What matters when choosing an investment fund

14 November 2023
Understanding fund analysis

Understanding investment funds and how they are structured

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When individuals seek to invest their hard-earned savings into stocks and bonds but lack the time or expertise, investment funds become a valuable option. These funds not only allow investors to delegate the intricacies of investment to professionals but also facilitate diversification across various assets, even with a modest initial sum.

An investment fund aggregate cash from numerous small investors and place it under the management of a dedicated, full-time money manager. This manager, adhering to predetermined criteria and strategic objectives, invests the pooled money. While each fund may have its unique focus, they are generally classified based on factors such as target asset class, region, investment strategy (e.g., growth or value), sector, and, in the case of stock funds, company size.

Investment funds come in two main structures: open-end and closed-end. Open-end funds, prevalent in the United States as “mutual funds,” European regions as “SICAVs,” and the UK as “unit trusts,” issue shares based on investor demand. Consequently, additional shares are created when investors buy into the fund, and when shares are sold, they are withdrawn from circulation. The value of an open-end fund corresponds to the net asset value (NAV) of its underlying investments.

In contrast, closed-end funds have shares listed on an exchange, similar to any public company. The value of these shares is determined by market demand and may trade above or below NAV. Investors looking to enter or exit a closed-end fund must find a willing seller or buyer for their shares, potentially posing challenges during periods of extreme market stress.

It’s important to differentiate investment funds from exchange-traded funds (ETFs) in two primary aspects. Firstly, most investment funds are actively managed, with fund managers selecting specific investments in an attempt to outperform the market. ETFs, on the other hand, generally operate on a passive management strategy, aiming to replicate the performance of an underlying market index.

Secondly, ETFs and closed-end funds are listed on traditional stock exchanges, allowing shares to be bought and sold throughout the trading day. In contrast, shares of open-end funds change hands only once per day and are typically transacted through brokers or specialized “fund marketplaces.”

Where to get fund data

Before delving into investment fund analysis, understanding how to access relevant data is essential. Numerous free online tools, such as Investing.com, Morningstar.com, Portfolio Visualizer, JustETF and Trustnet, allow users to search for funds and apply specific screening criteria. The initial point of reference when exploring a fund is typically its factsheet. These documents provide comprehensive details on performance data, the benchmark the fund aims to surpass, a breakdown of holdings, and an overview of the investment team. Some fund managers even include performance commentary in the factsheet, offering valuable context.

Qualitative analysis

Just as you’d research and analyze a stock before investing in it, you should do likewise before investing in a fund. This analysis can be conducted both qualitatively and quantitatively. Exploring a fund’s factsheet is qualitative analysis. When evaluating quality, the lead portfolio manager (PM) is a key figure. Assessing the PM’s experience, reputation, and track record is important, with an ideal PM possessing strong scores in all these areas. To gauge a PM’s alignment with investors’ interests, investigating whether they have invested their own money in the fund and if their compensation is tied to performance is essential. Such information is typically available in the fund’s prospectus or statement of additional information (SAI).

Similar scrutiny can be applied to the broader investment team. PMs typically oversee a group of analysts responsible for researching and recommending individual investments. Evaluating their experience and structure is paramount, and red flags such as high team turnover should not be ignored. Information on the investment team can often be found by searching financial news sites.

Returning to the factsheet, it’s worth checking the weighting of the fund’s top 10 holdings. A fund heavily invested (more than 50%) in these top positions may be overly concentrated and vulnerable to shocks. Similarly, if more than 10% of the fund is allocated to a single position, it could raise concerns. Striking a balance is key – an excessively diversified fund with, for instance, 100 or 150 positions may struggle for a PM to stay on top of each investment. Additionally, such a fund risks becoming an “index hugger,” merely mirroring the movements of a market index. That’s not what you’re paying an active manager for.

The final qualitative consideration is cost. A lower fund price is generally favorable, and this can be assessed using metrics such as the total expense ratio (TER). The TER expresses overall running costs as a percentage of the fund’s assets. This includes management fees (excluding performance bonuses) as well as trading, legal, and other operational expenses. For instance, a fund with a TER of 1% will see a 1% reduction in value that year before factoring in investment returns. Consequently, the PM must outperform the market by at least 1% for the fund to demonstrate success and justify its existence to investors.

