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Mutual Fund Investing with Style

Arohan — Thu, 04 Jun 2009 17:43:02 +0000

When deciding to invest in a mutual fund (or any other investment), it is generally accepted that a diversified portfolio reduces risk over the long term. The readers would have also come across findings and assertions along the lines that stocks do better than bonds over the long term, small cap stocks can be more rewarding than large cap stocks, junk bonds are riskier than treasuries, etc. What do all these terms mean? In this article, we will review the concept of a mutual fund stylebox, that was originally introduced by Morningstar, that can help visually illustrate these concepts and aid in developing a diversification strategy.

There are two basic styleboxes that we need to understand. One is for the stocks and the other is for the bonds. The key attributes that a stock stylebox reflects is the size of the stocks (in the fund) and the valuation of the stocks (in the fund). The bond (or fixed income) stylebox on the other hand reflects the credit quality of the bond and the duration of the bond (maturity). Each of the styleboxes are separated into 9 different quadrants that determine the style of the investment.

Stock or Equity Stylebox

Domestic Equity Stylebox

A stock or equity stylebox consists of the market capitalization of the stock on the vertical axis. The classification of market capitalization of a stock in Large/Mid/Small cap normally vary but a general rule of thumb is any company above $10 Billion in market cap is a large cap company and any company below $2 Billion in market cap is a small cap company, with $2 B – $10 B range classified as mid-cap. Small caps could be further broken down into ultra-small-cap and micro-cap stocks.

Valuation of the stock is represented on the horizontal axis. Traditional industry measures of valuation such as Price-Earnings ratio and Price-Book ratio are used to determine valuation for a domestic equity. For international equity, Price-Cash Flow measure may be used as the Earnings measurement differs across the globe due to differences in accounting standards.

From a risk perspective, small cap stocks are generally considered the riskiest with large cap stocks considered the safest. Additionally, the value stocks are perceived to have less risk than the growth stocks while offering higher potential returns.

Bond or Fixed Income Stylebox

Bond Stylebox

Similar to Equities, the Bond stylebox has 2 axis displaying 9 different styles. The emphasis here is on the credit quality of the bond as well as the time to maturity or the duration of the bond. Vertical axis shows the credit quality, with High (AAA-AA), Medium (A-BBB), Low classifications. Typically government/municipal bonds and very stable corporate bonds are classified as High quality while junk bonds are Low quality bonds. Horizontal axis reflects the time to maturity of the bond. The shorter the time to maturity of the bond, safer it is as the company and economic risks are minimized. Similarly, highly rated bonds are deemed to be safer, although it should be noted that sometimes the rating agencies fall behind and do not completely reflect all the known information in their ratings (one of the main reasons for the mortgage crisis was the AAA ratings issued by the rating agencies on questionable mortgage debt securities).

While we have discussed the styles above in the context of stocks and bonds, mutual funds are classified using this style boxes using weighted averages over all their holdings. Therefore it is possible to find a short term high quality bond fund that has a portion of its portfolio invested in junk bonds.

Style drift: When investing in mutual funds, one should keep in mind that the reported style of a mutual fund may drift over time. For example, a small cap value fund can over time become a mid-cap blend fund if its holdings value increases and the fund did not replace the holdings that ran up in price. Generally this is not a problem if the fund manager sticks to his/her stated objective of the fund and the new investments are aligned with the objective. One should be wary of the funds where the style keeps changing randomly without any reason and not in line with the fund objective. This may be an indication of exessive trading (churn) and/or incompetence of the manager.

Caveat: While the styleboxes provide an easy way to classify one’s investments and develop an asset allocation strategy, they should not be the sole criteria for picking an investment. One needs to consider additional factors such as manager experience, past performance, fees and expenses, portfolio turnover, diversification, etc. There are a few well respected managers that run highly concentrated portfolios with little regard for styleboxes and have generated outstanding returns for the investors. You can analyze the horse and the weather and other things all you want but if you do not have the right jockey than your bet is still going to be very risky.

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Mutual Fund Investing with Style

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Low Cost Investing and Diversification with Index Funds

Miranda — Thu, 30 Apr 2009 19:52:28 +0000

One of the best ways to get a diversified investment portfolio without a great deal of work is to invest in funds. Funds offer a collection of stocks in one investment. Invest in a fund, and you own a portion of each stock in that fund. It can be a simple way to enjoy the combined performance of several (or even hundreds or thousands) of stocks without going through the time-intensive process of picking stocks. And one of the easiest types of funds to invest in is the index fund. An index fund is inexpensive, usually diversified and simple to get started with. Additionally, index funds make great long-term investments for the buy and hold aficionado.

