Investors have more than 8,000 different mutual funds to choose from in the U.S. alone, according to Statista, which can quickly lead to a bad case of analysis paralysis. In order to overcome these issues, many investors narrow down the field by selecting funds with the lowest expense ratios since they are the easiest variables to control. A growing body of research also suggests that it may be the only way to boost long-term returns.
While expense ratios are definitely important, investors shouldn’t ignore risk and return metrics that may help them maintain an appropriate level of risk and perhaps optimize returns.
Consider the Risk
The Efficient Market Hypothesis suggests that the only way to improve absolute returns is to take on greater risk since the higher returns are compensation for the greater risk.
While there are many different ways to measure risk, the most popular is the beta coefficient, which measures a mutual fund’s volatility relative to the overall market. A beta coefficient of 1 means that the fund exhibits the same level of volatility as the overall market. When the beta rises above that, the fund is more volatile than the overall market, and when the beta falls below 1, the fund is less volatile than the overall market.
Investors nearing retirement may want to consider mutual funds with lower beta coefficients in order to reduce risk, while those with a longer time horizon may want to take a look at higher beta funds in order to realize potentially higher returns.
The Efficient Market Hypothesis may not agree with the idea of alpha – or beating the market – but that doesn’t mean that it’s not possible to do so in the short term.
While the easiest way to look for alpha is to compare a mutual fund to its benchmark index, this doesn’t account for any added risk that the fund manager may be assuming. A risk-adjusted return metric like the Sharpe Ratio is often a better way to assess outperformance. The calculation takes the difference between the mutual fund’s return and the risk-free rate and then divides it by the fund’s standard deviation. In general, higher Sharpe Ratios indicate better risk-adjusted returns.
Investors may want to check a mutual fund’s Sharpe Ratio rather than simply looking at its headline total returns to get a better idea of whether the manager is taking on greater risks in order to achieve higher returns or whether they are actually beating the market.
There are a number of other qualitative factors that investors may want to consider when analyzing mutual funds.
Actively managed mutual funds depend largely on their fund managers to generate good risk-adjusted returns, which means that the manager’s tenure is often important. While tenure isn’t a guarantee of performance, a long-term track record of success bodes much better than a short-term streak that could be attributed to luck. Investors may also want to consider an actively managed mutual fund’s focus in terms of strategy and holdings.
Most investors should stick with passively managed mutual funds, but smart-beta and other active strategies have been growing in popularity. Before jumping into these funds, it’s important to take a closer look at the strategy and manager executing it.
The Bottom Line
Investors have many different options when it comes to mutual funds, but there are a lot more to consider than just an expense ratio. From risk to reward to managers, investors should take a close look at the mutual funds they select to ensure that they’re the right fit for their portfolios and are well positioned to generate maximum risk-adjusted returns.