Archive for the ‘Asset Allocation’ Category

The markets are down, making mutual funds all that much more important for risk averse investors. That is not to say stocks do not have their place, but the reason I love mutual funds so much is because they offer so much diversification (some would argue over-diversification) that risk becomes somewhat limited. So what does that mean for a mutual fund investor? It means greater participation in specialty funds like gold funds, small cap funds, BRIC funds, and so on. What this ultimately means for your every day investor is:

• yes, the markets will tank and bring down their investments. But when core investments drop, other investments hold down the fort. Which investments will it be? Bond funds? High Yield Investments? Small Cap funds? If I or anyone else could predict such things ahead of time, we would never both with those core holdings in the first place, would we? By being properly invested, the risk of being wrong is reduced or eliminated… something’s gotta win.
• opportunities to rebalance. Maintaining a proper asset mix is essential to long-term success (compared to chasing the winners every time a winner is identified). This means that as markets increase or decrease, the asset mix will shift. This calls for rebalancing, trimming those assets that have done well and dumping money into smart mutual funds that have not fared so well. This achieves two things: it reduces over-exposure and it allows to buy assets when they are considered “lower.”
• buy more when markets suck, buy less when they are heroic. This is the basis of dollar cost averaging, something we should probably stress more often at this site. Still, when markets tank, it reminds us of the importance of never throwing all of our money on the table at once. It reminds us to ease into a position(s) gradually.

Now what does this all mean to how I would invest 10,000? It means that if I was given $10,000 today and told that I had to invest it (instead of spending it on a bunch of toys for the summer), I would:

1. Determine my asset allocation model. You can do that right on this site if you want, or you can ask your advisor to help you figure it out for you. Mine will show: 60% Equities and 40% Income (this is after I decided to ignore the cash recommendation and invest instead in fixed income). Seems conservative unless I am a balanced investor, yes. But let’s take a closer look…
2. Research the following mutual funds; a good Balanced Fund like the PIMCO All Asset fund, which is a medium risk, high return 4-star rated fund. I would throw $7,500 at this fund because it is not only well managed, but the underlying assets are those that I actually believe in. And then I would invest in the Ivy Small Cap fund (a fund I have been laughed at for picking and sticking to, but one that maintains all of the fundamentals that I personally believe in and trust). This fund will allow me to invest $1,500 of the remaining $2,500, leaving me with $1,000 which I would throw at the Franklin MicroCap Value fund, another 4-star fund but one that has virtually no risk associated with it and a track record that would make old pros blush.
3. Review, review, review. Yes, three times.  Per month, that is. Because I think these assets are placed so well, the portfolio would fall out of balance fairly quickly.

If permitted, I would add a 4th point: split the $10,000 into ten $1,000 contributions. This would not be possible in the case of the funds I chose here, but if I had, say, $40,000 to invest, I would invest 10K now, the remaining $30K over the next 2 years. And all of it would be in mutual funds; small cap funds and a balanced fund, maintaining as close to a 60/40 split as I possible can given that balanced funds will not report in real-time what their holdings are.

Nearly a decade ago, David B. Leoper of Wealthcare Capital Management published a well-read paper on asset allocation. In his paper, he argued that diversification alone, which we underline here at the Mutual Fund Site, is not enough to water down the risk attributes of a portfolio. It seemed to me when I first came across his piece that he was either nuts or the concept of asset allocation, which is one of the fundamentals driving all mutual funds, might be widely misunderstood.

Diversification alone is not enough

One of the most striking arguments that Mr. Leoper makes in his paper is that diversification should not be used as a carte blanche excuse to explore higher risk investments within one’s portfolio. And while we have examined some very worthy small cap funds at length recently, Leoper’s point is extremely valid.

Just because you might have the risk tolerance to jump in bed with the RBC Micro Cap fund, it does not necessarily mean you should. Even if you were to limit that exposure to just 5% or even 2%, making an investment like that needs to be done for the right reasons.

And that, the idea of making investment decisions for the right reasons, is really the message we and every other financial planner, consultant, advisor should aim for. And while it sounds hokey, superficial and possibly even contrived, the reason for really getting to know an investment, whether mutual fund, ETF, or individual security makes perfect sense.

