Who’s Monitoring Your Mutual Funds?
Ron DeLegge, Editor
August 12, 2009

SAN DIEGO (ETFguide.com) – How good are mutual fund investors at minding their own money?

According to Charles Schwab, a recent survey of mutual fund investors discovered that less than half (45%) have become more knowledgeable about their investments since the financial crisis began around two years ago. If that’s not enough, 36 percent indicated they did not know which mutual funds they own!

What about fund investors who’ve hired a broker or financial advisor to supervise their investments? Are they better off? Maybe not. Around 70 percent have infrequent communications with their advisor.

Let’s examine four key parameters that can help you to successfully evaluate your mutual fund investments.

Your Fund’s Performance vs. its Matching Benchmark
The correct yardstick of your mutual fund’s performance should be its risk-adjusted returns relative to its corresponding benchmark index. For example, if you own a small cap mutual fund you should be comparing its historical performance to small cap benchmarks like the S&P Small Cap 600 (NYSEArca: IJR), the Russell 2000 (NYSEArca: IWM) and MSCI U.S. Small Cap Index (NYSEArca: VB). Has it outperformed or underperformed over the same time period? Remember: Always compare apples with apples and oranges with oranges.

It’s become popular in mutual fund research to analyze the performance of funds relative to their peer group, but beware! Peer group comparisons can give a distorted view of performance and should only be used as a secondary reference point. What good are mutual funds that beat their peers but not their benchmark indexes?

Doug Fabian publishes a quarterly report called the “Mutual Fund Lemon List.” According to his latest numbers, a whopping $795 billion “is currently languishing in these underperforming mutual funds.” If you own a mutual fund that consistently underperforms its benchmark, there’s no time like the present to unload it. 

Your Fund’s Secret: Closet Indexing
Do you own a mutual fund that’s pretending to be something it’s not? A closet index fund is an actively managed fund that closely mimics the volatility and performance of an index fund. Financial shenanigans! How does it happen?

As funds obtain more assets, they buy more securities in order to reduce over-concentrated positions. Some fund companies will purposely avoid making large bets on certain stocks or bonds to avoid the risk of making a lousy call, badly underperforming and having unhappy investors defect. The final result is a mutual fund portfolio that looks and acts just like an index fund – but charges substantially higher fees. While most active managers would publicly scoff at managing money this way, closet index funds are very profitable to fund companies because most investors don’t even realize they own one!

How can you make sure you don’t own a closet index fund? One way is to evaluate your fund’s R-squared or R2. The R-squared measures the correlation of a fund’s movement in comparison to its corresponding benchmark. An R-squared score of 1.00 would indicate a perfect correlation, whereas a score of 0.00 indicates no correlation.

Think twice about owning any actively managed mutual funds with an R-squared above 95. It could be the sure sign of a benchmark hugger!

Your Fund Manager’s Eating Habits
According to a Morningstar study published last year, an amazing 47 percent of domestic stock fund managers reported no ownership in the mutual funds they manage. And that’s just the beginning of the valuable cooking lessons being dished out.

An astonishing 61 percent foreign stock fund managers similarly haven’t put their money into their own funds. Managers of taxable bond funds and balanced funds are shamefully worse. A ridiculous 66 percent and 71 percent respectively, reported having a zero percent stake in the fund’s they manage.

What does it mean? It means fund managers aren’t investing their own money alongside of their fund shareholders. It also means if fund managers have so much confidence in their own financial acumen they sure aren’t showing it. Put another way, it means they aren’t eating their own cooking.

“It is obvious that fund managers should invest significant dollars of their own in their funds, so as to align their personal interests with their investors’,” says Louis Lowenstein, author of The Investor’s Dilemma: How Mutual Funds are Betraying Your Trust and What to Do About It (John Wiley 2008).

Lowenstein adds, “Managers’ willingness to put their own dollars alongside the public’s may be the single best marker for their credibility and integrity.”

For fund investors, the message is loud and clear: Don’t invest with fund managers that don’t invest with themselves.

Your Fund’s Churn Rate
Is your mutual fund manager a long-term investor like they preach or are they an imposter? One way to find out is to examine the churn or turnover rate of holdings within your mutual fund’s portfolio.

Portfolio turnover measures the frequency by which securities within a mutual fund or ETF are bought and sold. Turnover is determined by the dollar value of buys or sells (whichever is less) during a year divided by the total assets in the fund.

It’s public knowledge the typical stock mutual fund has a churn rate of 100 percent, indicating the fund manager has sold the fund’s entire portfolio and bought new holdings during the course of a year. High portfolio turnover translates into higher investment costs whereas low portfolio turnover is better because it lessens the impact of trading and tax related expenses.

In summary, it’s doubtful the typical mutual fund investor will ever pay attention to any of these valuable tips, but you never know.