What is an index fund?

US Stock Indexes Source: Wikimedia Commons

Like a mutual fund, an index fund is a collection of the stocks of individual companies. However, an index fund tracks a stock index, commodity index, bond index or some other investment index, rather than being composed of stocks chosen by a manager of some sort. An index fund is composed of all of the stocks on a particular index. The most popular index funds usually involve tracking the S&P 500 index. Indeed, the first index fund — introduced by Vanguard — did just that. But there are other funds that track index performances:

Wilshire 5000, which tracks all publicly traded companies in the U.S.
Russell 2000, which tracks the companies with the smallest market cap.
MSCI EAFE, which tracks global stocks.
MSCI Emerging Markets, which tracks stocks in countries with emerging economies.
S&P Global Clean Energy, which tracks clean energy stocks.
Bond funds that follow the performances of aspects of the bond market.

There are, of course, numerous stock index choices, from those that track oil stocks to tech stocks, and including the ability to invest in funds that follow individual European and Asian stock indexes such as the FTSE 100, Stoxx 600, Nikkei 225 and the Hang Seng. It is even possible to find index tracking funds that are also exchange traded funds (ETFs), allowing you to more easily trade them on the stock market.

Using index funds in your investment portfolio

Index funds offer many advantages to a number of investors. They can provide diversity and relative stability to your investment portfolio over long periods of time. These funds have the advantage of being exceptionally low cost. Because they do not require the help of a manager, index funds often cost between 0.5% and 0.8%. This is much better than the average 1.5% to 2% that you pay for many actively managed mutual funds. When you use index tracking funds, you will find that you get to keep more of your money. It is also worth noting that many index funds are tax efficient. This means that they often manage to avoid realizing significant capital gains that an actively managed fund does. When combined with a retirement account, index mutual funds or ETFs become even more tax efficient.

Index funds are ideal for long-term, buy and hold investors because of their ability to do well over long periods of time. Since they track the stock market, they generally go up when your time frame extends out more than 10 to 15 years. Because, historically, the stock market always gains over the long haul, you are unlikely to lose out if you keep your money in index funds that track the stock market. There are some investors that compose their entire portfolios using index funds, adding foreign funds and commodity funds for a little more risk, and using bond funds as conservative investments. When you properly use index funds, asset allocation can become a little easier, allowing you to easily and precisely allocate your investments in different asset classes by choosing appropriate index funds and investing in them in the ratio that you desire. This takes away the guess work of figuring out which asset class a particular investment falls under. Your investments in each asset class will also be diversified as an additional bonus

You should note that many index funds require high minimum investments. This can make it somewhat difficult to get started with index fund investing. However, it is possible to find online investment accounts and work through other brokerages (almost everyone loves Vanguard) that have lower limits. In some cases, it is possible to avoid the minimum as long as you sign up to automatically invest from your checking account every month. Index ETFs offer the opportunity for you to track an index, but without the worry of minimums. Popular ETFs that track indexes include Spiders, Vipers and iShares.

If you are looking for more information on index funds, you can visit Morningstar.

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Low Cost Investing and Diversification with Index Funds

Learning to Invest with Mutual Funds

Arohan — Wed, 29 Apr 2009 21:42:02 +0000

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If you have a small account or if you are just learning to invest, you should consider investing with mutual funds. A good mutual fund offers access to professional money managers and also allows you to diversify your holdings across multiple asset classes. Once you feel you understand how to evaluate businesses and stocks and have enough capital to diversify into asset classes that you want, than you may consider buying stocks on your own and build your own unique portfolio. Even seasoned investors with significant investments may still want to use mutual funds as part of their portfolio as it saves time by outsourcing the research and due diligence of stocks to a professional mutual fund manager. In practice, however, you still need to perform detailed due diligence on the mutual fund that you are considering buying to understand its investment philosophy, managers, fees, performance and its fit into your asset allocation and investment strategy. Besides, many investment accounts available today (such as 401Ks, 529 plans, etc), offer mutual funds as the only available investment options, and therefore, it is important to understand mutual funds and how to invest in them.