Quantitative analysis

Quantitative analysis involves calculating and examining statistics and ratios based on a fund’s historical returns. While past performance is never a guarantee of future success, quantitative analysis remains useful. It allows investors to assess the return and risk characteristics of individual funds and aids in choosing between similar options.

A sensible starting point for quantitative analysis is conducting a quick check of a fund’s historical returns. The duration of these returns and whether the same PM and core team have been in charge throughout that period are critical factors. Past performance under a different management regime may not provide meaningful insights into future prospects. Additionally, it’s essential to determine whether the historical returns cited are live or “back-tested,” meaning they are simulated. Newly launched funds, particularly those relying on mathematical rules, may cite back-tested returns. However, caution is advised when interpreting simulated data.

Moving to more in-depth analysis, measuring the fund’s historical average annual return and the exhibited volatility is essential. Investors often calculate the geometric mean, accounting for compounding, to determine the compound annual growth rate (CAGR). This is calculated using the fund’s current net asset value (NAV) relative to NAV at inception or another specific point in time.

Investment funds: CAGR formula

Volatility, a measure of a fund’s riskiness based on NAV fluctuations, is the metric to look at to understand risk. A highly volatile fund, all else being equal, carries more risk than one with low volatility. Calculating volatility typically involves using the standard deviation, a classic statistical measure. To compute the standard deviation of a fund’s historical returns, find the average monthly return over a specific period, subtract this mean from each monthly reading, square the results, and determine their average. If using monthly returns, multiply the resulting monthly volatility by the square root of 12 to annualize the volatility.

Investment funds: annualized volatility formula

Focusing on annualized volatility enables a meaningful comparison with the annualized return measure (CAGR). Another widely used metric to assess investment funds is the Sharpe ratio. This ratio measures risk-adjusted returns, calculated as the fund’s CAGR divided by its annualized volatility. Essentially, the Sharpe ratio provides insight into how the fund performed per unit of risk. While Sharpe ratios should technically subtract the risk-free rate (equivalent CAGR of a super-safe asset like short-term government bonds) from the fund’s CAGR before dividing by volatility, this step is often omitted for simplicity when making comparisons between different funds.

Another ratio to evaluate returns against risk is the information ratio. This ratio tracks a fund’s excess returns beyond its benchmark, typically a market index, compared to the volatility of those returns.

Investment funds: Information return formula

By way of example, consider a fund solely investing in US stocks, with the S&P 500 index as its benchmark. Calculating the information ratio involves determining the active return, which is the fund’s CAGR minus the CAGR of the S&P 500 over the same period. For the denominator, examine the fund’s historical monthly returns and subtract the S&P 500 equivalent for each month. Calculate the annualized volatility of these excess returns following the previously outlined process to arrive at the “active risk.” Divide the active return by the active risk, and you obtain the fund’s information ratio.

A higher information ratio indicates superior excess returns compared to its index, with consistent performance indicating lower active risk. This metric is particularly useful for assessing funds explicitly benchmarked against indexes, a category that encompasses the majority of active funds.

The last quantitative computation to consider is a critical measure of risk known as the maximum drawdown (MDD). This tracks the largest peak-to-trough decline in a fund’s NAV, and provides insights into a fund’s risk management. Funds with large maximum drawdowns should be approached with caution, as this suggests inadequate risk management by the PM and their team. Knowing the fund’s worst loss can be telling; for instance, a 50% drawdown means the fund would need to double in value just to recover its previous level.

Investment funds: maximum drawdown

While these calculations may appear intricate, most of them are often included on funds’ factsheets or accessible through online tools mentioned earlier. But understanding how these metrics are calculated and understanding their meaning is essential when comparing similar funds. When evaluating multiple funds, a preference should generally lean towards those with higher Sharpe and information ratios and lower maximum drawdowns. The recommended approach is to first narrow down candidates qualitatively and subsequently analyze the remaining few quantitatively to identify the most suitable investment.


Knowing not only where to find information on investment funds, but how to analyze that information both quantitatively and qualitatively, enhances the decision-making process and leads to informed investment choices.

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