The Hidden Secret To Finding The Best Mutual Funds
July 31, 2017How do you evaluate the tsunami of information you find when you’re trying to pick the best mutual fund for your portfolio? Even if you’ve narrowed down your choice so you know what type of fund (index fund vs. actively managed, large cap vs. small cap, growth vs. value, etc.) there are still hundreds of choices available.
Should you pick the fund that did the best last year, or over the past ten years? My colleague Kelley addressed this already and the answer is a firm no. When my financial planner calls me to recommend a fund, she does this all the time and it drives me bananas. I tell her that’s like looking in the rear view mirror while you are driving.
There’s a better way to evaluate. The key is to look for one simple number, the Sharpe Ratio.
How much return would you have gotten for the risk you took?
The higher a fund’s Sharpe ratio, the better the fund did, adjusted for risk. And by risk, I mean the risk that the price could fall (you won’t care if the fund goes up more than expected, right?) The Sharpe Ratio tells whether the fund manager makes wise decisions – what to buy, how much of it, and when to sell it – and how much risk they were willing to take with someone else’s money. Did they bet the farm on a few stocks, risk a lot and get lucky (or not), or did they have good returns without too much risk?
You can use the Sharpe Ratio of an index fund in that fund category to see what the average risk is, then compare. For example, if the 10 year Sharpe Ratio of the index is .54, but an actively managed fund in same category for the same period is .78, you’ll know the fund may worth considering. If another fund in that same category only has a Sharpe Ratio of .15, for example, you should walk away from it. Keep in mind that most actively managed funds do not beat an index fund consistently over time (if you’re into math, see here for the research), so this is a simple way to separate the better ones.
Make sure it’s calculated net of fees
You have to compare apples to apples. It doesn’t help much if an actively managed fund beat the index by 1.5 percent if the fees are also 1.5 percent. Make sure the fund’s Sharpe Ratio is after fees, not before.
Where to find the Sharpe Ratio
The Sharpe Ratio is easy to find on most mutual fund ratings, such as Morningstar and Lipper (if you have a brokerage account, you may be able to download longer Lipper profiles there). You can also generally find it in the fund’s prospectus, although you’ll have to dig through a lot of legalese to get there.
In my opinion, after decades as an investment adviser, the Sharpe Ratio is by far the best measure of a mutual fund when you’re trying to choose among several with similar objectives. All the other stuff is generally just fluff.
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