We will present the basics of investing in mutual funds in a set of articles that will cover all aspects of investing in a mutual fund. Please be sure to check back often for new articles in the series.

What is a mutual fund?

At its very basic, a mutual fund is a way of pooling investments from many different investors to invest according to a definite strategy. Typically the strategy of the mutual fund is outlined in its Prospectus. Every mutual fund investor should review the mutual fund prospectus of the fund they are looking to invest in. Wide array of strategies are available today. Investors can choose from bond mutual funds of different durations (short term, intermediate term, long term), stock mutual funds of all types and flavor (value, growth, small/medium/large cap, sector specific funds, income funds, long only funds, short only funds, global funds, international funds, country or region focused funds, etc), blend funds, commodity funds, real estate funds, index funds and so on. The concept of pooling investments from many investors allows a fund to leverage a large capital base to make investments in a diversified set of securities. Most funds available to retail investors have low minimum investments that allows an investor with small capital to invest. An investor in a mutual fund is issued shares of the mutual fund. Every share of a mutual fund is equivalent, meaning they all represent a portion of the total assets of the mutual funds equally.

Types of mutual funds

There are essentially two main types of mutual funds in US today (similar concepts exist in most other countries globally), Open Ended Mutual Fund and Closed-Ended Mutual Fund. Exchange Traded Funds (or ETFs) have recently emerged as a new kind of investment fund that essentially combines the features of an Open-Ended mutual fund and a Closed-Ended mutual fund.

An Open-Ended fund is a mutual fund where new shares are issued as new investments come in. Conversely, as investors redeem their shares, the redeemed shares are retired. This means that there is no secondary market for the shares of an open-ended mutual fund. All buy and sell transactions of these funds are ultimately conducted with the mutual fund itself (even though the funds may be sold through brokers and advisers). A new investment in these mutual funds mean that the mutual fund manager may use the new money to buy additional shares of the investments it carries. Similarly, a redemption often means that the mutual fund manager may need to sell some of the investments to meet the redemption request. An open ended mutual fund is always quoted and transacted at its Net Asset Value (NAV), which is the market value of all its investments on a per share basis. Typically mutual fund NAVs are revised once each trading day (although there may be cases where the NAVs may be revised less often, mostly if the underlying investments are illiquid).

A Closed-Ended fund has a fixed number of shares that it issues once when the fund launches. The launch of the fund creates the capital base for the fund that it can use for investments. The fund may choose to do additional issues or even buy back shares at a later date. Once the fund has launched, its shares can be bought and sold in the secondary market. The shares of a closed-ended funds are continually priced just like stocks and may be higher than the NAV (selling at a premium to NAV) or they may be lower than the NAV (selling at a discount to NAV). A good rule of thumb when buying a closed-ended mutual fund is to always buy it at a discount to its NAV (A quick tip: if you use Yahoo Finance to look up the quotes on a closed-ended fund with ticker ABC, you can in most cases find the NAV of this fund using the ticker XABCX, i.e, by adding Xs before and after the ticker symbol). Closed-ended funds are legally a closed-end companies in US and are similar to Investment Trusts in UK or Listed Investment Companies in Australia.

Exchange Traded Funds have recently emerged as an attractive alternative to traditional mutual funds. ETFs combine the best features of Open-Ended mutual funds and Closed-Ended mutual funds. ETFs trade on exchanges just like a stock at a price very close to its NAV. This is accomplished by letting retail investors trade ETFs in the secondary market and at the same time allowing authorized participants (mainly large institutional investors) the ability to buy or redeem shares of ETFs from the fund manager directly in exchange for a basket of underlying securities. This arbitrage opportunity for the institutional investors helps maintain the ETF price close to its NAV. ETFs were originally created to track indexes but can now also be actively managed. Exchange Traded Funds are an attractive alternative to traditional mutual funds as they typically have low cost, tax efficiency and high liquidity.

In future articles we will cover each of these fund types in greater detail, including some tips on how to select these funds for investment. In the meantime, here are some excellent resources on mutual funds available around the net. Feel free to explore these sites

Morningstar - Most popular mutual fund research site in US and creator of the ever popular Morningstar Style-box classifications and rating system. The forums at this site are a great place to meet and discuss with like minded and helpful investors.
Lipper - Another well regarded mutual fund rating service
Closed End Fund Association
ETF Connect – A great source of information on ETFs, ETNs, and Closed-End Funds

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Learning to Invest with Mutual Funds

Socially Responsible Investing for “Values” Investors

Miranda — Thu, 23 Apr 2009 20:49:45 +0000

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Yesterday was Earth Day, and the event encouraged many people to start thinking about their investments and whether or not they support companies that have policies and practices that are environmentally friendly and socially responsible. Socially responsible investing is growing in popularity as an increasing number of people wish to embrace an investment strategy that takes the good of society into account as well as returns.

