The oldest rule of investing is simple: Don’t put your money into something you don’t understand. Because a cornerstone of my company’s advice is to invest in mutual funds, many people ask how they can really understand funds before investing in them.

In an ideal world, each investor would thoroughly read a fund’s prospectus before buying shares. But in this real world, we are fortunate that others have already read those legal documents and know how to find the most important points. Even better, a wealth of good information on funds is available online, without charge, at Morningstar.com – and it’s easy to find if you know what you are looking for.

In previous episodes of Sound Investing TV, we have discussed why asset allocation is so important when it comes to investing.  In this article, I’ll tell you how to ferret out the details that matter most. I’ve found a few nooks and crannies that even Morningstar old-timers may have overlooked.

But first, I want to point to one feature of this site that I hope you do NOT rely on: the Morningstar star rating system that grades each fund from one to five stars. This rating is based on a composite of factors that’s weighted very heavily to past performance. More on that topic later in this article.  

Instead, I hope you’re willing to look “under the hood” of a mutual fund and discover for yourself some very interesting things that can make you a better fund investor. In the following 10 examples, I’ll use Vanguard’s 500 Index Fund for illustration.  

First, an overview. At the top of Morningstar’s home page you’ll see a box containing the word “Quotes.” Click there and type the ticker symbol of the fund you’re interested in. In this case, it’s VFINX for the Vanguard fund. (If you don’t know a fund’s symbol, just start typing the fund name and then choose from the possibilities that pop up.)

Click on “Go” and you’ll be taken to the snapshot view for the fund you specified. This is your gateway to a great deal of information. Here you will find the fund’s main asset class, its expense ratio, summary performance data and much more. On the left, you’ll see a list of tabs that can take you deeper.

Second, the fund’s performance. Click on the left-hand tab labeled performance, and you will find a chart of annual returns going back a decade. Right below that is a table of annual performance figures and a second table of “trailing total returns.” These tables compare the fund to the asset class that Morningstar believes is most comparable. In the case of the Vanguard fund we’re looking at, it’s the Standard & Poor's 500 Index.

Third, investors’ performance. Near the top of the performance page, click on a tab labeled “Investor Returns.” After you read Morningstar’s brief description of this data, you will see a year-by-year comparison of the fund’s returns vs. the returns of the typical investor in that fund. In the case of VFINX, these aren’t very different, because the typical investor in an index fund is not making buy and sell decisions to get in and out of the market while chasing performance.

But the difference can be significant in funds that attract heavy inflows of money when certain assets are hot and heavy outflows when assets in their portfolios grow cold. For example, take a look at VGPMX, the Vanguard Precious Metals and Mining Fund. You will see that the investor return was lower in the most recent one-year, three-year, five-year and 10-year periods. In the five years ended June 30, 2009, the fund’s annualized performance was 13.5 percent. The investor return was 8.2 percent, indicating that the typical investor received only about 61 percent of the return of the fund. This was a result of bad timing of buy and sell decisions by individuals, based on emotions, media hype and in some cases herd mentality.

Fourth, the fund’s portfolio. You get a quick overview of what a fund owns in its snapshot view. The style box and “ownership zone” graphics as well as the brief asset allocation table give you the big picture. But much more information is just a click away in the left-hand “portfolio” tab. There you will find detailed breakdowns of asset allocation, growth rates of the holdings, sector weightings and the fund’s top 25 holdings. On this page you can also compare the fund to a benchmark index and to the other funds in its category.

Fifth, other stock ownership details. The tab showing the top 25 holdings also tells you how many stocks the fund owns (508 for VFINX), the annual turnover rate (6 percent) and the percentage of assets concentrated in the 10 biggest holdings (21.4 percent). When I compare two otherwise similar funds, I always favor the one that owns more stocks (which is much less risky than concentrating in only a few dozen), the one with the lower turnover rate (which keeps costs and taxes under control) and the one with a lower percentage of its assets in its top 10 holdings (which indicates lower risk). This is especially important in the riskier asset classes such as small-cap, small-cap value, international small-cap and emerging markets.

The most important of these figures in my view is the number of stocks.

