Mutual Funds

Owning a single or a hand full of stocks or bonds can be risky. Instead of buying individual stocks and bonds an investor has the choice of buying a mutual fund. A mutual fund is a group of securities typically, stocks, bonds or both. By owning a single mutual fund an investor gains exposure to hundreds or thousands of securities thereby reduces her risk.

There are thousands of mutual funds. The category choices alone can seem bewildering to most people: large-cap core, intermediate-term bond, small growth, high-yield bond, balanced allocation, mid-cap growth, etc… The best way to understand these categories is to understand 4 basic characteristics of mutual funds: Asset Type, Fund Style, Geographic Area, and Management type.

1. Asset Type

To keep things simple let’s say the world of mutual funds and exchanged traded funds (ETF) are made up of two asset types only: Stocks and bonds. Stocks give the investor ownership in the company and bonds are a loan to the company by the holder/investor. Stock investors make money when they sell the stock at a higher price than the purchase price. They also make money if the company issues a dividend. Bond holders get paid interest on the loan until maturity and then collect their principal at the end of the loan period.

Let’s call the first category of mutual funds, “Asset Type.” The Asset Type can be Stock, Bond or both (Balanced).

2. Mutual Fund Style (Stock)

A stock mutual fund can be made of small, mid, or large size companies. So capitalization (or Cap for short) size is one way a stock mutual fund can be categorized. A stock fund can also be made up of “Growth” or “Value” companies. Growth companies tend to have above average growth in earning and or sales. They often do not pay dividends because opting instead to reinvest their retained earnings in the business. Value companies are companies that are deemed to be undervalued. Value companies often pay dividends.

The style box combines the cap-size and the growth/value dimensions to define the investment style of a fund:

The top right box represents a large growth company fund. The middle box represents a mid-size blend company fund. For example the Vanguard Capital Opportunity Fund (VHCOX), a mid-cap growth fund is represented as follows:

3. Mutual Fund Style (Bond)

A bond fund can focus its holding on the type of duration to maturity and credit quality. For example the Loomis Sayles Bond fund (LSBRX) invests in low credit quality (some times called junk bonds) and extended duration bonds. Here is the style box representation of that fund:

The rows represent the credit quality and the columns represent the duration. The lower the quality the high the risk of default and the higher the interest. The longer the duration of the bonds in a fund the more sensitive the fund will be to interest changes (risk).

When interest rates increase the value of existing bonds decreases. The reverse is also true. If you hold a bond that pays 2.5% and interest rates increased by 0.5%. That means people who want to buy a similar bond can get 3% by buying new bond issues rather than buying your bond which pays only 2.5%. So keep in mind that bond mutual funds lose value in a rising interest rate environment and gain value in a decreasing interest rate environment.

4. Geographic Area

A mutual fund can focus its investments in a specific region such as North America or it can invest worldwide. An important difference between domestic funds (US) and foreign company funds is the currency difference. Fluctuations in currency exchange rates will affect the foreign company funds in dollar terms. Adding a foreign company fund(s) to a portfolio is another way to diversify. Foreign funds are often grouped into developed and emerging market funds. Emerging market fund invest in countries such as Brazil, Russia, India and China and maybe more volatile than developed market funds (Europe, Japan, Canada, etc…). The added volatility (or risk) maybe worth it for investors with a long time horizon since emerging markets will likely grow much faster than developed ones.

5. Management Type

Some funds are passively managed while others are actively managed. A passively managed fund tries to mirror the performance of an underlying market index such as the S&P 500. The manager will own the same stocks as the S&P 500 and in the same proportion. For example, if Microsoft represents 1% of the S&P in market capitalization then the fund will have 1% of its assets in Microsoft stocks. Passively managed funds are known as index funds. An actively managed fund attempts to outperform a particular market index. The fund manager will choose to own companies based on her judgment as opposed to the company’s weight in an index.

Which is better passively or actively managed funds?

Index funds cost less than actively managed funds. Most actively managed stock funds fail to outperform the relevant market index for their stock type (large, small, growth, value, core, etc…) (Research here). But, some actively managed funds such as the Fairholme Fund (FAIRX) succeed at beating the relevant market repeatedly.

For most stock investors passively managed or “index funds” are tough to beat. The Wikipedia page on managed funds lists some reasons for choosing managed funds. The index funds should outweigh managed and individual stock holdings in most people’s portfolio. Before buying any managed fund make sure you read the Morningstar review on the funds you are considering. Also, check also our “special funds” section.

The best advocate for index funds is John Bogle. Here is a brief article where Bogle makes the case for index funds: A Visit with John Bogle. The best source for index funds is Vanguard (www.vanguard.com). The best place for researching mutual funds is Morningstar (www.morningstar.com).