Are you aware of what your mutual funds own?
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Since investment is such a critical part towards achieving financial freedom for most of us, and mutual funds is one common vehicle for that, one does need to know what is contained inside the portfolio of fund. Think about it, do you buy a new house for primary residence simply by looking at it from the outside. You won’t, simply because a house represents significant financial commitments, with mortgages that stretches to more than 20 years for most, I don’t think anyone will anyhow buy without looking at every single thing inside.
The same goes for investing in mutual funds, though one can buy and sell at any time, it is not advisable due to sales charges and lost in capital if enter and exit at the wrong time and price. However, it is unlikely that one can lose 100% of the capital when investing in mutual funds due to legislations prohibiting any fund from holding more than 30% of a single company stock or bond.
The following words will address some elements of any mutual funds that any one investing must know. They will assists you in understanding why the prices behave in the past, make reasonable predictions on how it will do in future and most importantly, how that fund can complement your investments in other areas.
A mutual fund basically owns either one or a combination of three things – cash, stocks or bonds. I once saw an advertisement for an actively managed bond fund that claims to holds up to 40% cash during volatile times. The problem is you don’t need to pay someone more than 1% per year in management fees just to kept 40% of your cash in their bank accounts, accruing interest for them and earning 1.5% from you as well. Knowing what you own is important because how a fund manager invests and where he invests has a significant impact on performance.
In addition, most of the times, a fund name nowadays does not tell you what it actually owns because their names are too generic. In other words, you can’t even tell whether they invest in small cap or large cap, the first thing that one need to be aware of in deciding to invest. A fund prospectus also did not tells you anything much about the fund other than some basic parameters, they are written in broad terms so that the fund managers can have the flexibility to invest as they think fit.
For a stock mutual fund,
1. Geographic regions
Most funds have their respective specific geographic regions in which they invest in order to suit the risk appetite of various investors. One simple way in which to group stocks based on regional is developed and emerging economies. Other than this, mutual funds can also be grouped by countries and continent like, United States, Europe, China, Asia (including or excluding Japan) and last but not least, Australia and New Zealand.
2. Stock size – average market capitalization
Most of the funds either focus on micro cap, small cap, mid-cap or large cap in their portfolios. In investing vocabulary, stock size is measured by market capitalization which is basically price of one share multiplied by number of shares outstanding. Cap size alone can affect a particular portfolio of stocks risk level. How it affects and to what extend depends on a permutation and combination of other factors as mentioned in this blog post. Although there is a much greater number of small caps companies than large caps, they only make up around 10% of a given region total market capitalization of all companies.
Not every mutual fund focus entirely on either large caps or small caps, there are some funds that got contain a mixture from every cap size. In this case, their average cap sizes determine their risk levels from market capitalization.
3. Investment style – Value or growth
After the above two, the third of grouping stocks is growth or value. In the simplistic sense, growth stocks are those with higher price-earnings ratio while value stocks are those with lower price-earnings ratio. But fund managers do not necessarily use the simple measure of price-earnings ratio only to determine whether a stock is a growth or value. Other parameters like dividend yields and its past and expected future earnings growth are taken into consideration also.
If we define three categories for market capitalization and three categories for investment style such as value, growth and a blend of the two, meaning somewhere in between. We will have a total of nine permutations with different levels of risk. The large cap and value will be lowest risk while that of small caps and growth will be of higher risk.
4. Sectors – Energy, utilities, health care, financial services, electronics etc
Our economy is made up of many different sectors that provide different products and services. There are funds that diversified onto different sectors and funds that focused exclusively on one sector. There are 12 major sectors that stocks can be in and these 12 sectors can be under three major groupings like information, manufacturing and services. Knowing how much of your fund is exposed in each sector, i.e. percentage of exposure in each sector, is crucial since which industry the fund invests in determines its performance much more than the fund managers behind for most of the time. A perfect example is during the dot com boom and bust period.
In addition, if one fund is heavily concentrated in one sector like automobile industry, then it is better that any spare investment dollars are invested in funds that hold stocks that are not in the same industry as it.
5. How many companies are inside the fund?
There will be significant difference in the behavior of fund prices if it holds 25 stocks (or companies) compared with if it holds more than 500 different stocks. Obviously, a fund containing 25 different stocks is going to be more volatile, for better or for worse, than a fund with over 500 stocks, regardless of who is the fund manager.
6. Turnover rate
When we invest in actively managed mutual funds, we are paying a substantial management fees per year, of course the fund managers must do something like buy and sell at the right time, in order to achieve higher than overall market returns. However, if the turnover rate is too much, it most probably will reduce returns by virtue of its transactions costs involved.
Defining turnover rate,
A turnover rate of 50% means a holding period of two years.
A turnover rate of 100% means a holding period of one year.
The turnover rate for a mutual fund for a particular year is simply calculated by dividing the lower of that fund total purchases or sales by its mean monthly assets for that year.
High turnover fund not only reduces return through transactions costs but also shift the markets prices substantially. This is especially so for a large fund looking to either shore up or off loading large amount of shares in a particular company. At any one time, the market cannot absorb a large number of shares at a certain price. In general, funds with large assets base, like in billions, with a high turnover rate, are unlikely to achieve higher than overall market returns in the long run, though there will always be exceptions but they are few and far between.
As a result, you will greatly increase the odds of getting better long term performance if the bulk of investment dollars are placed in relatively low turnover funds.
For a bond mutual fund,
1. Interest rate sensitivity
A bond is more sensitivity to changes in interest rates than a stock. The reasons behind is easily explained, when a new bond is issued at a time when the interest rate is high, investors will rather buy them than older bonds with longer time to maturity that yield lesser in interest payments. This in turn depresses the price of existing bonds in the market as investors sell them to buy new bonds with high interest. The opposite happens when interest rate is low. One thing to note is that the number of years left to maturity for bonds greatly affects its sensitivity to interest rates.
2. Credit rating of bonds
Unlike stocks, credit ratings determine the prices of bonds much more than other parameters like cap size of companies issuing the bonds, high or low price earnings ratio, etc. Independent third parties like Standard and poor or Moody determines and then assigns credit ratings to bonds. Credit rating is a measure of how likely the bond’s issuer is likely to go default on payments, in both interests and principals.
Of course, in a bond mutual fund, where it invests in bonds from many different issuers, the bond fund credit rating is basically the weighted average of the credit ratings of all the bonds inside the fund. In general, bond funds with higher credit ratings and low interest rate sensitivity are deemed to be less risky than otherwise, less risky as in lesser changes in prices and lesser chance of default by bond issuers.
Knowing what your fund actually owns is the first step in investing in bond funds, knowing how to measure performance is the second step.
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