Investors often use mutual funds to fill out target asset allocations and create well-diversified investment portfolios. In this introduction to mutual funds, we cover the quantity and asset size of available funds. Also, the variety of asset classes, subclasses, and specialty areas you can invest in using mutual funds.
It is extremely large, both in number of funds and assets.
We look at the number of mutual fund and assets under management. In Canada, the US, and the world.
How the mutual fund industry has grown over the years. As investors shift from investing in individual, non-diversified investments into better diversified investment products. As increased competition has continued to reduce product costs. And as investor knowledge has improved over time, resulting in the demand for more customized offerings.
“What are some of the asset classes that I can access with mutual funds?”
Investors can invest in every possible asset class and subclass. Based on your overall investment strategy, shorter term tactics, and to enhance diversification in your base portfolio.
We discuss some of the subclasses and ideas on how to assess them for your portfolio.
“How can I find the better funds when there are so many available to buy?
We discuss fund ratings and rankings as one tool to compare performance between mutual funds in an investment category.
There are a variety of analyst rating systems. We use Morningstar as an example in this video.
“What other considerations may arise with mutual funds?”
We discuss hedging versus foreign currency exposure. Or investing internationally, at all. Most Canadian investors have a substantial home country bias in their equity portfolios.
Perhaps you prefer a balanced mutual fund, which may match your target asset allocation. Or a target date fund that takes a balanced approach, but rebalances over time until its (and presumably your own) retirement date. So you get everything all in one investment product. Which improves simplicity in your investment management.
Maybe you want alternative asset classes or niche sectors. Private equity, commodities, collectibles, real estate. Or specialty areas such as Environment, Social, Governance (ESG) investments. A hot investment sector currently.
Many investors passively invest using open-end index mutual and exchange traded funds.
Some investors lump the two instruments together when discussing passive holdings. And there are a lot of similarities when assessing for investment potential.
But there are also material differences between the two, so I shall discuss them separately.
Today, a brief look at open-end index mutual funds.
An Index Fund is Still a Mutual Fund
An index mutual fund, or “tracker” fund, is exactly like any other open-end mutual fund.
There are mutual funds that invest in U.S. large capitalization stocks, Russian bonds, Canadian mining companies, etc. Pretty much any type of investments one can configure.
An index fund simply invests in a designated benchmark index for a specific investment style.
For example, the BlackRock iShares U.S. Aggregate Bond Index Fund (BMOAX) is a fund that attempts to match the total return of the Barclays U.S. Aggregate Bond index. The Fidelity® Emerging Markets Index Fund (FPEMX) seeks to replicate the MSCI Emerging Markets Index.
We have spent a fair amount of time discussing open-end mutual funds. If you want an in-depth analysis, please take a look at Mutual Funds in my category listing on the right.
I will briefly go through some of the key points and try to cross-reference to any specific posts for greater detail.
Open-End
Open-end funds are purchased and sold through each fund’s company.
Unlike most investments, you do not acquire open-end mutual funds on a stock exchange. However, often you can buy and sell open-end funds through your brokerage account as many brokerage houses will act as intermediaries between you and the mutual fund company.
If not, you need to create an account with the fund company. Something they love as your money becomes a sticky asset.
Note that investors tend to stick with a fund company (or financial institution) even if performance or client service is not great once their assets are in place. Clients find it too much a pain to go through the process of moving to a new institution. Needless to say, financial institutions often create obstacles as well that deter clients leaving painlessly (e.g., perhaps 60 days to transfer to a new institution).
Before committing to an individual financial institution (bank, fund company, etc.), realize that you may be with them for a long period. Take care before committing your assets.
Transaction Costs
A goal of passive management is cost minimization.
In most cases, avoid mutual funds with loads. This is especially true for index funds. Paying a sales charge for an index fund is not justifiable in my opinion.
Be careful with any brokerage commissions you are charged when trading through your account. If you invest directly through the mutual fund company, you should not be subject to commissions on trades.
Some brokerage houses offer commission-free mutual funds. Consider these as well when looking at index fund offerings.