Make investment decisions for the right reasons

Ultimately, each investment within your portfolio will relate differently with other securities. It is like having a classroom full of male computer geeks (yep, I would be there!) and then adding an aggressive female athlete into the mix. All of a sudden, the dynamic changes. Some students might compete for the female’s attention, others might take a more aggressive position when it comes to their projects, etc.. Either way, the classroom would change, maybe dramatically or maybe subtly, but definitely it will change. And with time, that change may have a positive or negative impact; either way, there will also be an impact.

To invest for the right reasons, investors will want to understand how the new, added investment will change the portfolio’s dynamics. This might involve simply aligning the investment with other asset classes and sub-classes or it can involve something as complicated as R-Squared.

More importantly (and a lot simpler), the new investment should make sense with the portfolio’s overall objective. For example, if one wants long term growth, choosing an investment that focuses on speculative technologies might not make much sense. As well, this sub category may not correlate well with other asset classes within the portfolio.

By taking a closer look at one’s portfolio, it can be fairly easily ascertained whether a new investment will make much sense at all. Of course, for investors who are die hard mutual fund investors, the concept of diversification is an easy one to understand and appreciate. But that alone does not give free reign to buy assets that add no value, either tangibly in terms of risk-adjusted returns or intangibly in terms of how well such an investment compliments the balance of the portfolio.

It is about that time again where the Mutual Fund Site stresses the importance of asset allocation. This has very little to do with the recent market turbulence that has seen volatility (as measured by the VIX) jump to the highest levels of the year and more about how asset allocation accounts for more than 90% of one’s long-term performance track record. Regardless of whether mutual funds, exchange traded funds or any other asset management system are part of one’s investment strategy, asset mix is clearly important.

What else influences long term performance in an investment?

Other factors that influence a portfolio’s long term returns are asset selection, market timing and other factors (such as dollar cost averaging, expense ratios and so forth). But as shown here, none of those factors account for more than 5% of returns.

And here is why: the above factors involve investor intervention whereas asset allocation does not. An investor must consciously decide when to buy and sell (market timing), what assets to include (asset selection) yet asset allocation does not involve decision making.

Asset mix can be determined through a series of a questions like the handful of questions we ask on our Asset Allocation Model Builder. All the investor needs to do is stick to the asset mix recommended. Plain and simple; no emotion-driven investment decisions required unless it is for rebalancing or making higher level changes to the asset mix itself.

This is supported by the simple fact that many fund managers are better managers with their portfolios than we are with our own: we have an emotional investment in our savings whereas fund managers do not. Emotions cloud the logic that one needs in order to be a successful investor.

At more than 90% of a portfolio’s long-term returns, it is therefore well worth taking the time to review one’s asset allocation and making the appropriate changes to one’s investment portfolio. This is a no brainer, really.

When we look at the recent popularity of bank stocks, it is evident that a lot of people will get burned. The recent run up has resulted in higher volatility, which means that just as quickly as things have risen, they will drop. And up until the point that the prices really start to head south, someone will keep buying up these “popular” bank stocks. Everyone except the mutual funds who, for the most part, know better that to get sucked into the popular investment strategy when things rise, they will only keep rising.

Taking a contrarian investment approach like those we discussed elsewhere on this site might help.

Or it might not. After all, financial services firms remain relatively unpopular unless we are talking specifically about the “big banks,” the same stocks and companies that burned people in the past. But not all financial services firms are created equally. People who want to know where to invest their money might do well to examine the smaller firms, like those where Ivy Small Cap Value fund invests.

After all, our recommended Ivy Small Cap Value Fund has rewarded investors with a 13.39% return YTD.

Evidently, the folks at Ivy are doing something right, yet in their top 25 holdings you will not find any Citigroup, AIG, Fannie/Freddie, et al. holdings. Not a single one of them. In fact, they invest a large chunk of their assets in Small-cap stocks… not large, not Giant. (To a lesser extent, they invest in Medium cap securities, but as a small cap focused fund, they are pretty keen on sticking to their small-cap guns.

Given that less than 4 months of the year have passed, a 13.39% return (as at April 9, 2010) is pretty respectable. They know where to invest, no doubt about that, especially when it comes to investing in financial services firms. So, for those investors who have enjoyed the volatility rise and continue to pour money into some of these unsupported (fundamentally anyway) financial services firms, don’t let yourself get burned. Invest in a mutual fund that pays the pros to put your money where it belongs — in the right firms.

