Mutual Funds for the Utterly Confused: Mutual Fund Risk(s) in a New Year
Today we begin a look at the different types of risk facing mutual fund investors. (You can find an extended discussion of these topics in Mutual Funds for the Utterly Confused as well.)
Active Trading Risk
One of my pet peeves with funds that exist in the world outside of indexed mutual funds is the cost of turnover. Turnover is the number of trades down by a fund in a given period. The higher the number of trades; the greater the fees (not only in transaction costs but research and analysis fees just to name a few).
And unless the results of all of this activity by your fund translate into significantly higher returns, the investment might not be worth the trouble. But there are exceptions. If the fund compares itself to an index related to what it owns (small-cap funds comparing their returns to the S&P 500 for instance) and beats that index and the cost of managing the activity, then you might be looking at something worth considering.
Active trading carries a great deal more risk from market volatility. While the potential for huge profits are often why such risks are undertaken, the downside is equally as large. The sophistication needed to assume this kind of risk is not for the timid. Mutual fund managers must be extremely nimble and have the confidence of their shareholders.
In a fund, shareholder dissatisfaction can lead to mass exoduses and those redemption fees, coupled with the possibility that stocks in the portfolio are ahead for the year, capital gains taxes. Had you invested in a mutual fund (outside of a tax advantaged account like an IRA or 401(k)) at the end of 2008, you will understand what I mean.
For the average investor, these funds should be the last on your list and a small part of your portfolio. 2009 will be a very good year for these funds. The recent market turmoil has shifted the dividing line between capitalized companies, making what were once mid-cap stocks, small-caps. This will give these types of funds a distinct advantage.
Just know that the fees and the risks are high and 2009 may not see a significant turnaround until well into the third quarter of the year. But investing now, in small quantities could find you well positioned when the markets recover.
Next up: counter party risk
