How to Analyze Mutual Fund Investment Risks

Before you head out to purchase mutual funds for your investment portfolio, you must analyze what your investment objectives are, the levels of risk you can take, your age, the # of years to your retirement, etc. Apart from these factors, you must also research the risks that an individual mutual fund contains if you put your money in to it. One of the best ways to analyze risk is to measure the performance of the mutual fund. Many times, the performance of a mutual fund depends on the manager's stock picking abilities or his methods of allocating funds to different categories of assets. Below we explore some ways of analyzing risks of mutual fund investments.
i) Portfolio Analysis
Every mutual fund has an investment objective written on its prospectus. The investment objective describes the ultimate mission statement of the mutual fund, the types of companies/assets it will invest in (whether they are large cap, mid-cap or small cap) and whether the mutual fund invests in value or growth opportunities. One way to do portfolio analysis is to dig deeper in to the sector weights of a mutual fund.
Attribution analysis breaks down the performance of a mutual fund between i) a manager's stock picking abilities versus ii) a manager's asset allocation abilities. There are 2 methods that mutual fund managers use to pick their investment portfolios:
a) Top-down approach: Manager evaluates the economic environment as a whole and picks sectors that are set to boom and perform well during those economic times. The fund manager will then pick the best companies in each of those sectors and invest capital in to their stocks.
b) Bottom-up approach: Manager ignores the macro-economic factors such as GDP, unemployment rate or the big economic indicators. Instead, the fund manager does screening for the best companies across multiple sectors by filtering for criteria such as earnings per share growth, price to earnings ratio, dividend yield, operating cash flow, return on cash flows, return on equity and more.
With attribution analysis, an investor can tell if a fund manager has picked the right or wrong sectors of the economy or has picked the right or wrong stocks in each of the sectors. For instance, a manager could pick the wrong sectors but the best stocks in each one; this would indicate the manager is skilled at picking individual stocks but not skilled at picking booming industries.

By; Hussein