In order to achieve long-term growth within your mutual funds portfolio it is believed you will need to incorporate a fairly significant amount of equity or growth funds. While this certainly seems to be a valid argument based on historical rates of return and the difficulty associated with accurate market timing, not all investors need to have a portfolio that consists entirely or primarily of growth mutual funds.

For highly risk averse investors, loading up on growth mutual funds would obviously be imprudent and no financial advisor, tenured or otherwise, would ever recommend doing so. But imprudent would also be ignoring the growth asset class entirely.

Now there is a way for investors to ensure that they eliminate equity risk in their portfolio, even while investing in the wildest, highest of high risk equity funds. They do this by finding a guaranteed investment, whether it is a quality bond, term deposit or other virtually or entirely risk-free investment and working out how much interest they will earn over the time horizon of their investment.

Let’s take a closer look at an investment that pays 5% per year. If you had $10,000 in total to invest and you wanted to make sure that it was guaranteed over ten years, you could actually invest $3,860 in high risk equity mutual funds that could return whatever the market allows. The remaining $6,140 would earn 5%.

But regardless of the performance of those equity funds, the remaining $6,140 invested in that guaranteed or extremely low-risk investment at 5% would be worth $10,000 after ten years. This allows you to invest $10,000 today and enjoy absolutely no risk at all. The catch? That you wait 10 years without touching the $6,140.

The worst-case scenario would see the equity mutual funds worthless after 10 years. The best-case scenario is that the return is greater than 5%, leaving you with more than if you invest $10,000 in its entirety in the guaranteed 5% investment. Realistically, you should expect a higher return. Even a 7.5% return on the equity fund would bump your portfolio’s performance from 5% to a little over 6%.

Might not seem like a lot, but 7.5% over 5 years is really a lower-risk equity fund. And, really, the point is not so much that you are now outperforming your friends, but that you are achieving that performance without any risk at all to your capital.

Introducing our Asset Allocation Model Builder

Have you ever wondered what your asset allocation model would be if you could work it out on your own? That is without your planner or advisor looking over your shoulder or asking the questions while you sit across from him or her?

Well, now you can. This Asset Allocation Model Builder allows you to work on your Investor Profile independently of your planner or advisor. In fact, if you do not work with a planner, the Asset Allocation Model Builder will let you know what kind of asset mix you should incorporate into your own investment portfolio.

And the best part is that it will not cost you a dime.

What The Asset Allocation Model Builder Does

The following six (6) questions ask you about your beliefs about investing. They are not intended to be tricky or deceptive so that we might “sell” you an aggressive, speculative fund that pays a pretty trailer fee (remember, we do not sell anything at the Mutual Fund Site).

When you complete this form and submit it, the team at the Mutual Fund Site will evaluate your responses and provide you with an independent, minimum 2-page standardized report as to what your Asset Allocation Model should look like.

What Will You Do With My Name, E-Mail and Information?

We use your name and e-mail simply to personalize and respond to your Asset Allocation Model Builder submission. We will never write to you again, meaning you will never receive S-P-A-M e-mails from us. Period. (BTW, in order to be compliant with anti-SPAM regulations, webmasters must use third-party e-mail response systems like AWeber and a host of others).

Your information (the responses to the following 6 questions) is used simply to analyze your tolerance for risk, time horizon and investment objectives. From these questions plus some of the secondary questions that relate to how much risk you should prudently take (based on income and net worth, for example), we can gauge just how much weightings you should place in each asset class.

Aside from using this information to provide a professional recommendation, we have no other use for it. In other words, we are not using it to conduct any kind of demographic or market research (we can use Quantcast for free and save ourselves a ton of work).

How Long Does It Take To Get My Recommendation?

Due to volumes, we currently need 2 business days to e-mail responses to those who submit the survey.

Even though we are not here to sell you anything and we still urge you to speak with a professional planner who is licensed in your State before embarking on an investment program (you should use our Asset Allocation Model Recommendation as a great starting point), we believe in providing you with quality recommendations or nothing at all.

We have chosen quality.

So please help yourself to our Asset Allocation Model Builder and expect a response from us within 2 business days.

There are plenty of reasons why investors should steer away from mutual funds that invest in gold. While some mutual funds have performed well thanks to their gold holdings, there is a lot of concern among professional money managers that gold may have reached the end of the profit road.