Annual Costs
Look for index funds with low operating costs, as indicated by their expense ratios.
Passively managed index mutual funds should have little to no management fees attached. Do not pay for a service that you are not buying.
All mutual funds incur some administrative and other operating expenses. But focus on those with low expenses.
Note that larger funds or fund companies tend to exhibit economies of scale. The larger the fund, the easier it is to spread out fixed costs among investors. That tends to lower overall expense ratios. In large part, why behemoths like Fidelity, BlackRock, and Vanguard, have such low expense ratios. And competitive advantages versus smaller peers.
Match the Market Return
When assessing funds for investment, always compare a fund’s returns against its benchmark and its peers. Remember that performance is a relative concept and you need to analyze investments in proper context.
Find funds with minimal tracking error, that match the benchmark index return as closely as possible.
Risks of Open-End Mutual Funds
Counterparty Risk
As the contractual relationship is between you and the fund company, be certain you minimize the counterparty risk.
You can only sell your shares back to the fund company. Not to a multitude of potential buyers via a stock exchange. Try to be sure that the fund company will be in existence and able to repurchase your shares when you want to sell them. Note that counterparty risk may also be known as default or credit risk.
Liquidity Risk
Normally fund companies calculate a fund’s per share net-asset value (NAV) daily using closing market prices for fund holdings. And most fund companies let investors buy or sell fund shares on a daily basis at a fund’s NAV.
However, some funds may not perform valuations on a daily basis nor allow for acquisition or divestment of fund shares daily. These funds may only allow redemptions on a weekly (or longer) basis. If the market you are invested in suddenly plunges, you may be unable to sell in a timely manner.
Know the frequency in which you may buy or sell shares. The less opportunity that you have, the greater the liquidity risk.
Depending on the indices you invest in, there may be an overlap of securities. This may create an over-concentration of certain investments and actually reduce diversification. Always monitor the key holdings in each fund you own.
For example, Apple is present in (it seems) every US equity fund. Even if you spread your wealth around, you will own Apple in multiple funds. Watch for potential over-concentration of one investment over all your holdings.
You will also find that, in many funds, the top 10 or 20 holdings will make up a disproportionate share of fund assets.
Consider BlackRock iShares S&P 500 Index Fund (BSPAX). 500 U.S. listed companies across a variety of industries. Nice diversification. But if you review the portfolio, the top 10 companies make up 22.35% of fund holdings. Not quite as diverse as you might initially think. And yes, that ratio holds true for any S&P 500 Index Fund, not just iShares.
Here, we also see Apple and its market dominance. Out of 500 companies in the index, Apple alone accounts for almost 4% of total fund assets (as at August 13, 2018). Always an issue with capitalization weighted indices.
Note that while the S&P 500 represents a relatively large market, this tends to be a bigger issue the smaller and/or more niche market covered by an index.
South Korea is always a good example. iShares MSCI South Korea ETF (EWY) owns 114 different companies. Samsung alone is 22.28% of total fund assets as of August 13, 2018. Not to mention, many other Korean companies in the index are reliant on Samsung for their own business. While you may own the South Korean market as a whole, in reality your risk is heavily tied to the fortunes of Samsung.
Note that this South Korea fund is not a mutual fund. Next up we will start to look at the other popular passive investment, exchange traded funds (ETFs).
Having an investment professional managing your assets is usually perceived as a big positive. In fact, that is the marketing point for many mutual funds.
But should it be?
This is one of the biggest issues for investors. And a prelude to the active versus passive management debate.
I believe that non-professional investors should not normally compete with professionals.
In some ways, I view it as competing against Dustin Johnson or Jason Day on the golf course. Unless you have the same skills, it is difficult.
The professionals have an unfair advantage over the amateurs and it is not wise to try and beat them in picking investments. Professional asset managers have more technical expertise, better tools and data, and better access to information than you at home on your computer.
So it seems pretty straightforward. Go with the pros. Except ….
Two Types of Investment Professionals
I shall quickly differentiate between two types of investment professionals.
