Mutual funds

Advantages of different types of mutual funds

March 26, 2008-- by Issam Chleuh

A Mutual fund is a professionally-managed form of collective investments that pools

money from many investors and invest in stocks and bonds, short-term money market
instruments and other securities. The fund manager, also called portfolio manager, does the
trading realizing capital gains or losses, and collecting the dividend or interest income.
Mutual Funds, known as “open-end company”, are one of three basic types of investment
companies available in the USA. The two others are closed-end management investment
companies, also called closed-end funds, and Unit Investment Trusts, UITs.
In investment companies, investors buy shares, and ownership is proportional to the number of
shares purchased.
In the following lines, we will focus on two important aspects of portfolio building. We will first
of all look at what should be the basis for a typical portfolio. Then, in the second part, we will
analyze more specialized funds that will permit you to have a competitive mutual funds
portfolio.

I- Understanding of the different core stock funds

a- Identifying Core Stock Funds

At the heart of nearly investor’s portfolio, no matter what his or her time horizon is, should be at
least one or two stock funds that can be considered core holdings. As a rule of thumb, at least
75% of your equity holdings should be in so-called core stock funds.
When we talk about core funds, we are typically referring to those funds that focus on large-
company stocks displaying less volatility than smaller stocks.
What is more, because the U.S. market, as represented by the Dow Jones Wilshire 5000 index,
currently has about 70% of its assets in large-cap stocks, it makes sense to allocate the biggest
part of our assets in large-company stocks in order for us to be in accordance with the broad U.S.
market. Advisors usually recommend that the allocation of investors’ equity assets be in funds
that land in Morningstar’s large growth, large-blend, or large-value categories.
(See exhibit page for Morningstar styles box)
Alternatively, a way to obtain core equity exposure is to buy an all-in-one fund that combines
stocks and bonds in a single package.

b- Growth Funds
There are three main mutual funds types investors can choose from: growth, value and blend
funds.
As their names suggest, growth funds invest in stocks of companies that have the greatest
potential for long-term growth. While growth funds are generally volatile and are subject to the
fluctuation of the stock market, their long term potential is considerable. Indeed, there is no “free
lunch”. Within growth funds, three subcategories need to be distinguished: earnings-driven
funds, revenue-driven funds and blue-chip growth funds.

- Earnings-Driven Funds:
The majority of growth managers use earnings-driven strategies, which means they use a
company’s earnings growth as their gauge for determining how quickly the company is growing.
They want a company whose earnings are growing significantly faster than those of the average
company in its sector or the market as a whole.

- Revenue-Driven Funds:
Not all growth stocks have earnings. Some stocks may not produce earnings for years because
they have more spending than earnings. Young companies in the technology and biotechnology
industries are the perfect example. Some growth managers will buy such companies if they’re
generating strong revenues. However, since there is no guarantee when firms without earnings
will turn a profit or if they never will, this approach can be risky.

- Blue-Chip Growth Funds:

In general, blue-chip growth funds can serve as fine core holdings for investors’ portfolios. Their
managers look for companies growing in a slow but steady fashion. The slow-and-steady group
has historically included such blue-chip stocks as Wal-Mart and Procter & Gamble. As long as
these stocks continue to post decent earnings, the managers tend to hold on to them. Blue-chips
growth funds often have more modest price ratios than other growth-oriented funds, and often
fare relatively well in slow economic environments because they favor large companies than
aren’t dependent on economic growth for their success.

c- Value Funds
As opposed to growth funds, value ones focus on companies that are considered to be
undervalued in price and that are likely to pay dividends. The risk involved with this type is that
the market may not recognize that securities are undervalued and may not appreciate as
anticipated.
Although value investing makes a lot of intuitive sense (in fact, most same people would agree
that it’s better to buy a cheap stock than a pricey one), it does not pay off all the time. Both value
and growth stocks can be subject to major performance swings.
Although value funds generally show less volatility than growth funds, that doesn’t guarantee
safety. For instance, in many previous market downturns, such as the financial decline of 1990,
the utilities debacle of 1994, and the Asian crisis of summer 1998, value funds lost as much or
more money than growth funds.

