Thursday, November 10, 2011

Mutual Funds - Tic-Tac-Toe & Beyond

There are different types of funds, a good and necessary step is to identify its Morningstar style box. The Morningstar style box looks like a tic-tac-toe board. It is a nine-square grid that gives you a quick and clear picture of a fund's investment style. The style box classifies funds by whether they own large-, mid-, or small-capitalization stocks, and by whether those stocks have growth or value characteristics or land somewhere in between.


Selecting a particular fund style can enable investors to have an important degree of risk control. For example Large cap value funds have assumed about 50 percent less volatility compared to average fund where as small growth fund have assumed about 50 percent more. Taking the analysis a step further - risk-adjusted returns almost doubles when we move from small growth fund to large value fund in the category and style. In fact investors who rely on style specific funds can then reflect personal risk preferences. Let’s look at them one by one.


Index funds Revisited

Index funds are about as simple as it gets. They simply own the index. They are passive investors – yep dull and boring. Index funds have plenty of benefits. Most important, they tend to be low in cost. For example, Schwab 500 Index's SWPPX expense ratio is just 0.09% versus 0.84% for the typical large-blend fund. Because the index-fund managers aren't actively managing their funds—instead of making buy and sell decisions, they're simply doing what the index does—management fees tend to be low.

Index funds are also advantageous because they are fairly predictable. First, they tend to return what the index does, minus their expenses. Second, they always own what the index owns, which means they tend to be style specific. For example, if a fund indexes the S&P 500, that means it owns large-blend stocks; it'll own those types of stocks today, tomorrow, and the next day.


Growth Funds

The majority of growth managers are earnings-driven, which means they use a company's earnings as their yardstick for growth. Some managers look for earnings surprise, some look for firms which can generate long term capital appreciation and some just hunt for steady growers. Managers who seek growth at a reasonable price (GARP) try to strike a balance between strong earnings and good value. . As a result, these funds can land in the blend column of the Morningstar Style Box.  The hope is that these rapidly growing companies will continue to increase in value, thereby allowing the fund to reap the benefits of large capital gains.

In this style there are three categories depending on the fund’s average market capitalization – large, midcap and small cap funds. In general, growth funds are more volatile than other types of funds -- in bull markets they tend to rise more than other funds but in bear markets they can fall much lower, but there are mamagers who have delivered otherwise. Small cap growth funds are volatile and meant for people with long horizon.


Value Funds

All value managers buy stocks that they believe are worth significantly more than the current share price, but they tend to argue about just what makes a stock a good deal. How a manager defines value will determine what his or her portfolio includes and, ultimately, how the fund performs.

Fund managers practicing relative-value strategies compare a stock's price ratios (such as price/earnings, price/book, or price/sales) with a benchmark and then make a decision about the firm's prospects. Then there are managers who try to figure out what a company is worth in absolute terms, and they want to pay less than that figure for the stock. Absolute-value managers determine a company's worth using a variety of factors, including the company's assets, balance sheet, and likely future earnings or cash flows. They may also study what private buyers have paid for similar companies.

Value stocks are often the stock of mature companies that have stopped growing and that use their earnings to pay dividends . Thus value funds produce current income (from the dividends) as well as long-term growth (from capital appreciation once the stocks become popular again). They tend to have more conservative and less volatile returns than growth funds. Value funds also have categories based on market caps.


Sector-Fund Investing

The power of focusing is the principle behind sector funds, mutual funds that invest in a specific industry. How powerful can sector investing be? At the end of 1999, nine of the 10 funds with the best 10-year returns were technology funds.
Investors have many sector funds to choose from, spanning eight different Morningstar categories: communications, financials, healthcare, natural resources, precious metals, real estate, technology, and utilities. Some sector funds focus more narrowly, homing in on a particular subsector of an industry such as FSMEX that focuses on medical instruments subsector of medical sector funds.

It can be so tempting to dive into a part of the market that you think will soar based on some trend, an analyst's recommendation, or your gut.  In general, sector funds are more volatile and risky than mutual funds that invest their assets across a wide variety of industries. Reserve a very small slice of your portfolio—say 5% or less—for such activities and make sure the remainder of your portfolio is well-diversified and designed to meet your long-term investment goals with a level of risk that is acceptable to you.


Focused Funds

There is no standard definition for focused funds. The most common reference point is the number of individual stocks a fund holds. Generally, a focused fund will hold fewer than 40 stocks, and some of the most focused funds, such as Oakmark Select OAKLX, hold just 20 names. Numbers aren't everything: A fund can also be considered focused if it concentrates a large percentage of its assets in its top five or 10 holdings. Some funds concentrate in only one or a few market sectors.
If you think your investment portfolio could use a focused fund, look for the following qualities before you buy.

Ø       Experienced management Because so much rides on the individual stocks in a focused fund's portfolio, it is crucial that you look for a fund run by a seasoned manager.
Ø       Strong long-term performance You may be attracted to a focused fund because of a great quarter or sensational year. But because focused funds are linked so tightly to a few stocks or sectors, most of them will have a few glory days. Instead, look for a fund that has done well over time.


