This is the second and final part in our series which details what Morningstar analysts consider when researching funds. To read part one, click here.

Stock Selection
Morningstar analysts spend considerable time studying a fund's complete holdings--both as they stand currently, and as they've evolved through time. The portfolio's holdings tell us about the fundamental risks inherent in the portfolio--if the manager is investing in heavily indebted companies, for example, it could find itself in trouble in a recession. More broadly, a review of the holdings tells us if the manager is sticking to his strategy, and how that strategy changes in response to shifting market conditions. For example if a manager has a strong track record investing in larger cap stocks suddenly starts moving down the cap ladder into smaller companies, where information is much more difficult to come across, it's worth asking why – especially if the manager operates on his own and has previously been heavily reliant on broker research which is far sparser at this level. Or, if a manager claims to have a strong valuation discipline, but richly valued shares appears in the portfolio, we'll want an explanation. We also focus on how the manager's buy and sell disciplines play out with regard to specific holdings. Of particular interest are where managers' have opposed consensus views to good effect, or have made mistakes but learned from them.

Remuneration
A fund manager's incentive pay can be multiples of his base salary. As such, it has a strong impact on how he runs the fund. If a fund manager's bonus is tied to his short term performance he may well be more reckless and take on more risk because he wants to maximise his near-term pay out – after all at the end of the year the slate is wiped clean. We therefore prefer to see managers who are incentivised over the longer term thus providing performance goals that are more closely aligned with the time horizons of investors. It's even better if the awards vest over time, as this provides additional incentive for good managers to stick around. However, if an incentive scheme is heavily weighted towards asset growth or profitability of the fund manager, that's a potential cause for concern--such measures can encourage managers to grow funds beyond their optimal size (a big concern in the small- and mid-cap arenas) or to keep expenses at a high level.

We also want to see managers invest in their own funds: If they are not willing to risk their own money, one has to question why others would. Some of the best shops we know pay bonuses in fund shares that vest over time, but this is sadly unusual.

Charges
Charges are a vital part of any fund assessment. Many factors can impact fund performance, but expenses eat away at the value of your investment year after year after year, and the effect compounds with time. Unfortunately in the UK there has been very little pressure on the competitive pricing of investment funds, but the effects over the life of an investment can be quite staggering – for example take the Fidelity Moneybuilder UK Index fund. It has a TER of 0.28%, which compares favourably to the Nationwide Tracker which levies a TER of 1.5% to follow the same benchmark. If you invested £10,000 into both of these funds, and assumed an annual return of ten percent, your investment in the Nationwide fund would be worth £2,888 less after ten years (that's the equivalent of an additional 28.88% cumulative return on your original investment that you would miss out on!). Among active funds, the more expensive the offering, the more outperformance a manager has to deliver just to break even with his benchmark. Studies we have run elsewhere suggest that managers of higher cost fixed-interest funds systematically take on more risk than their lower-cost rivals in an effort to make up for this disadvantage.

Performance
Judging a fund by its performance alone can be a recipe for disaster, but patterns in a fund's long term performance can be a helpful way to see if a fund is behaving as we expect given the manager's stated strategy. We not only consider the portfolio's benchmark, but more importantly the Morningstar category into which the fund falls – this helps give a fairer reflection of how the fund has performed compared to similar offerings that investors can buy. For example, if a fund claims to only buy companies with strong cash flows, but did well in TMT-led 1999 and got clobbered in the ensuing meltdown, it would suggest that manager deviated substantially from that discipline.

Short term performance is often meaningless, so ideally we like to see a strong longer term (5 years +) track record, that has been achieved with below average volatility, but again, it's important to judge that record in the right context. There are plenty of large-cap managers who are very good at what they do, but who have looked poor versus the larger universe of UK equity funds during the mid-cap rally of the last five years. That's not a fair or useful comparison. Just as it makes no sense for a mid-cap manager to be given credit for beating a FTSE 100 fund, we wouldn't dismiss larger-cap funds that fail to beat an all-cap benchmark or peer group.

Conclusion
Readers will note that performance comes only at the end of this two part series. Although it merits attention, investing based purely on past performance--especially short-term performance--is a fool's errand. In our experience, it leads investors to purchase funds when their style or strategy is peaking and ready for a downturn and to sell funds just as they might be ready to rebound (i.e., buy high and sell low). Moreover, it really is a poor predictor of future results. So use it as a starting point, but focus on long-term, risk-adjusted performance, and follow up with an investigation of the other fundamental factors we discussed above. If you do that, and if you remember that the goal is not to select the hottest fund today, but those that will help you reach your investment goals over time with the least amount of risk--in the context of your overall portfolio--we think you'll ultimately have far more success.