d- Blend Funds
Although some of the best-known mutual fund managers use either growth or value approaches,
a giant group of fund managers splits the difference between these two investment strategies.
Within the blend category, the most common management style is the so-called growth at a
reasonable price approach (GARP). Managers who seek growth at a reasonable price try to find a
balance between strong earnings and good value. Although similar to the blue-chip growth style
we discussed earlier, blend funds differ in subtle ways. Some managers in this group find
moderately priced growth stocks by buying stocks investors have rejected; often, these
companies have reported disappointing earnings or other bad news and their stock prices may
have dropped excessively as investors overreacted by dumping shares. GARP managers also
look for companies that analysts and other investors have ignored or overlooked and that are
therefore still selling cheaply.

e- Active and Passive Managed Funds

Are actively managed funds better or worse investments than index funds?
Actively managed funds employ portfolio managers who try to outsmart the market by over- and
underweighting certain stocks or sectors. Index funds, however, hold exactly the same stocks –
in exactly the same proportion – as a given market benchmark. For example, Vanguard 500
Index – which is a passive managed fund - tracks the S&P 500 Index, and if the S&P allocates
5% to General Electric, so will Vanguard 500. Both managements have their competitive
advantages; it is a matter of where index investing and active management are most effective.

f- Exchange-Traded Funds as an Index Fund Alternative

Like index mutual funds, ETFs are groups of securities that are designed to give you
diversification in a single shot; they track sector-specific, country-specific, or broad-market
indexes. But like stocks, ETFs trade on an exchange. That means that investors can trade ETFs
throughout the trading day, unlike mutual funds, which investors can only buy or sell at the price
at the close of the day. Anything you might do with a stock, you can do with an ETF.
You might consider an exchange-traded fund if you like to trade a lot, if you’re particularly
concerned with limiting taxes, if you are going to make a big one time investment and let it
grow. Otherwise, an index mutual fund will serve your needs just as well.

II- Use Specialized Stock Funds

The key to a successful fund-investing plan is to make sure that you have selected appropriate,
high quality stock and bond funds to serve as the foundation of your portfolio. But finding ways
to reduce your portfolio’s overall volatility and potentially boosting your returns is as important
and can be done through the adoption of specialized funds.

a- Foreign Funds
Foreign-stock funds’ returns can be appealing. In the past years, the typical foreign-stock fund
gained more than 20%, while S&P 500 index rose only about half as much. Foreign investing
can offer diversification. Foreign markets are often influenced by different factors than the U.S.
market, so adding foreign funds to your investment mix gives you a better chance of always
owning something that’s performing well. The addition of foreign stocks can actually reduce
your portfolio’s overall volatility level.
Moreover, the investment style you choose should depend on how much risk you can handle and
the other funds in your portfolio. If your U.S. stock funds lean toward growth stocks, consider a
foreign fund that’s more inclined toward value. If you think you might sell if a fund endures a
substantial drop, steer clear of foreign funds that emphasize small companies; they tend to be
more volatile than funds that focus on large firms. Remember, however, that small-cap stocks are
generally better diversifiers than foreign large-cap stocks, because large-cap stocks tend to be big
multinationals and often perform much like U.S.-based multinationals.
 b- Small-Cap Funds
In recent years, small-cap funds did better than large-company rivals. This illustrates the benefits
of diversification. However, one should be prudent with small stocks, because they can be a lot
more volatile than large caps with the same investment style.
Small-value funds tend to have more dramatic ups and downs than their large-cap counterparts;
small blend is more volatile than large blend, and so on. Indeed, the best thing to do is to own a
mix of large and small stocks. You will benefit when the market favors one type of stock without
missing out completely when investors turn to the other. For most investors, smaller stocks
should represent between 10% and 20% of the stock portion of their portfolios.

c- Real-Estate Funds
Real-estate funds can add a lot of variety to a portfolio. They’re technically sector funds (see
definition), but they play such a distinct role in a role in a portfolio that they deserve to be treated
separately.
In fact, the average real-estate fund has remarkably low correlation with the S&P 500 index.
That means that when the S&P 500 goes up or down, real-estate funds probably won’t move in
sync with the index. That makes real-estate funds appealing when large-cap stocks are down. In
other words, real-estate funds do not behave much like large-cap U.S. stocks, which is what most
long-term investors have as the core of their portfolios. Nor do the funds behave like bonds,
which are the common choice to stabilize a stock portfolio. Adding real-estate fund to a portfolio
of stock and bond funds could add greater variety, resulting in a steadier performance. This
competitive advantage is partly attributable t the high dividend yields of many real-estate
securities. Most funds in the category invest predominantly in real estate investment trusts
(REITs), which pool together investors’ money and invest in income-producing property or
mortgage loans. REITs bring in a lot of income, but they’re required by law to pay out most of
that income as dividends to shareholders. That consistent yield can boost returns during good
times and offset losses in down years. Moreover, real-estate funds are more tax-efficient than
other income offerings such as bond funds because, for accounting reasons, part of their dividend
is considered a return of capital. That means not all of the yield paid by a real-estate fund will be
treated as income and taxed at that higher rate, whereas the entire yield from a bond fund is
likely to be taxed as income. (No need to mention, however, that it is not the right time to invest
in them).

