Mutual Funds for the Utterly Confused

A knee-jerk reaction can often lead to unexpected consequences. Without weighing the unknowns - an exercise that might seem futile but can be done if you can eliminate the greater risks in favor of the lesser ones - it is hard of investors to judge the quality of their mutual funds.

Many of us have either pushed our investable dollars to the sidelines, parked them in questionable target-dated (lifetsyle) funds, or moved into broader based index funds such as the S&P500 style indexes. While on the surface, this might seem like a good idea, it is not.

There are two reasons. Index funds offer a tax efficient investment and should, if handled correctly be excluded from tax-deferred accounts such as defined contribution plans (401(k) or IRAs). As long as the capital gains tax remains at this historic low, you would be better off paying the taxes on this type of fund now as opposed to putting off paying on it when you retire.

The second reason is explained by our sister blog, Retirement with a Plan.

Morningstar has revamped its strategy at looking at mutual funds focusing on how retail investors (that would be the average fund holder, like you and me) approach a purchase.  Until now, the information was vague, if not spotty, offering stars and style boxes to determine such things as volatility and investment methods.

The new approach is attempting to delve deeper into the mind of the manager and what Morningstar (and institutional investors) call the economic moat - a term credited to Warren Buffet.  The later looks at companies a fund might hold that would be considered stars in their field, businesses that have strong position against their competition and because of that, would be more apt to weather a storm in a sector.  The question: will it make a difference?

Investors who care have always taken a crossover look at what they held in their portfolios.  Holding an S&P500 fund and a large cap growth fund would find the investor placing money with similar companies.  If they had done something like this, they would have overlapping exposure in both funds, suggesting that the investor would be at greater risk because they had failed to diversify.

A couple of things come to mind here. In spite of what would be called an increase in investor education, these consumers have not done their homework.  In fact, these investors, many of whom have felt the downturn more than others who had chosen to diversify their fund holdings with either total market funds (such as indexes).

Once an investor step outside of the comfort of an index fund, no amount of information can change their belief that they are on the right track with the right fund(s) to meet their risk goals. So Morningstar has taken the process one step further, looking at the mind of the manager.

We have approached much of our fund managers as group of people (sometimes computers - which have been programmed by people to do certain computative equations) as experts.  This thinking, adding years of service and past performance as guides, is no longer a good measure of how a fund will perform. 

Keep this in mind.  No matter how Morningstar looks at funds, some relevant facts remain.

First: past performance is no longer a measure of how a fund will do.  With markets now at 1997 levels, the fund manager has scrambled to retain whatever investors they may have had.  The Fidelity Magellan Fund once held over $100 billion in investor assets.  Because of the market downturn and redemptions (the investor who has lost faith in the fund or simply panicked and sold moving into cash or worse, a target dated fund) the balance of holdings is no $20 billion.  Morningstar believes that this is due to the economic moat.

Second: Managers are human and subject to the same biases that you are.  They believe that the past offers some indication of the future.  They embrace the notion that they can somehow divine the next move, the market bottom or some other investor fallacy.  They are not supreme beings capable of such feats.  In fact, the pressure they feel from their companies (many of the largest funds are public companies who are beholden to a much more vocal group of investors) and this has a negative effect on their decisions.

Third: economic moats are now not what they were.  As companies scramble to realign themselves and simply survive, the moat between companies has shrunk to that of a small ripple separating one business from another.  This measure might work for large well established companies but what about small caps and mid-cap funds whose competition is not clearly defined and can shift based on the ability to obtain credit and keep customers while trying to innovate.  Judging a company based on this meteric does not take into consideration the value of a company’s share price.

Even if Morningstar had instituted these new measures a year ago ( a testament to reacting after the fact, which many fund managers and investors are doing), we would still be where we are.  Moving forward it might help but I would disagree.  For many investors, the following applies: “you can lead a horse to water, but you can’t make them a duck”.

We have seen a lot over the last year. And it looks as if the unfolding crisis has yet to spread itself out completely over the whole globe. While it may have started here in the United States, gradually it has found itself into all of the major economic contributors and is now exposing its toxic self in countries many of us would not have considered as much more than secondary players.

Read more here.

Accompanying our sister site, Retirement with a Plan, we are attempting to construct, or should we more accurately say, re-construct a new portfolio. On the other blog, we will discuss the thinking behind what we are doing. Here we will highlight the funds we find the most promising in each of the categories we have previously identified as the highest possible growth sectors in the return to a marketplace normality.

The first of those funds is a small-cap growth fund. Slightly higher risk but probably, over the next several years, worth every bit if it. It is our opinion that the market will recover from the smallest to the largest and if that turns out to be true, look for this fund, or similar ones to make the move first and stay with it the longest.