The first is the mutual fund manager. The person who makes the investment decisions on behalf of the fund.
The second is the research analyst. The person who prepares the buy and sell recommendations on specific investments.
There are other investment professionals including individuals who invest for their own livelihood. But for discussion purposes here, we will focus on fund managers and analysts.
Advantages of Investment Professionals
Investment Skills and Experience
It is not a simple process to pick individual stocks, bonds, or other investments. Fundamental analysis requires strong quantifiable skills and an understanding of the business, industry, and economic conditions to properly assess the qualifiable considerations. We quickly looked at Quantitative and Qualitative Analysis previously.
Professional fund managers and analysts should have the financial skills and experience to conduct better investment analysis than the average investor.
Better Information and Tools
Investment professional likely have access to better analytical tools and data than you or I.
They also have better access to the corporations that they follow. This includes access to a company’s investor relations staff or management as well as to special conference calls that companies conduct for investors.
These two areas make life difficult for investors such as myself. I would be considered an investment professional given my technical qualifications and experience. But having less timely access to corporate information and other relevant data puts me at a disadvantage to a financial analyst in a large firm or mutual fund. While I may not mind playing Jason Day for money, I want to make sure that I am not using golf clubs from the 1970s when I do so.
Also, funds with significant investments in companies are often able to shift the company’s business agenda. This is usually done at shareholder meetings where funds hold enough shares to pressure companies to follow strategies the funds prefer.
It’s Their Job
Another problem for most individuals is that they are not full-time investors. Fund managers and financial analysts spend their days researching investments. That is their job.
Some of you are students. Others are lawyers, doctors, dentists, plumbers, government employees, and so on. Whatever you do, you put in a full week at your own job. Any time for investing comes at night or on the weekends.
If you had the time and the tools, you might be better able to compete with the professionals. But you do not. This also puts you at a competitive disadvantage.
So many advantages in having professionals manage your money. Except ….
Disadvantages of Investment Professionals
There are a few potential disadvantages to using fund managers or analyst recommendations when investing. I will expand on a couple of these points in subsequent posts.
Some Professionals are Better than Others
As should be expected, some research analysts and fund managers are better than others.
The trick is to find the good ones and to avoid the poor.
Not always a simple thing to do. In fact, often you see rankings that have one analyst or manager perform highly in one period, then less so the next. And vice-versa.
Reviews of peer group performance and category ranking is the main way to assess relative performance. But they are not always a perfect predictor of future results.
Does Active Management Work?
There is great debate as to whether analysts or fund managers can out-perform their relevant benchmarks.
In some select instances, I believe it is possible. But for the most part, I am doubtful as to whether active management can beat a passive approach to investing.
We will look at the arguments for and against active management later in some detail.
Neglected Market Segments
Professional investors focus on specific market segments. The segment may relate to their area of expertise (e.g., an oil and gas analyst focuses on oil and gas companies) or investment style (e.g., a Swiss large-cap equity fund analyzes relevant Swiss companies).
Often there are neglected market segments that analysts do not follow and/or funds do not invest in.
These may be extremely small segments such as micro-cap mining companies in Australia. Or markets where information is scarce so that analysts and managers do not follow the segment closely. Equity investments in Iraq might be a good example. Or perhaps the local market is relatively inefficient and analysts/fund managers cannot match the local expertise. For example, a New York based real estate analyst trying to assess the residential real estate in Tucson, Arizona.
In neglected or inefficient markets, small investors, especially those with specialized knowledge of the market segment, can out-perform the investment professional.
An amateur investor with sophisticated knowledge in 18th Century art may be equally skilled against professional investors who trade in fine art. Or a geologist working in Calgary, Canada who deals with small oil and gas companies on a daily basis may have an advantage over a professional investor who lacks the local knowledge and contacts.
Fund Management Fees
Like anything in life, if you want a service you must pay for it.
For every dollar spent on management fees, that is one less dollar of performance. And one less dollar that can be reinvested to compound over time.
We have previously reviewed mutual fund operating costs and seen that management fees can be a significant component in a mutual fund’s expenses.