Maverick Funds

Legendary fund manager Peter Lynch would take some heat today. The former head of Fidelity Magellan FMAGX was an opportunist. Sometimes he liked growth stocks. Other times, value investments held more allure. Large companies struck his fancy but so did smaller firms. But flexible funds have their downside: They can make building a portfolio tricky. After all, if a fund is a small-cap fund one day and has large-company tendencies the next, how can investors be sure they're really diversified? Do you think we should categorize Fairholme (FAIRX) in this?


Bond Funds

These funds are more of fixed income style fund. The bond funds distinguish among each other on the basis of the credit quality and the duration of the bonds it owns.

Bond fund interest-rate sensitivity can be categorized into three groups: limited, moderate, and extensive. In previous lessons, we explained that short-term (or limited) bond funds are the least affected by interest-rate movements and thus the least volatile; long-term (extensive) funds are the most volatile. Credit quality of bond funds can also be broken into three groups: high, medium, and low. A fund's placement is determined by the average credit quality of all the bonds in its portfolio, and also adjusts for the fact that default rates increase more rapidly between lower grades than higher grades. Funds with high credit qualities tend to own either U.S. Treasury bonds or corporate bonds whose credit quality is just slightly below that of Treasuries. On the other hand, funds with low credit quality own a lot of high-yield, or junk, bonds. Medium-quality funds fall between the two extremes.

Risk in Bond Funds

Ø       Duration helps in evaluating the fund’s sensitivity to interest rate risk.
Ø       Volatility, a measure of the vraition in a bond fund’s return relative to the average taxable or tax-exempt bond fund.
Ø       Portfolio’s average credit quality.

Beware of two things when buying bond funds in general

Ø       Because bonds typically gain less than stocks over time, their costs become a heavier burden. Costs are the most important factor when evaluating bond funds, hands down.
Ø       Note that, in addition to their expenses, high-cost bond funds often take on more risk than low-cost bond funds. Expenses get deducted from the income the fund pays to its shareholders, so dwindling capital but higher yield is big no-no.

So what types of bond funds can I buy

Short/Intermediate Term US Government/Corporate Bond Funds
For your first—and maybe only—bond fund, consider intermediate-term, broad-based, high-quality bond funds that hold both government and corporate bonds. Remember, funds favoring high-grade bonds with far-off maturities can be pretty volatile, depending on what interest rates do. So when interest rates rise as they did in 2006 or they will in 2013 then favour short term bonds and when interest rates fall shifht your focus towards intermediate term bond funds.

Muni Bond Funds
Investors in the highest tax bracket may profit most from municipal bonds' tax-exempt status. Unlike income from bonds issued by corporations or the federal government, income generated by municipal bonds is exempt from federal and sometimes state income taxes. So when examining a municipal bond's yield, you must take the implicit tax advantage into account. The intermediate-term and long-term municipal-bond fund categories have returned roughly the same (4.7% annualized) over the trailing 10 years through 2010. But the intermediate-term muni category has had less volatility. Also try to stick with munis with average credit qualities of AA. They have enough high-quality bonds to skirt most credit scares but are still flexible enough to snap up higher-yielding, lower-rated issues. You don’t want to take the Harrisburg route.

High Yield Junk Bond Funds.
If you are looking to expand your bond-fund horizons, high yield may be the first area you've considered. High-yield bonds are often called lower-quality bonds, or junk bonds. No matter the name, these bonds offer much more income than Treasuries or other high-quality corporate bonds. That's because they have more credit risk.

Junk bonds pay higher yields and are often denominated in shorter maturities, they aren't as sensitive to interest-rate shifts as higher-quality, longer-duration bonds are. The junk bond can get hurt badly when number of companies are filing for bankruptcies such as the Lehman Brother’s turmoil. Similarly Worldcom's bankruptcy roiled the high-yield market.

Treasury Inflation-Protected Bond Funds
Treasury Inflation-Protected Securities (or TIPS) are issued by the U.S. government and are designed to offer protection against the ravages of inflation. Unlike regular Treasuries, TIPS promise investors that their principal value will rise in lockstep with the Consumer Price Index. That guarantees investors' principal will keep up with inflation, and because TIPS' coupon payments, which are just the real yield, are still calculated as a percentage of that principal amount, their value can move up with inflation as well. But it is important to understand that TIPS do not directly offer protection from rising interest rates. Interest rates and inflation rates don't have to move in unison, and if rates spike without a corresponding rise in inflation, TIPS can suffer a loss.

Rule of Thumb for Bond Funds.
Common sense would dictate making bond fund selections primarily from among funds in the lowest-cost quartile, the better to maximize the chances of enjoying returns above segment norms. The lowest cost group had not only the highest returns, but also the lowest risks. The returns go down as the costs go up. In fact each percentage point reduction in cost , on average , increased the returns by over 1.2 percent for an average bond fund.


Funds of Funds

Funds of funds are mutual funds that invest in other mutual funds. That may sound redundant, but it's true. Just as a regular mutual fund offers the skills of a professional manager who assembles a portfolio of stocks or other securities, the manager of a fund of funds will select a portfolio of funds, managed by other managers. If you have only a small amount to invest each month, a fund of funds allows you access to more funds than you might be able to afford on your own. It also allows investors to avoid the recordkeeping and paperwork that comes with owning an assortment of funds.

So what's the catch? Expenses, mostly. The fund of funds structure creates a double layer of costs.

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