By Diahann Lassus, CFP^®, CPA

Jan 30, 2001 11:32 AM

There are an incredible number of mutual funds available today and they come in every possible flavor or type. How do you evaluate these funds and determine whether to hold on or move on? There is certainly a proliferation of information available on performance and comparisons and charts and graphs, but how do you really make sense of all this information.

Here are some basic steps to help you determine if that fund is still a good long-term investment or a friend that is no longer being true to you.

First, determine what kind of fund you are currently holding which may be very different from the fund you originally purchased.

The size of companies your fund invests in is one way to characterize it. One of the major issues we are all dealing with today is the evolution of individual stock mutual funds. An example of this would be the great performing small cap growth fund I purchased 10 years ago.

It really has done very well up until recently. Now it just doesn't compare very well with other small cap growth funds. The reason is that it has evolved to become a mid-cap growth fund. Many of the companies the fund purchased many years ago and held on to have done well and grown in value which in turn has increased the average size of the fund's holdings.

The fund hasn't really changed the new investments it makes but it is still a very different fund than when it started. So make sure you determine what your fund is currently being classified as: small cap, mid cap growth, large cap growth or maybe a blend of several levels of market capitalization.

A second way to characterize a fund is the investment style that really drives the stock selection process.

There are many different types of reports available that can help you identify the current style of your fund. Mutual fund reports such as Morningstar provide what we call style boxes that classify the fund according to whether it is investing for growth, value or a combination of the two.

The third way to characterize a fund is the investment philosophy of the fund manager or fund team.

Is the fund actively managed or is it an index fund? If the fund is actively managed, the investment philosophy depends upon the fund manager or fund management team. A fund manager that is a stock picker may buy very different stocks from a fund manager who buys leaders in selected sectors or who buys the stocks that have momentum. The performance of funds managed by these different philosophies may have very different results.

Next, select the benchmarks that you will use for comparison.

This could be the average for the type of fund you are holding which in many cases will be the most appropriate comparison. It could also be an index for the type of fund such as the S&P 500 for large cap growth stocks or it could be the Russell 2000 Index for small cap stocks.

The key is to select a benchmark that is really a good comparison. Remember, if you are comparing a mutual fund to an index that the mutual fund has expenses from management, etc. and the benchmark does not. This means that you are starting out comparing apples to oranges and need to be aware of this difference.

The best-known and most-often quoted benchmark for the stock market is the Dow Jones Industrial Average. However, the Dow is rarely (if ever) an appropriate benchmark for a stock mutual fund because the Dow consists of only 30 of the largest U.S. companies.

Select the time-frame for performance tracking and measurement.

It is very important to compare performance for the same time periods. Many new stock funds have been marketed in the last few years. When you compare a fund that has only been around for two or three years with a fund that has been around for ten years you have to use the same time frame and not the average annual return since inception.

Understand what total return really means.

To evaluate a mutual fund's investment performance you have to understand total return. Total return is the sum of a fund's income and capital gains or returns--after ongoing expenses are paid.

A more precise definition is that "total return is the change in the value of an investment in a fund, taking into account any change in the fund's share price during the period and assuming the reinvestment of income dividends and capital gains distributions."

The total return of a mutual fund includes one or both of the following components:

• Income return. A mutual fund may produce current income from investments in interest-bearing securities such as bonds or money market instruments, or from dividends paid on common stocks owned by the fund. Yield is the dividend and interest income that a fund pays over a time period--and it should not be confused with total return, which includes any capital gains.
  
• Capital gains. When the securities held by a mutual fund rise in value--or appreciate--above the price at which they were purchased, the fund has a positive capital gain. This can create capital gains distributions when the fund sells the securities or when an investor sells fund shares. Investments that can generate capital gains can also suffer capital losses if the securities decline in price.
  

Use long-term performance data for a more reliable indicator of how the fund has done.

Conclusions are more reliable when you use longer-term data to evaluate performance. Assuming your fund has been around for more than a few years. Use 3 to 5 year average annual returns as the starting point.

Compare year-to-year performance to understand volatility.

Many funds may have comparable average annual performance for a ten-year period of time. The next question is how many ulcers did you get during that period. One fund may have achieved the performance in a dull and boring way with very low volatility while the other fund may have soared in 1999 and tanked in 2000. What kind of volatility can you live with?

Your fund performance may vary from the reported fund performance. If you haven't been reinvesting dividends and capital gains or if you have continued to dollar cost average and buy shares over time, your performance could be very different from the reported fund performance. Keep this in mind when reviewing the numbers.

Review the fund expenses. Fund performance is very important, but you also don't want to pay money you don't have to pay. Take a look at the fund expenses as one of your screens. An index fund should have a very low ratio of less than .5% while an actively managed fund might be closer to 1%.

If the ratio goes over 1%, take a closer look at why. Many international funds and small cap funds have high expense ratios due to a higher trading cost but you can compare the ratio to other funds of the same type to see if your fund is out of line.

Take a step back and put performance in perspective. Don't chase the latest hot fund. Take a look back at some of the hottest tech funds of 1999 and what happened in 2000. Consistent and boring performance is not a bad thing.

What's next? If you complete your analysis and determine that your fund is under performing based on your benchmark, the next step is to analyze why. Has there been a fund manager change? Has the fund taken a position that has caused a short - term problem? Is the fund doing something different like investing in technology when they have never done that before?

Think about selling if the fund is under performing your benchmark and it is not an identifiable short-term issue.

Don't ignore funds that are doing much better than your benchmark either.

These funds may be doing things very differently also. A good example is the value fund that started buying technology stocks to help increase returns and along the way significantly increased risk. If a fund is doing well when you would not expect them to do well based on the market - ask questions or you may suffer the consequences later.

And last but not least, what is the impact on my overall situation if I sell this fund? If I hold it in a taxable account will I have a large capital gain? Is the risk of poor performance higher than the cost of the tax liability?

Don't get so caught up in tracking day-to-day performance that you lose sight of your objectives. Switching from one fund to another based on short-term performance can be very costly. But holding a fund that continues to lose money because you know it will come back someday can also be very expensive.

There is a balance between being a long-term investor who doesn't want to deal with this and tracking the values on a day-to-day basis. Neither extreme is good for you financially or emotionally, but there is a point somewhere in between that can help you balance your investments and that long-term performance.