Not surprisingly, management fees can be a relative concept.
Top fund managers command greater compensation levels which impacts fund performance. Is it better to choose a fund without a star manager? You may forego potentially better future returns but you will certainly save money on fees.
Or what about funds that require greater amounts of work by the managers. Investing in developing markets typically requires more work (i.e., management time and other costs) than in developed nations. Is it better to pay greater fees and expenses for access to these markets?
Do the Advantages Outweigh the Disadvantages?
I do not think that the typical investor should compete against the professionals. And by competing, I refer to the selecting of individual securities and other assets.
The typical investor lacks the technical skills, investment and economic experience, and time to be a professional investor.
Unless you have specialized expertise or access to better information in an inefficient or neglected market segment, I suggest avoiding selecting specific investments on your own.
That said, do the costs and performance achieved via active management make use of professionals a wise move? Except in specific circumstances, I generally think not.
I shall expand on why I generally think not in coming weeks. As part of the active versus passive management debate.
Asset allocation is a cornerstone of successful investing.
As the name indicates, it involves investing one’s capital among different asset classes and investment styles. You want an allocation that best meets your objectives, including expected returns and risk. Diversification and inter-asset correlations are key to success. However, if you allocate incorrrectly, you reduce the probability of achieving your investment goals.
So how does investment style drift figure into this?
Investment Style
Mutual funds should adhere to their stated investment style.
The stated style is disclosed in the prospectus.
The name of the fund itself should also indicate the investment style.
For example, the Fidelity Japan Fund (symbol: FJPNX) invests in Japanese securities. The Oppenheimer Emerging Markets Local Debt C (OEMCX) invests in fixed income instruments of issuers located in emerging markets.
Style Drift
Investment style drift occurs when funds shift from their stated investment objectives.
The shift can be unintentional or intentional.
Unintentional Shifts
An unintentional shift can occur without any physical changes in a fund’s portfolio.
For example, a small-cap fund holds shares of companies that have relatively low levels of market capitalization. Over time, some of these companies grow and become mid-cap or large-cap in size. Think of companies such as Microsoft and Google. They went from being small firms at inception to corporate behemoths today.
The same can be seen as growth companies mature. Revenues and earnings growth slows. As internal growth slows, these maturing companies begin to issue dividends. Before long, they morph into value companies. At one point in time, companies like Pfizer and General Electric were strong growth stocks. Now they are both value plays.
Companies can shift the other direction too. If you want a great example of changes in multiple characteristics, check out the rise and fall of Nortel.
And some companies are still in transition. Microsoft is included in many growth mutual funds. But I also see Microsoft in more than a few value funds.
If fund managers are not careful, they can find their style has drifted without any action on their part.
Intentional Shifts
A manager can manipulate his portfolio to intentionally deviate from the fund’s stated style.
Why?
The main reason is that fund performance is compared against the fund’s peer group and benchmarks. Relatively strong performance means more new investors and better fees for the fund managers.
Some managers will increase their portfolio risk in the hope of attaining greater returns. Or during bear markets, some managers will move from growth stocks (if that is the style) into value and/or defensive stocks to try and minimize the damage from a down market.
Same with bond funds. If interest rates are rising, long-term bond fund managers may try to shorten the duration of their bonds. If rates are falling, short-term bong funds may try to increase their durations.
The 80% Rule
Securities commissions often require some truth in advertising. The so-called “name rule” tries to ensure that fund names match the actual investments owned. In our examples above, you would expect the Fidelity Japan Fund to hold Japanese equities. And the Oppenheimer Emerging Markets Local Debt C to own emerging market debt instruments.
In the U.S., funds need to invest at least 80% of fund assets according to the stated style. Many other jurisdictions have similar requirements.
But that leaves 20% of a fund’s assets that can be invested outside the stated objectives, albeit subject to certain limitations. And that 20% can have an impact on the overall performance and style of the fund.
Picture a typical value fund. It probably has about 25-30% of its assets in its top 10 holdings. With 20% freedom to deviate, the fund could almost equal its top 10 holdings with investments in a completely different style.
