouting for a new fund is whether or not it pays a dividend, and if so how much it yields. The more it yields the better of course; after all who doesn’t want to get paid simply for owning a fund? For example, SPDR’s Standard and Poor’s Dividend index ETF (NYSE: SDY) or Vanguard’s Dividend Growth mutual fund (MUTF: VDIGX) both pay sound dividends. You can either cash in these dividends, or use them to buy more shares.

However remember what the fine print says: “results may vary”. Dividends on funds are never guaranteed and can be lowered or canceled at any moment. This happened a lot in 2008-2009. The following aggressive ETF for example, iShares’ High Yield Corporate Bond Fund (NYSE: HYG) skipped a few beats delivering dividends when the market fell apart in 2008 and 2009. It went back to paying its shareholders steadily since the market recovery in 2010.

2. By market capitalization

Also know as “market cap”, the market capitalization is the number of outstanding shares of a public company’s equity, multiplied by the current share price. The resulting number is the company’s capitalization size in dollars. In other words the amount of dollars you’d have to pay if you wanted to purchase the whole company. This is how one determines whether a company is considered small-cap, mid-cap or large-cap in comparison with its peers. Small and mid-cap companies tend to be more volatile and riskier than large-caps, but sometimes experience greater growth during times of prosperity.

General Electric (NYSE: GE) is an example of large-cap company, valued at about $164 billion as of January 2010, while San Francisco shipping company CAI international (NYSE: CAP), valued at $154 million is considered a small-cap company.

Some funds are designed to mix companies with similar market caps so that the fund capitalizes on market cap trends. If you believe that small businesses have a good chance to grow this year, you could pick an ETF like Vanguard’s Small-Cap ETF (NYSE: VB) for instance. If on the contrary you bet that “blue chips” (i.e. large companies) are on a roll right now, you could choose a mutual fund like Vanguard’s Large Cap Index (MUTF: VLACX).

Note that ETFs can be traded and therefore have a market cap of their own, just like a company’s stock.

3. By geographical localization

Some funds are created to take advantage of markets in foreign countries that cannot be easily accessed by common investors. The equities they contain are traded on foreign markets and are considered exotic. If you’ve ever tried to open a bank account in mainland China to trade Chinese equities from the comfort of your home in America, then you know how handy such funds can be.

These funds can target:

• a continent (Asia, Africa, the Americas, Europe, Oceania)
• a particular market variety (“Third-world” or “emerging” markets versus “developed” markets)
• a specific country (like Vietnam, Russia or Japan)

It really is up to you to find and pick a fund by the geography it targets. But be aware that some regions of the world, particularly emerging markets, are more likely to be affected by events like natural catastrophes, epidemics, political shakedowns or war – all of which will negatively affect the local economy and therefore the fund.

Need examples? Check out WisdomTree’s Middle East Dividend Fund (NYSE: GULF), an ETF that aggregates shares of incorporated Middle Eastern companies. If you’d rather bet on businesses headquartered in Peru, iShares’ All Peru Capped Index Fund (NYSE: EPU) might be just right for you (and has been performing strongly since its creation in 2009).

4. By industry

Some mutual funds specifically blend values related to a certain sector of activity such as:

• Finance and banking
• Healthcare and medical research
• Energy
• Transport and shipping
• High technology

Among other things, Omaha billionaire Warren Buffett is famous for stating that you should “never invest in a business you cannot understand”. However, picking industry-oriented funds can be a good way to partially overcome that challenge.

Let’s say that besides paying your electricity bill and the weekly trip to Chevron to fill up the car, you don’t know the first thing about energy. You’re no fool; you have solid evidence that the world’s demand in energy is not going to decrease anytime soon, and that fossil fuel is in limited supply. But since you don’t know whether beet juice, ethanol or recycled cooking oil is the way of the future, you are completely unable to pick one alternative energy company’s stock over the other. Tough choice.

No need to get a PhD in unconventional energy sources. A solution could be to invest a lump sum in a mutual fund like Firsthand Funds’ Alternative Energy (MUTF: ALTEX).

In a similar fashion, no need to be a doctor or a nurse to know that with an aging population in the Western world, Fidelity’s Select Medical Delivery (MUTF: FSHCX) might be a good pick. The fund targets hospitals, nursing homes, health maintenance organizations and other companies specializing in the delivery of health care services.

5. By expense

The main downside of buying funds over stocks is the fees. Both ETFs and mutual funds have yearly fees that can range from 0.01% for the lowest ones, up to a whopping 10% for the most expensive ones. Why are there fees with funds you might ask? It’s pretty simple; these fees are actually a fund’s operating expenses. Understand that there is a management team behind each fund, and all these people are on a payroll.

