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The number of Canadian mutual
funds increased greatly during the last decade. With over 11,000 mutual funds
to choose from, investors are finding it very challenging to select mutual
funds for their portfolios. A few companies, for example Morningstar, the Globe
and Mail and Fundata, have developed ratings which aim to assist investors in
their mutual fund selection. These rating products rank the mutual funds
according to a number of criteria such as risk and return. These products make it easier for investors
to quickly compare mutual funds and arrive at a short list. While using these
products simplifies the mutual fund selection process, investors should do some
homework and understand the grading methodology used by these products. For
example, some of the things that an investor may wish to consider when using Fundata's
FUNDGrade® grading method are as follows:
Understand the high level
Fund Grade grading process. The
purpose of the method is to compare a fund's performance to its peers. An "A"
fund in Fund Grade indicates that the fund is in the top 10% amongst the mutual
funds in its peer group, in terms of risk-adjusted returns. Risk-adjusted
returns take into account not only the returns of the fund, but also its risk
level. Risk is measured by the volatility in the fund's historical returns.
Select a well performing
fund in a well performing category. A
rule of thumb is that 90% of an investment portfolio's return is explained by
its' asset allocation. A fund's assets can be allocated to various financial
instruments such as stocks, bonds and cash and this asset allocation determines
a fund's category. In recent years, one of the well performing categories has
been the Natural Resources category, with the average 3 year return of 19.7%.
Selecting an "A" fund within this category should improve your results,
provided that the category continues to perform well.
Carefully consider other
qualitative factors. Fund Grade
grading is based on historical performance. Qualitative factors such as
management changes or changes in the fund's mandate that are not a part of the
rankings can affect future performance of a mutual fund.
Consider the correlation
in multi-fund portfolios. The classic
investing principle of diversification suggests that when you purchase multiple
funds for your portfolio, you can lower the overall risk of your portfolio by
choosing funds with low correlation amongst them. Correlation measures the
similarity between the returns of two funds over a period of time. For example,
if you consider two funds that both invest in natural resources, there would
generally be a high correlation between them. And, in comparison, the
correlation between a Science and Technologies fund and an Emerging Markets
Equity fund would be generally lower.
Consider long-term
performance. Do not expect a fund to
be always graded "A". What is more important is the consistency of Fund Grades
in the tight interval. Grades are based on monthly performance and mutual funds
investing in certain categories such as stocks should be done with a long-term
view. If a fund is able to stay most of the time in "A" or "B", it is a good
sign. An example would be the Sceptre Equity Growth Fund. While continuously
maintaining an A grade, it generated 2-year, 3-year and 5-year annual returns
of 16.16%, 21.43%, 30.07%.
In conclusion remember to use
the grades as a guide, but investigate a fund thoroughly before making your
final investment decisions. A wise
investor is a well informed one.
Olga Peram is Director of
Analytics at Fundata Canada Inc, a leading source of Canadian mutual fund
information. For more information, please visit www.fundata.com.
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