The practice of socially responsible investing in the Americas goes all the way back to the middle of the 18th Century, when Quakers insisted that their congregants avoid investments in enterprises related to the slave trade. Today, socially responsible investing encompasses an awareness of whether a company has practices in line with diversity, transparent and ethical corporate governance, consumer protection, environmentally sustainable efforts and human rights. Socially responsible investing can also include choosing investments based on how well they align with religious beliefs; Christian and Muslim investing are two growing strategies within the religious financial realm.

Socially Responsible Mutual Funds and Exchange Traded Funds

One way to make socially responsible investments is to choose mutual funds and exchange traded funds (ETFs) composed of companies that have approved practices. Most socially responsible funds and ETFs do not include companies that do business with countries that violate human rights, such as Somalia or Sudan. Additionally, many funds avoid including companies that represent “sin” stocks, such as tobacco, alcohol or gambling. It is also possible to choose funds, such as the The Sierra Club mutual fund, that avoids including companies that pollute excessively. You can find a number of socially conscious funds, and their criteria, on SocialFunds.com. It is possible to use the criteria posted by a fund to determine how closely it aligns with your values. The downside to socially responsible mutual funds is that the fees are often higher than other funds. Imagine an actively managed fund, and then add 0.5% to 1% to the fee. The argument, of course, is that as soon as the fund starts increasing its returns, the fees will be reduced. But I wouldn’t count on it.

For those who want to combine two investing trends, it is possible to invest in socially responsible ETFs. There are a number of exchange traded funds that include companies with approved social practices, as well as funds that include only companies that are related to the production of clean energy. And, finally, there are socially responsible index funds. These funds track indexes such as the Domini 400 Social Index and the Citizens Index. There are a number of indexes now (including the Dow Jones Sustainability Index) that are composed solely of socially responsible companies. The fees on socially responsible ETFs and index funds are generally lower than the fees charged by their mutual fund counterparts.

Investing in socially responsible companies

If you are interested in investing in individual companies, it is possible to find companies that are socially responsible. One of the easiest things to do is to look at which companies are included in funds and on socially responsible indexes. In order to be included, companies have to meet certain criteria. However, it is a good idea to check the criteria the funds set; some only require a very small threshold of policy that may not be stringent enough for some socially conscious investors. And some socially responsible investors decry the inclusion of some oil and nuclear power companies in a few of the environmentally friendly funds.

Another place to look for socially responsible investing ideas is SustainableBusiness.com. This site keeps track of sustainable companies, putting out lists of the most sustainable stocks available. Many of the stocks are reasonably good performers, appearing on top stock indexes around the world. Indeed, it is possible to diversify a socially responsible stock portfolio to include small cap and large cap companies, as well as domestic and foreign companies.

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Socially Responsible Investing for “Values” Investors

2008 was a bad year for mutual funds investors. Really!

admin — Mon, 12 Jan 2009 06:04:17 +0000

Source: stck.xchng Photo: lusi

Washington Post wraps up an exceedingly bad year for investors with its take on the US based mutual fund performances.

Among some startling (or not) facts:

The worst performing fund was down nearly 60 percent, the average financial fund declined 42 percent, and not one diversified stock fund bigger than $100 million ended the year with a gain.

Overall, the average mutual fund plunged 30 percent in 2008, and many didn’t fare as well as the Standard & Poor’s 500 stock index, which fell 38 percent for its worst year since 1937.

The article goes on to talk about how the mutual funds were much better investment vehicles compared to hedge funds and so on and how liquidity is better than illiquidity

But here is what jumps out to me. The average mutual fund (-30%) performed better that the S&P index fund (-38%). Hmm, does this mean that professional management improved returns this past year?

On second thoughts maybe they are including bond funds and money market funds in their ‘average’ mutual fund. In that case it is strange that they would make a comparison to the S&P index

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2008 was a bad year for mutual funds investors. Really!