It could be one of those situations where hindsight will tell us that the warnings signs were all to apparent. Here are some of them:

Consider the abundance of infomercials on television that ask people to send in their unused gold to be converted into “cash.” At these prices, many of these companies are able to turn a nice profit from all of that activity – in fact, they can even offer to pick up the tab on the courier expenses and insurance. The bottom line is that Gold is at a healthy, attractive price right now… if you are selling it.

…there are some fundamental reasons to steer clear of gold and gold funds

When it comes to investing in gold, one of the most active players are Exchange Traded Funds. Think about that. ETF’s, not central banks, not large financial institutions. What this tells us is that retail investors, who are investing in these ETF’s, are picking up Gold at prices that are so attractive that some of the largest countries in the world are offloading the metal at extremely lucrative prices. What Contrarian Profits.com points out is that when these investors decide to take a profit, the selling of gold by these exchange traded funds will push the price of gold down faster and farther than most expect.

And this makes a great deal of sense. Consider oil. The year was 2008, the month was July and oil touched $147.30, the highest it had ever seen. Since then, oil gradually fell (okay, that’s being polite: oil actually fell like a stone) to under $40 by November of that same year. This does no suggest that gold will suffer the same fate, but nobody expected crude oil to take such a drastic hit in such a short period of time. In fact, some analysts were calling for oil to hit $250 by the following summer (it never reached that).

Although they called crude oil the new “liquid gold” there are more than just rhetorical similarities between the two. First off, oil ran up as the economy reached its peak. Gold, on the other hand became a lot more overbought as the economy reached its trough and has begun to recover. For gold to remain in high demand, the economy needs to remain beaten down and all other inflation hedging investments lights currencies as well as other commodities become less attractive. Ultimately gold prices can be seen as highly sensitive and linked to the economic cycle.

Secondly, oil is a commodity, just as gold is. Just as oil supply is essentially limited and its production is controlled by OPEC, so too is gold supply controlled. In fact, gold production and supply is also shrinking. The point here is simply that arguments that gold will continues to see its prices climb in steady succession are unfounded and cannot be mistaken as fact, despite what some of the others are saying.

Essentially, the Mutual Fund Site believes that gold is expensive right now. We agree with Contrarian Profits that there are some fundamental reasons to steer clear of gold and gold funds that are heavily invested in the commodity, including some Gold ETFs. But because of this uncertainty, we also do not recommend taking a short position against the commodity either; it is best to sit this one out rather than endure a painful recovery process like those who, in the 1980’s bought Gold in the high $500’s and had to wait over fifteen (15) years for the prices to reach such highs again.

One of the reasons we like the Ivy Small Cap Value fund so much that we named it as one of our top mutual fund picks for 2010 is that it invests heavily in the right kind of financial services firms. The kind that have great value, even if they are consider small cap stocks or mid-cap stocks. We feel that as an investment strategy, these types of securities will allow the Ivy fund to not only outperform in pure growth areas but with its generous dividend it will also generate some decent income.

One of our reasons for liking the Ivy fund is that its underlying securities stand to benefit handsomely from a housing recovery, something we have already started to see according to a recent post over at Reuters about Homebuilder Confidence.

So why Ivy Small Cap Value and not something like the Fidelity Real Estate Income fund? After all, some of these real estate funds produce fairly substantial gains and income — Fidelity’s sure is one of them with a nice 4.8% yield and high returns compared to its peers, along with its “low” risk rating. But comparing Fidelity’s fund to Ivy’s is not a proper comparison. You cannot compare the two.

You cannot compare a real estate income fund to a small cap value fund.

For starters, funds like Fidelity’s are part of the income class. They invest in income-producing securities with roughly 50% of their total holdings in bonds. Of the 20% they hold in  stock, guess what 91% consists of? (Hint, we talk about about them a lot and suggest the difference between “good” and “bad” financial services firms to hold. Somewhat surprisingly, they seem to be holding the “bad” ones).

In comparison, the Ivy fund is equity driven. They have a purpose, with roughly 40% of their portfolio invested in the type of securities that will benefit from the same recovery from which a pure real estate fund (equity based) should.

So while the Fidelity Real Estate Income fund exists to produce income, Ivy Small Cap Value exists to generate long-term gains with income being a nice bonus. For people who are bullish on real estate, Ivy still makes better sense as an equity play because it stands to profit from the recovery. For the Fidelity fund to remain attractive, rates would have to continue dropping, which is still possible given how fixed mortgage rates continue to drop).