Sixth, fees and expenses. You might think this is boring territory, but every dollar you pay in fees is a dollar of return that you’ll never have for yourself. The “fees and expenses” tab on the left is essentially the fund’s price tag. Vanguard 500 Index has very low expenses and no sales load. But other funds in the same asset class have very different numbers. To use what could be an extreme example, the Pioneer Ibbotson Aggressive Allocation B Fund (IALBX) has a published prospectus expense ratio of 2.46 percent, though the fund is not charging its shareholders more than 1.64 percent through December 1, 2009. The 10-year projected cost shown by Morningstar for a $10,000 investment in that fund is $2,666. That’s more than a quarter of an investor’s entire initial investment! The Vanguard 500 Index Fund, by contrast, has a 10-year projected cost of only $230.

In order to overcome that huge cost disadvantage, the portfolio managers of the Pioneer fund would need to generate substantially higher performance than the index fund. (And that can be done only by taking significantly more risk.)

This has taken us to one of the really interesting parts of using Morningstar.com. You might ask: Since both these funds are in the large blend category, has the Pioneer fund done a good job of competing with the Vanguard index fund? The Pioneer fund’s snapshot page shows that it lagged behind the S&P 500 Index in 2006, 2007 and 2008, though it beat the index in the first half of 2009. Before you are enticed by this recent performance, remember the cost: $2,666 vs $230.

Seventh, management. We don’t recommend actively managed funds, but we know lots of people invest in them. If you’re considering such a fund, click on the left-hand “management” tab to find out how long the current management has been in place. If you’re attracted to a fund because of past performance, this page can tell you whether that performance was produced by a team that’s still there.

Eighth, risk. Brokers and salespeople would like you to think about how much money you could make by following their advice, not how much you could lose by taking their advice. But savvy investors spend lots more time controlling their risks than daydreaming about possible gains.  

For the fund you’re researching, click on the left-hand “risk measures” tab. If you’re interested in drilling into details, you can click on the “show data definitions” link. Some of these measures are much more useful than others. When you are comparing one fund against another, the following three items might be sufficient.      

Standard deviation shows how volatile or unpredictable a fund’s returns are. A lower number is usually more desirable.

The Sharpe ratio attempts to measure return per unit of risk. A higher ratio indicates better performance related to the amount of risk that was incurred.    

Alpha measures what investors really want, the “excess” return that a fund provided above what was statistically predictable.  Any positive number is desirable, the higher the better.

Ninth, purchase information. This tells you whether the fund is open to new investors, the minimum investment for opening an account, which brokerage firms offer the fund and contact information such as address, phone number and web site. The contact information is useful to investors who would like to deal directly with the fund and avoid paying the transaction fees charged by some brokers.

Tenth and finally, I want to mention another very useful tool at Morningstar.com, called “Instant X-Ray.” You’ll find this under the site’s “tools” tab near the top of most pages. This lets you enter your holdings (or proposed purchases) including stocks and funds. Once you’ve entered that information, a single click shows where your portfolio would fall in Morningstar’s style box, and a pie chart will break down your holdings in cash, bonds, U.S. stocks and international stocks.   

Scroll down and see your overall expense ratio, your total estimated mutual fund expenses, your top 10 holdings and your portfolio’s weightings by geography and sector. Morningstar premium members have access to further portfolio analysis.

I said earlier that I don’t recommend Morningstar’s star rating system, which is based mostly on a mutual fund’s past performance. You may be thinking that I must be nuts, because performance is the proof of the pudding and exactly what you want. If you’re talking about future performance, I’d have to agree. But unfortunately you can’t get that insight from these ratings.

Morningstar’s ratings are so seductive that many analysts, graduate students and other academics have studied them to see if they are good at predicting future performance. Investing would be a lot easier if the answer were yes. But in fact it’s often the opposite. I have never read about anybody finding a statistically valid correlation between the present star rating of a fund and its future performance.

If you’re willing to settle for an easy answer, even though it could very well be the wrong answer, you can look no further than the star ratings. But you now know how to do much better than that. I hope you’ll join the many smart investors who take advantage of Morningstar for its data, not its star ratings.

Paul Merriman is founder of Merriman.