d- Commodity Funds
Finally, another category of funds has been doing well over the past few years; commodity
funds. These funds don’t generally buy commodities directly, but rather buy derivatives that give
their portfolios exposure to fluctuations in the price of commodities such as oil, wheat, metals,
and hogs. Like real-estate funds, they exhibit a very low correlation with the U.S. stock market.
As stand alone investments, commodities funds are extremely volatile. But when used as a very
small piece in a broader portfolio, these funds’ limited correlation with the stock market means
they can actually reduce that portfolio’s overall volatility level and potentially improve its return
potential. Commodities funds also have the potential to help save off the ravaging effects that
inflation can have on your stock and bond holdings. In fact, commodities invariably gain in value
when inflation is rising.

In conclusion, the most important advantage of mutual funds is diversification. In fact,

when you buy a mutual fund, you automatically have shares in several companies. The subtlety
however, like in any investment venture, is to find which mutual funds are outperforming the
market in a specific time frame.

****
Definition

Fund or portfolio Manager:

The person or persons responsible for investing a mutual, exchange-traded or closed-end fund's
assets, implementing its investment strategy and managing the day-to-day portfolio trading.

Morningstar Inc:
A Chicago-based investment research firm that compiles and analyzes fund, stock and general
market data. Morningstar also provides an extensive line of internet, software and print-based
products for individual investors, financial advisors and institutional clients.

Price ratio (price-earning ratio):

A valuation ratio of a company's current share price compared to its per-share earnings.
Calculated as:

For example, if a company is currently trading at $43 a share and earnings over the last 12
months were $1.95 per share, the P/E ratio for the stock would be 22.05 ($43/$1.95).
EPS is usually from the last four quarters (trailing P/E), but sometimes it can be taken from the
estimates of earnings expected in the next four quarters (projected or forward P/E). A third
variation uses the sum of the last two actual quarters and the estimates of the next two quarters.

Benchmark:
A standard against which the performance of a security, mutual fund or investment manager can
be measured. Generally, broad market and market-segment stock and bond indexes are used for
this purpose.

Investment style:
The overarching strategy or theory used by either a retail investor or an institutional money
manager to set asset allocation and choose individual securities for investment. The investment
style of a fund helps set expectations for long-term performance potential and aids in advertising
the fund to investors looking for a specific type of market exposure.
Small Cap: Refers to stocks with a relatively small market capitalization. The definition of small
cap can vary among brokerages, but generally it is a company with a market capitalization of
between $300 million and $2 billion.

Sector Funds:
A stock mutual, exchange-traded or closed-end fund that invests solely in businesses that
operate in a particular industry or sector of the economy. Because the holdings of this type of
fund are in the same industry, there is an inherent lack of diversification associated with these
funds.

Source: Investopedia
http://www.investopedia.com

Exhibit
Source: Quick Guide to Morningstar Style Box
http://mutualfunds.about.com/od/mutualfunds101/fr/stylebox.htm

Resources
Putnam Investments’ Family of Mutual Funds
https://www.putnam.com/individual/

Mutual Fund Investment Styles

http://www.axaonline.com/rs/3p/sp/5044.html

Mutual Funds and Financial Advice from CNN Money

http://money.cnn.com/pf/funds/

An Introduction to Mutual Funds

http://www.sec.gov/investor/pubs/inwsmf.htm

ETFs offer more tax efficiency than mutual funds

http://www.smartmoney.com/etffocus/index.cfm?story=20080117-etf-tax-advantage

What is a Real Estate Mutual Fund?

http://www.wellsref.com/investmentproducts/global/what.html

Mutual Fund Introduction

http://www.investopedia.com/university/mutualfunds/?viewed=1

Mutual Funds Morningstar

http://www.morningstar.com/cover/funds.aspx
Wells Fargo Mutual Fund Center
https://www.wellsfargo.com/investing/mutual_funds/

Mutual Funds at Fidelity

http://personal.fidelity.com/products/funds/funds_frame.shtml.cvsr