January, as you can see here, was not so great of a month.

PIONEER SERIES TRUST I: PIONEER OAK RIDGE SMALL CAP GROWTH FUND; CLASS C SHARES ORICX
		As of 2/6/09 NAV: 15.17	1-Day Net Change 0.36	1-Day Return 2.43%	YTD Total Return -4.47%	Category Small-Cap Growth

LIPPER LEADER SCORECARD More on Lipper Leaders FUND STATS Portfolio Style: Growth Net Assets ($Mil): 21.90 Inception Date: 3/1/97 Expense Ratio: 2.20% Sales Charge: Load Type Level Load Front-End Load 0.00% Back-End Load 1.00% Investment Policy: The Fund seeks capital appreciation by investing primarily in equity securities of domestic small capitalization companies. The Fund may invest in all types of equity securities that, in the opinion of the Manager, have the potential to appreciate faster than the general market. PURCHASE INFO Status to New Investors: Open Manager Name: Team Managed Manager Start Date: NA Initial Purchase Regular: $1,000 Phone Number: 800-225-6292 TOTAL RETURNS (%) 3, 5 and 10 year returns are annualized. YTD 1Yr 3Yr 5Yr 10Yr Fund -4.47 -25.58 -10.42 -0.46 3.38 Category -1.78 -34.77 -14.28 -4.98 0.93 Index (S&P 500) -3.60 -32.90 -9.90 -3.50 -1.80 % Rank in Category 86 3 14 4 23 Quintile Rank E A A A B

This guest post from Melissa looks at the question:
Where Can You Invest In A Recession?

That seems to be the number one question on everyone’s mind these days. The stock market continues to see-saw wildly, housing hasn’t completely bottomed out yet, and companies are shedding jobs like crazy, pushing down consumer demand. So, do you stuff your money in a mattress? Do you forget about mutual funds, 401 K, any form of investing? Well, you can still invest in the stock market and in mutual funds, as long as you follow some areas that historically do well during a recession.

Commodities

There are funds out there that have a healthy percentage of stocks that deal with commodities that typically do well during a recession, or even a depression. Usually, it’s not a great bet any other time, but it can be safer than some other areas at this time. People right now are particularly fond of mutual funds that have precious metal commodities and agriculture.

Value Funds

Other mutual fund picks are those that style themselves as “value funds.” They usually are not aggressive earners, but also they typically don’t lose much either. They focus on companies that are a good value and have a solid foundation. They usually include the word “value” in their names, like the Growth-With-Value fund.

Infrastructure

A new trend is to find some mutual funds with stocks that are investing in infrastructure. This can be a good pick because of the focus on the stimulus plan to enhance infrastructure around the country. So, while it’s not going to be giving out spectacular results, it should provide a more stable investment than many other types of funds out there right now.

There’s no arguing that investing in this economic climate can give even the most seasoned investor a queasy stomach. However, if you have time to wait out the recession and need to make some decisions, there are funds that can offer an umbrella in stormy weather, at least for a short while.

I have mentioned before that some odd things have occurred in the markets. The S&P 500 may be down 40% over the last twelve months and ten percent just this year but what happens when stocks lose value? They drift from large-cap to mid-cap and mid-cap stocks wander down into small-cap territory.

If you currently own a small-cap mutual fund, settle in for a wild ride. For fund managers, he current environment is presenting some unique buying opportunities. Although the companies in these funds face somewhat greater risks at finding and retaining financing for their businesses, there is no doubt that if they have a good plan, they will survive.

And those that do will be subject to some fire sale buying by larger companies that have downsized themselves right out of growth. If you keep cutting costs to satisfy shareholders, eventually you wind up with a lean, but far less innovative company focused on surviving and not growing. These businesses will look to the expensive land of small-caps to get ahead in the coming years.

In this kind of investment environment, the pressure is on the manager. Shy away from newly appointed fund chiefs and focus instead on those that have made a name for their style. Another thing you might consider as small-caps recover, style will not much matter. It is the quality of the underlying portfolio, the ability of the manager to lead their fund from yet another down market and find your return on investment where other have failed.

As we continue or discussion about risk, we look at what was supposed to be one the risk-free - well almost risk free - types of investments, many of you will find in your company sponsored retirement plans. Promising good returns with minimal risk, stable value funds, with their conservative approach have found their way into many participants strategy of saving for the future. Many of them did not know what they we getting into when they thought stable meant safe and conservative.

