Investing in pooled funds like exchange-traded funds and mutual funds provides a more convenient route toward building a personal investment portfolio and meeting personal investment goals and objectives. These are some of the most accessible options for both budding and seasoned investors. A particular market index like the S&P 500 has at least a dozen index funds. There is also a wide selection of actively managed equity funds and bond funds. However, because of the availability of different funds from different companies, choosing the most suitable one can be challenging. This is the main reason why it is important to know how to pick the right fund using a set of evaluation criteria.

How to Evaluate Pooled Funds: Important Criteria for Assessing Investment Funds Like Exchange-Traded Funds and Mutual Funds

Importance of Evaluating Pooled Funds

There are more specific reasons why an investor should evaluate prospective pooled funds before investing in one. One is to compare across different funds. Consider index funds as examples. One of the steps in choosing an index fund for a particular market index is to compare similar index funds that track the same market index.

Another reason is to ensure that the chosen fund is aligned with the risk tolerance or risk profile of the investor. A particular fund might have a higher risk compared to similar funds. Each fund also has its investment goals and objectives that should be aligned with the personal investment goals and objectives of an investor.

It is also important for investors to maximize the benefits of their investment choices. This requires making informed investment decisions. A particular investor must choose a fund that is well within his or her investing capacity. The chosen pooled fund must be effective and efficient in terms of meeting goals and objectives and costs.

Criteria for Evaluating Pooled Funds

Nevertheless, with the aforesaid knowledge in mind, evaluating pooled funds without knowing what to look at or how to approach the evaluation process is a futile pursuit. It is reassuring to note that information about funds or fund facts is readily available. Each fund has its prospectus. Other information can be contained from fund screeners.

The different sources of information provide insight into how prospective funds work and how they did in the past based on a set of characteristics. Both the prospectus and information from mutual fund screeners often summarize the data and information that are relevant to investors. The following are the criteria to look for when evaluating pooled funds:

1. Objective and Strategy

Each fund has its statement of objective and strategy. This can be found in its official prospectus, fund facts available on the website of its providers, and third-party sources like fund screeners. The overall investment objective and strategy tell investors the focus of a fund. This focus can be on growth or capital appreciation, income generation through dividend or interest payments, or a balance of both. The same statement also tells investors how the fund managers achieve the goals and what securities or asset classes the fund invests in.

2. Style Map or Style Box

American financial analytic firm Morningstar has introduced the style map or style box as its fund classification scheme. The style box provides a visual or graphical representation of the investment characteristics of a particular equity fund or bond fund. It serves as a tool for investors to readily determine investment allocation and the risks involved. There is a slight difference between the style boxes of equity or stock funds and fixed-income or bond funds.

Stock or Equity Style Box

The style box for equity funds is composed of a vertical axis and a horizontal axis. The vertical axis represents the company size based on market capitalization and is divided into three sections. These are large for large-cap companies, medium for mid-cap companies, and small for small-cap companies. The horizontal axis represents the investment strategy and is also divided into three sections. These are value for value investing, growth for growth investing, and blend for a mixture of value and growth strategies.

Nevertheless, based on all possible combinations, the vertical axis and horizontal axis of an equity style box are used to classify a particular equity fund into one of nine categories. These categories are large value, large blend, large growth, medium value, medium blend, medium growth, small value, small blend, and small growth.

Fixed-Income Style Box

The style box for fixed-income securities also has a vertical axis and a horizontal axis. The vertical axis represents credit quality ratings and is divided into three sections. These are high for high rating, medium for medium rating, and low for low rating. The horizontal axis also has three sections that represent sensitivity to interest rates as determined by the duration of the fund. These sections include short-term for short-term securities, intermediate for mid-term securities, and long for long-term securities.

Hence, considering all possible companies, the vertical axis and horizontal axis of a fixed-income style box are also used to classify a particular fixed-income fund into one of nine categories. These are high short, high intermediate, high long, medium short, medium intermediate, medium long, low short, low intermediate, and low long.

3. Portfolio and Holdings

Remember that the style map of a particular pool fund provides a snapshot of its composition and the general characteristics of its entire portfolio or holdings. This is helpful in making quick decisions but is not enough to get a complete hold of how the fund works and its level of risk. It is in this regard that it is also important to look at the underlying assets the fund invests in. An investor should be able to gauge if the holdings are aligned with his or her risk tolerance and that he or she has no qualms about investing in some of the fund components.

4. Expense Ratio

The expense ratio of a fund is the annual management fee that is expressed as a percentage of the total value of its assets. This management fee covers all the costs associated with running the fund like specific management fees to pay the fund managers and operational fees covering administrative, marketing, and recordkeeping costs. Remember that the expense ratio is deducted from the assets. A higher ratio means that investors receive reduced overall returns. A lower ratio is generally preferred. The following are the ideal expense ratios:

• Passively Managed Funds: Passively managed funds like index funds do not require active management and research. They have the lowest expense ratio. The ideal ratio ranges around 0.10 percent to 0.20 percent. An expense ratio that is above 1.00 percent is not ideal and is considered more expensive than most actively managed funds.