In addition to the yearly fee, some funds even carry “loads” (trading charges). This means you’ll be charged a fee when buying and/or selling shares of a fund – a big trading deterrent, but not a real problem if you plan to hold a position in the fund for the long run. Add brokerage fees plus commissions to all that and you’ll understand that it’s better to try and find low-cost funds right off the bat.

Although best avoided, higher fees might be justified. For example, international funds span investments in several countries and therefore require international management teams. Small cap funds aggregate smaller businesses which are riskier by essence. More research, monitoring and due diligence is necessary, incurring more expensive expertise as a result.

Still, I really cannot think of a good reason to purchase any fund with yearly holding fees over 1.5% (let alone double-digit ones!), no matter how stellar the management firm is. In the long run, compounded fees will eat your profits and will considerably weaken your return on investment. Besides, you’ll pay these fees regardless of the fund’s performance and the economic conditions! The numbers prove it: a low-cost fund will always surpass an equivalent higher-cost fund by the difference in expenses.

Luckily for you, there are a lot of high-quality, low-cost funds out there. Vanguard is the leading investment firm for such products, so do not overlook them.

6. By risk versus reward

Mutual funds and ETFs are profiled by independent rating agencies such as Moody’s or Morningstar to help investors assess the inherent risk versus reward ratio. Funds are equity aggregators and therefore less risky than individual stocks, but it does not mean they are devoid of risk! To find out what is the exposure before buying any fund, I like using Morningstar’s fool-proof website; it displays quite clearly all the parameters I need. Unfortunately, not all funds are rated.

Vanguard’s mature VFINX is a classic example of a moderately risky index fund.

7. By market trend

Who said funds only work when the economy is bullish? Probably some fool that never heard of short funds. The vast majority of mutual funds and ETFs are unquestionably designed to perform at their best when the economy is booming, the best example being index funds. Some primarily bullish funds are hedged, which means they contain a few short positions among a majority of bullish ones. But some fund managers even went further and engineered peculiar funds that short the market, and therefore perform well during economic downturns or “bearish markets”. Short funds are also commonly known as (drum rolls)… bear funds!

For example: ProShares’ UltraShort Financials ETF (NYSE: SKF) and ProFunds’ UltraBear mutual fund (MUTF: URPIX) both performed great during the 2008-2009 economic debacle.

Sophisticated investors do not overlook bear funds and short ETFs because they are designed to go up and make them money while other bullish funds will go down. Owning both bullish and bearish funds is smart because this hedges your portfolio. So get a variety of funds, and trade one or the other kind according to whatever the market trend is. This way you’ll make money during bright and grim times.

8. By minimum initial investment

Some mutual funds require a minimum investment sum varying from a few hundreds to several thousand dollars to get in. Some funds (especially of the more sophisticated or exotic kind) can be out of reach for the average investor due to a very steep required initial investment sum. For instance, ProFunds’ UltraBear mutual fund (MUTF: URPIX) requires a considerable $15,000 just to get in.

Don’t worry though; there’s almost always a cheaper alternative. Besides, such high entry price funds are designed for institutional investors rather than individual ones, most of which would not tolerate so much “skin in the game” in a single fund.

9. By asset manager

When looking for mutual funds, it can be valuable to know which company is responsible for the creation and management of the fund. Keep in mind that when purchasing a fund you hope will perform well, you entrust a team of professionals that constantly manage the allocation of values in the fund. Talent and experience are a must. Some long-established investment management companies (like Vanguard) have a stellar performance record. It’s best to invest your money with historically successful asset managers.

10. By… religious belief

Islamic and Kosher funds, anyone? Yes, there is such a thing for discerning, morally-driven investors.

Not all mainstream and legitimate trades are clean by strict religious standards: gambling, pornography, tobacco and alcohol are among a few business activities that Nicholas Kaiser’s Muslim clients want to stay away from when investing their money. This is why Kaiser, a Christian, created in the 80s the successful Amana funds. Not only do his Islamic funds have a stellar track record, but they also follow the principles of sharia finance, much to the satisfaction of his investors.

Not all religious-driven funds are successful, but Kaiser’s Amana funds follow well-known Islamic principles that also happen to be sound financial advice: stay away from debt-ridden companies and avoid heavy day-trading (because akin to gambling).

The best part? No need to convert to Islam to buy these clean-cut mutual funds!