Mutual Funds: Strategies, Information, and Tips

What Are Mutual Funds?

In their most basic form, a mutual fund is essentially a sum of money that is managed by a professional money manager. There are many different types of mutual funds and as such, many different mutual fund investment strategies. These potential mutual fund investment strategies are limited only by the desire of the investor to establish such a fund, the ability of the money manager, and of course, by any applicable regulatory restrictions.

Types Of Mutual Funds Mutual funds are categorized based on their dominant investment policy and the types of assets that they hold. The broadest mutual fund categories include:

• Equity Funds: hold mainly common stocks or “equities”;

• Money Market or Short-Term Funds: hold treasury bills, money market securities and other income generating investments less than one year in term.

• Balanced Funds: hold stocks, bonds and short-term securities and allow the investment manager to alter the proportion of these investments.

• Bond or Fixed Income Funds: hold bonds and fixed income securities

• Income or Dividend Funds, hold preferred and common stocks to generate high dividend income.

Sector and Theme Mutual Funds Sector funds are mutual funds that are based on specific areas or “sectors” within a broader asset class or mutual fund grouping. So-called “high-yield” or “junk bond” funds are types of sector bond funds which invest in investment grade bonds. Resource equity funds are another type of sector fund that invests primarily in the equities of companies within the resource industry.

Theme funds are similar to sector funds, in that these types of funds invest according to a particular investment philosophy or “theme.” Traditional types of mutual funds, such as growth and value funds are also based on similar interpretations of investment philosophies. More recently, additional funds have been created with the objective of reflecting the “theme” of a particular investment strategy.

Strategies and Tips for Avoiding The Bad (And Finding The Good) Types of Mutual Funds

• Begin With a Solid Asset Allocation Plan Without question; the most important factor in avoiding bad mutual fund investments involves the selection of the proper asset types and strategies, based on current market conditions. In most cases, a diversified portfolio including domestic stock, international stock, bond, specialty, and money market funds is appropriate. But how much do you allocate to each asset class? That’s the most important question, and professional help in this area probably makes sense. Be sure to make an appointment with your Certified Financial Planner before making any type of investment decisions.

• Let Go of Your Favorites (If necessary) It can be hard to cut old ties, and long-term mutual fund holding ties are no exception. If it’s time to sell and upgrade from a mutual fund that’s lagging, though, it’s in your best interests to do it. Don’t hold a fund too long simply because it’s one of your “favorites” or because it has a short-term redemption fee. The investment merits of the switch almost always outweigh these factors, including any 1.5% or 2% fee. Of course, be reasonable. If you are within a few days of the expiration of the fee period, you may want to wait. But if it’s a month or more, pull the trigger.

• Pay Attention to Market Trends and Momentum This goes along with the above tip, because buying a mutual fund and holding on to it is a sure recipe for underperformance and disappointment. If you truly want to avoid bad mutual fund investments, than you have to be ready to upgrade your holdings to funds that are gaining momentum under current market conditions at a moment’s notice in order to keep in-step with the trends. Keep in mind that sometimes selling a bad mutual fund can be a more important factor to your performance than buying a good one

• Examine The Fees and Expenses of The Fund It is a well known fact that Funds charge both investor’s fees and expenses. Therefore, a fund with high costs has to perform better than a low-cost fund to generate the same returns for you, and even small differences in fees can translate into large differences in returns over time.

• Understand How A Fund Can Impact and Effect Your Tax Bill Generally, most funds are required by law to make capital gains distributions to shareholders if they sell a security for profit that can’t be offset by a loss. If you receive such a capital gains distribution from a mutual fund you will most likely be required to pay taxes on this distribution, even if the fund has generated only negative returns since day-one of your investment. This is why it is important to call the fund to determine exactly when it makes these distributions, so that you can time your investment strategies in order to avoid receiving (and owing taxes on) a capital gains distribution. Many mutual fund companies also post this information on their websites.