• Actively Managed Funds: Actively managed funds are more expensive than passively managed funds because they require active management through continuous research and modifications in their portfolio or holdings. The ideal ratio ranges around 0.50 percent to 0.75 percent. An expense ratio above 1.50 percent is regarded as too high.

It is important to underscore the fact that the expense ratio is just one of the criteria for evaluating pooled funds. A high-performing fund as determined by its more recent historical returns with a slightly higher expense ratio might still be a good option. It is important to note that the expense ratio or cost of a particular pooled fund is still one of the bases for rationalizing the performance of a particular fund. This is the reason that an expense ratio of 1.00 percent is not ideal for passively managed funds and even for low-performing actively managed funds.

5. Risk Metrics

There are several metrics used in communicating the risks and performance characteristics of pooled funds. Most investment professionals and some investors determine these metrics from scratch. There are also several websites or online resources that regularly publish these metrics to provide the average investors and public with easier access to information and help in making informed decisions based on individual risk tolerance and investment goals and objectives. Below are the commonly used metrics for evaluating pooled funds:

• Standard Deviation: This measures the price variability or returns of a fund over a period of time. A higher standard deviation is indicative of greater price swings or volatile price movements and translates to higher risk. There is no ideal standard deviation. A higher one might be riskier but might be more ideal for aggressive investors and a lower one is less riskier and is more ideal for conservative or risk-averse investors. Remember that there is a tradeoff between risk and return. A higher risk translates to higher return potential.

• Beta and Alpha Values: Beta measures the sensitivity of a fund to market movements relative to a benchmark or index. A value that is equal to 1 means the fund moves with the market. A value greater than 1 means that the fund is more volatile than the market and a value of less than 1 means it is less volatile. An alpha is an indicator of performance relative to the expected return based on its beta. A positive alpha means that it outperforms the market while a negative alpha means underperforms the same market.

• Sharpe and Sortino Ratios: The Sharpe ratio of a fund is a measurement of its returns adjusted for risk. A higher value indicates better risk-adjusted performance. The Sortino ratio of a fund is similar to the Sharpe ratio but focuses on downside risk and considers both the returns of the fund and its volatility. It aims to identify how much return an investor gets per unit of risk taken as determined by volatility. A Sortino ratio is an indicator that the fund has a better risk-adjusted return in consideration of downside risk.

• Maximum Drawdown: Another metric used for evaluating a pooled fund is its maximum drawdown. This measures the largest peak-to-trough decline in the value of the fund over a specific period and highlights the potential for losses during down markets. The maximum drawdown of a fund essentially indicates the most significant loss the fund has experienced. A value suggests that the fund is susceptible to substantial losses in the future. It is worth noting that historical performance does not guarantee future results.

• Upside and Downside Capture: The upside capture ratio and downside capture ratio measure fund performance in up and down markets relative to a benchmark or index. An upside capture ratio that is greater than 100 is an indicator that the fund outperforms the benchmark in rising markets. A downside capture ratio that is less than 100 loses less than the benchmark in failing markets. This means that an ideal fund should have both an upside capture ratio of greater than 100 and a downside capture ratio of less than 100.

• Turnover Ratio: A turnover ratio measures the trading activity of a particular fund over a specific period. It reflects the percentage of the holdings of the fund that have been bought and sold during a given timeframe. A 100 percent turnover ratio means that the fund has completely replaced its holdings. The frequency of trading has cost and risk implications. The ideal turnover ratio of an actively managed fund is between 50 and 100 percent. A passively managed fund should have a turnover ratio of less than 50 percent.

6. Income or Yield

Another one of the criteria used for evaluating pooled funds is their respective income or yield. Funds that are focused on providing investors with passive income should have a higher income or yield. These funds are invested in income-generating assets like dividend-paying or preferred stocks and fixed-income securities or bonds. Funds that are focused on value investing or growth investing prioritize capital appreciation and may have lower income or yield. These funds tend to reinvest their earnings to purchase more assets.

Investors must take into consideration the income or yield of a fund in accordance with their personal goals and objectives and risk tolerance in investing. A fund with a higher value means that it can provide a certain level of passive income. Those who prioritize long-term growth should not pay much attention to these values. It is not advisable to chase funds with higher yields because such can be an indicator of higher risks. An investor should look at income or yield alongside other criteria or factors like expense ratio and risk metrics.

7. Performance History

The past performance of a fund does not guarantee its future performance. It is still an important criterion for evaluating a pooled fund and comparing it with other funds. An investor can look at the performance of a fund over different market conditions. This can help in gauging whether it has the capability to survive through market downturns and experience a considerable level of returns during market recovery. Past performance can also tell investors about the capabilities of the fund managers by comparing it with other funds or a benchmark index.