Although a fund is required to stick to its style, there is potential for serious modifications within the actual holdings.
I suggest you review the rules in your jurisdiction to see how closely a fund must adhere to its stated style. The less the requirement, the greater the probability of style drift.
Why is this Important?
Ensuring your funds adhere to their stated style is important for two main reasons.
One, investors choose fund styles that meet their risk tolerances.
Conservative equity investors likely prefer funds such as: blue chip; large-cap, value, balanced, blended. They probably avoid small-cap or growth funds that have greater risk. But if a value fund exhibits style drift and starts accumulating growth stocks, its portfolio risk may increase to unacceptable levels for the low-risk investor.
Of course, unless the investor is aware that the fund’s style has changed, he will not realize his portfolio risk-return ratio has shifted.
Two, investors typically diversify their portfolios through asset allocation by purchasing funds in different investment styles and asset classes.
However, if one or more funds exhibit style drift, the diversification impact may be less than anticipated.
For example, you want exposure to to both growth and value stocks. You put 50% of your capital into Meteor Growth Fund and 50% in Slow and Steady Value Fund.
Initially the funds strictly adhere to their stated styles. But over time, some of Meteor’s high flying growth stocks mature begin to mature and become value plays. The economy has slowed and growth stocks are not expected to do well. Meteor’s manager decides not to sell these maturing growth stocks.
Further, given the economic forecast, the fund manager shifts a portion of his capital into value companies. Not enough to run afoul of the securities’ commission, but enough to have an impact on fund performance.
Without realizing it, your growth fund has shifted into more of a value fund than growth. Probably not 100% value, but maybe 50-60%. As a result, your asset allocation of 50% value and 50% growth is now 75% value and only 25% growth.
Not what you wanted and, as we will see when we discuss asset allocation, something that can impair your long-term portfolio performance.
When considering funds for your investment portfolio, do not rely solely on fund names or stated investment styles. Review actual holdings to ensure the fund reflects its stated style. Over time, for funds that you own, review fund holdings as part of your periodic review process. Very important to ensure your desired asset allocation remains accurate.
But you need to be certain that the holdings you review accurately reflect the fund’s investment strategy. If they do not, it may be due to the presence of window dressing.
Historically, the term “window dressing” refers to shop windows you pass while walking down the street. Stores present attractive display cases in the hope that you will be interested in their wares, enter the store, and make a purchase.
With mutual funds, I would describe window dressing in two ways.
The Common View of Window Dressing
Just before a reporting period (i.e., quarter or year end), fund managers will try to make their fund holdings appear more attractive to shareholders. Investments that either have significant unrealized losses or are considered poor investments will be sold and replaced with more appealing assets. These may include investments that are currently performing well or assets that are receiving positive publicity in the business news.
At period end, shareholders receive statements that show the fund made up of popular and appreciating investments, rather than dogs and assets that have fallen in value.
While this is the common view of mutual fund window dressing, I think it is a little simplistic. It also assumes fund shareholders are idiots.
Yes, I like to review my funds’ holdings. And I like to see what I think are appealing investments within the portfolio.
But I am more focussed on fund performance (and ensuring I am adequately diversified).
If the managers are choosing poorly and dumping losers just before period end, their actions will be reflected in fund under-performance. It should not take long for investors to see through this type of fund manager manipulation.
My View of Window Dressing
I am more concerned about window dressing for two other reasons.
That is, active fund managers that simply replicate their benchmark index in a passive management approach, yet charge shareholders for full active management.
By slightly altering fund holdings prior to reporting periods, fund managers can appear to show variances between their portfolio holdings and the benchmark. Yet once the new period commences, they revert back to the benchmark holdings.
As I hate to pay for services that I do not actually get, I like to watch for this in funds.
Style Departures
Second, window dressing can hide departures from a fund’s stated investment style.
A fund’s style is crucial to enable individuals to properly allocate their investment assets. Investors need to be certain that the investment style they believe they are investing in is truly the style.
A change in a fund’s investment style is known as style drift.