• Consider Both The Age And Size Of The Mutual Fund Before you invest any capital into a fund, be sure to read the funds prospectus to determine how long the fund has been in existence. Even though funds that are smaller or newly created can sometimes have excellent short-term performance records, as these funds grow larger and increase in the number of owned stocks, each stock will have less impact on the fund’s performance. This may make it more difficult for your investment to sustain its initial results.

• Think About The Stability Of The Fund. While past performance does not necessarily predict future returns, it can tell you how volatile a fund has been. Generally, the more volatile a fund, the higher the investment risk. If you’ll need your money to meet a financial goal in one year, you probably can’t afford the risk of investing in a fund with a volatile history because this means that you will not have enough time to ride out any declines in the stock market.

• Consider The Fund’s Portfolio Turnover Rate. A fund’s portfolio turnover rate measures the frequency with which it buys and sells securities. A fund that rapidly buys and sells securities may generate higher trading costs and capital gains taxes.

• Be Aware Of How The Fund Will Impact The Diversification Of Your Portfolio. Generally, the success of your investments over time will depend largely on how much money you have invested in each of the major asset classes – stocks, bonds, and cash – rather than on the particular securities you hold. When choosing a mutual fund, you should consider how your interest in that fund affects the overall diversification of your investment portfolio. Maintaining a diversified and balanced portfolio is key to maintaining an acceptable level of risk.

• Become Familiar With The Fund’s Fees and Expenses All funds charge investors fees and expenses, and a fund with high costs must perform better than a low-cost mutual fund in order to generate a higher return. The smallest differences in fees can translate into large differences over time, which is why it is important to calculate all of the fees and costs involved before investing.

• Think about the volatility of the fund. While past performance does not necessarily predict future returns, it can tell you how volatile a fund has been. Generally, the more volatile a fund, the higher the investment risk. If you’ll need your money to meet a financial goal in one year, you probably can’t afford the risk of investing in a fund with a volatile history because you will not have enough time to ride out any declines in the stock market. Read the fund’s prospectus and annual report, and compare its year-to-year performance figures. These figures can help tell you whether the fund earned most of its returns in a few small bursts or whether its returns came in a steadier stream. For example, over ten years, two funds may have gained 12% per year on average, but they may have taken drastically different routes to get there. One might have had a few years of spectacular performance and a few years of low (or negative) returns, while the performance of the other may have been much steadier from year to year.

• Factor In The Risks The Fund Takes To Achieve Its Returns. Read the fund’s prospectus and shareholder reports to learn about its investment strategy and associated risks. Funds with higher rates of return may take risks that are beyond your comfort level and are inconsistent with your financial goals. For example, a fund that invests primarily in stocks whose prices may change quickly – like initial public offerings or high-tech stocks – will usually be riskier than other types of funds. But remember that all funds carry some level of risk. Just because a fund invests in government or corporate bonds does not mean it does not have significant risk. For example, the fund’s investments could be very sensitive to interest rate changes. Thinking about your long-term investment strategies and tolerance for risk can help you decide what type of fund is best suited for you.

• Look Into The Types Of Services Offered And Fees Charged By The Fund. Read the fund’s prospectus to learn what services it provides to shareholders. Some funds provide special services, such as toll-free telephone numbers, check-writing privileges, and automatic investment programs. You should find out how easily you can buy and sell shares and whether the fund charges a fee for buying and selling shares. You can expect funds that require extra work by their managers, such as international funds, to have higher costs as a result.

• Don’t Buy Long-Term Performers—Unless You’ve Done Your Homework There are plenty of funds out there with good long-term track records that consistently perform at lower levels than their competitors. This doesn’t mean they are bad mutual fund investments, it simply means that there are other funds better suited to current market conditions. Take the time to see which funds are hot–and which are not. It can make a huge difference in your long-term returns, as well as your financial peace of mind.