Kelli Hueler, CEO of Hueler Analytics suggest in a n article written before the market melted down so completely las year that “it’s not just money-market funds that are being scrutinized. Many 401(k) plan participants and employers are fretting about stable-value funds. These products, which are generally available only in defined contribution and 529 plans, typically invest in high-quality bonds and bank or insurance-company contracts that guarantee the value of the principal and offer relatively high interest rates compared with money-market funds.”

This is a vastly different approach than the similarly named value fund offers. While the later invests in common stocks of beaten down or under-valued businesses in the hopes that they will recover, stable value funds invests in investment contracts, certain types of fixed income securities (e.g., U.S. treasury bonds, corporate bonds, mortgage-backed securities, bond funds), and money market investments.

She continues by pointing out that well-known names such as the “troubled insurance giant AIG is a major player in stable-value funds. The company, ” she write, “is a provider of “wrap” contracts that protect the funds against loss of principal. AIG wraps roughly 10% of the stable-value fund assets tracked by Hueler Analytics, a stable value research firm. And that has many investors on edge.”

And with good reason.

Numerous investors, studies have shown, seek safety and not risk in their investments. Stable value funds play to these fears of investor loss and promise returns that are higher than typical bond funds. The assurance of safety however is only as good as the financial institution that issues the fund. And many of these institutions are insurance companies.

Held outside a retirement portfolio, these types of fund offer liquidity, somewhat similar to money market accounts. This type of liquidity was favored by the 529 plan investor who sought to keep the money put away for the child’s college education as a safe as possible. Some folks use them to save for homes while others, simply keep them as risk adverse investments. What these conservative investors sought was safety. What they found was something quite different.

Running from risk doesn’t eliminate it. Stable value funds may not be exposed to the market, and your investment might be safe in principle, but lower interest rates generally tend to drag down the returns many investors expect.

The industry continues to stress the safety of these funds. The assets are actually owned by the 401(k) plan and insured by banks and insurance companies through the use of wrap contracts. Seldom is one wrap contract in place keeping the creditors of defaulted insurer from tapping the stable value fund’s assets.

The inability to make good on obligations such as interest payments puts the fund in line as a creditor. Some of the principal may be recovered but the risk of loss like this is rare in money market funds and much better defined in a bond fund. Long-term investors might suffer from a negative gain in these types of funds as inflation trudges forward but the returns lag behind.

Predictability has its price however. Too much of your portfolio in these types of funds, safe as they may seem, will negate the returns a recovery could have had in your portfolio.

Value funds are supposed to act in an opposite world from their growth-oriented counterparts. Value mutual fund managers tend to hold on to more cash as they troll the markets for the beaten and forgotten, the has-been names of companies that for whatever reason, remain solid players but are not so attractive as to entice investors in great numbers. They may pay dividends. They may have once been considered a growth venture but those days have since passed.

Value fund managers take an incredible risk when investing in these fallen angels. As someone once said, they make their living by standing on the tracks. The companies they look for may have fallen out of favor with the actively invested crowd but there is always the hope that the sentiment is temporary. Value managers attempt to be there when that turning point occurs and profit from the resurgence of a business.

But what happens when you focus on a segment of the market that is considered “value” only to find out that you have over-valued the stock yourself? Many value funds sailed along with handsome returns while growth stocks fell and then rose and subsequently fell again. There were numerous bumps along the road in between those moments, but value funds seemed to ignore those zig-zag movements and turned a tidy return for those that were patient.

The problem with this type of investing became evident as a particular value sector, namely the financials, fell even more precipitously in 2008 than the overall market. This sector, along with the broader market dependent on credit fell to the point that what was growth was now value and what was value was now nearly worthless.

Numerous value companies will have extended problems as they try to access a still-chilly credit market. Without long-range goals of growth or readily provable potential, just getting by may not be enough to get bankers to lend - at affordable rates. Some of these value companies may close their doors, declare bankruptcy or simply downsize themselves right out of the marketplace.

Should you ignore value funds if you have had them in your portfolio for awhile, especially as they were among the best performers in your retirement plan? No. If you have them, hold them. Value managers have become much more nimble as the amount of companies that were once growth now crowd this sector. Some of these companies still have access to credit and are suffering from depressed valuations by default of what the greater marketplace has wrought.

But owning value funds as they fell, many of which were without a doubt, heavily weighted in your portfolio, should be a lesson in the kind of risk the market can dole out. Balance is still the key. You don’t have to balance the funds with sales of shares. Simply make sure you have some of a lot and not just a few winners.

In fact, value may be the first to recover when the economy finally rights itself.

One final note, avoid a similarly named kind of fund that is now available in numerous 401(k) plans. The stable value fund is something wholly different than a value fund that invests in common stock.

Up next, stable value fund risk.