Comparing Funds within Categories
“A quality product at a fair price.” The principles of buying are the same for all products whether a mutual fund or a car. So what does quality or fair price mean when selecting a mutual fund? In Step 3 - Comparing Mutual Funds we will look at the information available on mutual funds and help you learn to decide what represents quality and what is a fair price.
Price
We will start with price because it is easier to compare mutual fund prices. The price of a mutual fund is the Gross Expense Ratio plus any sales fees (or loads) assessed by the fund company or the broker. Most funds in retirement plans have no sales fees. If that is the case in your plan you may use the Gross Expense Ratio to compare the cost of two funds in the same category. Remember it is important to compare funds of similar type. Comparing the expense ratio of a Small Cap fund to a Large Cap Index fund would be like comparing the cost of a 4-door sedan to a sports car. When selecting mutual funds price does matter. Even a small difference in the expense ratio can mean a lot of money after 30 years so shop carefully and wisely. If the price of one fund is greater than another fund of the same type ask yourself if the unique characteristics of that fund justify the extra expense.
Quality
Assessing the quality of a fund is more difficult than comparing price. When shopping for a mutual fund quality is determined by comparing the performance to the risk profile of the underlying investments. The ideal fund would have better than expected performance with less than normal risk. So how do you compare performance and risk? Here are some simple guidelines that will help you assess performance and risk.
Performance
Often the first thing that an investor looks at, it is important to remember that performance can be deceiving. Excellent performance over a short period of time is never a good predictor of long-term performance. So how do you measure performance? The best way is to compare a fund's performance over five or ten years to the performance of other funds in its class or, even better, a benchmark index. A good fund will show a consistent track record of beating the benchmark over time.
Risk
Possibly the best measure of the risk of a fund is to compare how much it goes up or down (the funds volatility) relative to the overall market. The statistic beta attempts to capture this information. The market has a beta of 1.0 so a beta less than one indicates the fund is less volatile than the market and greater than one means the fund is more volatile. Again it is important to compare similar funds. Growth funds will tend to be more volatile than the market almost by definition so it would be a mistake to dismiss a growth fund simply because the beta of the fund is higher than one. Remember that our goal is to build our overall portfolio which would require us to find the best quality fund at the lowest cost in each category in our portfolio.
Morningstar Star Ratings*
The Morningstar Star Rating is a useful short-hand way to evaluate the quality of a mutual fund. The rating is based on performance and risk. As the rating system is broken into five broad categories and the ratings change over time, it is best not to be too specific when using these ratings. If the fund is rated four or five stars you may consider the quality high, three stars is a mid quality rating and so on. A reasonable approach is to select only three, four and five star funds in your initial evaluation.
Edit Your List
Go back to the list that you created in the last step. Within each category on the list compare the funds that are available. Select the one that you think is the best value for each category. Record the percentage for each of the categories next to the fund that you have selected within that category. You now have your final list. If there are no funds in a given category for your plan it is probably OK. Simply use the funds that do exist to achieve as much diversification as possible. So for instance, if there are no small cap funds in your plan you may use mid cap as a fair approximation. Simply increase your allocation percentage for mid cap a little and assign the rest back to large cap. The important thing is to achieve as much diversification as your risk tolerance allows.
* For each fund with at least a three-year history, Morningstar calculates their Rating (based on their Risk-Adjusted Return measure that accounts for variation in a funds monthly performance including the effects of sales charges, loads and redemption fees), placing more emphasis on downward variations and rewarding consistent performance. Ratings are subject to change every month. The top 10% of funds in each category receive 5 stars, the next 22.5% receive 4 stars, the next 35% receive 3 stars, the next 22.5% receive 2 stars and the bottom 10% receive 1 star. Highly rated funds are defined as those that have a four or five star Morningstar rating. Data provided by Morningstar, Inc.® All rights reserved. The information contained herein; (1) is proprietary to Morningstar and/or its affiliates; (2) may not be copied or distributed; (3) is not warranted to be accurate, complete or timely. ICMA-RC does not review the Morningstar data and, for mutual fund performance information, please consult both the current Vantagepoint Funds prospectus or other applicable prospectus and MAKING SOUND INVESTMENT DECISIONS: A Retirement Investment Guide carefully for a complete summary of all fees, expenses, charges, financial highlights and investment objectives, risks and performance information prior to investing any money. Past performance does not guarantee future results. Investment returns and principal value will fluctuate, so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance may be lower or higher than the performance data illustrated. For performance data current to the most recent month end, contact ICMA-RC Services, LLC by calling 1-800-669-7400 or by writing to 777 North Capitol Street, NE, Washington, DC 20002-4240, or by visiting www.icmarc.org. Vantagepoint securities are distributed by ICMA-RC Services LLC, a broker dealer affiliate of ICMA-RC, member FINRA/SIPC. For a current prospectus, contact ICMA-RC Services LLC, 777 North Capitol Street NE, Washington, DC 20002-4240. 1-800-669-7400.