Ivy, however, does not need a housing recovery to remain a top-performing small cap stock fund. Why? Because the majority of its securities are already profitable. Remember, there is a difference between good and bad financial stocks; Ivy knows the difference because they hold the good ones. And those firms will only see their revenues increase when housing makes its come-back.This of course is one of the benefits to holding small cap stocks in a portfolio in the first place.

Would we recommend the Fidelity fund as an income play? Not now (besides, we prefer the Janus High Yield Fund as our preferred income fund for the year. Does that mean the Fidelity Real Estate Income fund is a bad one? Definitely not; it just does not make much sense as an investment strategy right now. And we feel our statement is fully backed up by the yield curve.

Over the last month or so, the Mutual Fund Site has had a lot to say about the financial services industry, whether we were bragging about our top small cap fund pick for 2010 (for those who have not read the post, the fund in question is the Ivy Small Cap Value fund), talking about the importance of dividend funds in building a profitable portfolio, or tooting our own horn about how we did a great job applauding Dryden’s approach with financials.

To tie these areas together, let’s consider that our 34% of our small cap fund pick for 2010 consists of regional financial services companies, many of which contribute heavily to the fund’s average dividend yield of 2.8%; many dividend funds will rely heavily on financial services companies whose stocks have become devalued to the point that the dividend yield alone makes them attractive assets to own; and Dryden’s Financial Services fund owns a substantial amount of high-dividend paying Canadian bank stocks.

The point above may not be obvious.

What we have here is something of a reverse-engineering problem. Consider that Canadian banks have been touted as the most solid in the world and they pay healthy dividends. Consider that dividend paying stocks are instrumental in ensuring healthy returns, whether inside or outside of a mutual fund investment. And consider, lastly, that Canadian banks are heavily involved in the retail banking segment of their  country, just like the regional banks held in the Ivy Small Cap Value fund are. In fact, those financial services firms in the Ivy fund are doing exactly what Canadian banks are doing – lending responsibly to Joe Public so he can go and buy himself a home, car, boat, whatever and get the economy turned around.

The point above might make a little more sense when you consider that regional banks are an important party in the economic recovery efforts that are being promoted by US officials like Barack Obama, Timothy Geithner, and a host of others who have taken a hard-nose approach with the “big” banks who are often blamed for bringing an end of the last economic boom and practically killing the global economy. In fact, a lot of these officials are trying to convince these big banks into behaving the way these smaller banks are behaving.

So what might that mean for the regional banks?

Well, it could be acquisition for one thing. Canadian banks, who conduct business in a similar manner as these regional banks, have been acquiring some of these regional banks for some time (and now with the US dollar as low as it has been, the Canadian Banks’ purchase power has increased) such as TD Bank purchasing Commerce Bancorp, an award-winning regional bank based out of Cherry Hill, NJ, in 2007.

More likely, however, is that these smaller banks, which pay bigger dividends (based on dividend yield) than their big bank counterparts like Citi and Wells Fargo, will have the support and encouragement of government. They are already operating the way the government would like to see them operate; they already understand responsible lending practices, they are already profitable and fiscally strong (one in particular has increased its equity value by more than 50% over the past two years alone!). The government should love these players.

And, most importantly, when the economy turns around and people start waiting in line for mortgage approvals, credit card approvals and other types of credit or credit-related services, these regional banks will see their income increase exponentially. Why? Well, they are already profitable and the economy is just slowly finding its feet.

It’s a perfect situation for mutual funds like the Ivy Small Cap Value fund (we went so far as to call buying this small cap fund a no-brainer). And for the strong-willed investor with the right risk tolerance, time horizon and investment objectives, it becomes and easy lesson in investment strategy, one that requires very little advanced research. It’s almost the best-kept secret in the mutual fund space (except we exposed it, and we are always proud to help out). And if you are not sure how to get your hands on these stocks, just head on over to Ivy and let them do the number crunching and trading for you.

Just yesterday (February 14, 2010) the Mutual Fund Site announced its top small cap pick for 2010 — the Ivy Small Cap Value fund. In that long-winded post, we outlined various reasons why this small cap fund is a no brainer, why all of the ducks are lined up and its sights for gains are clear for this year. With the mildly improving interest in housing thanks to the gradually improving employment figures, a lot of regional banks like those held by the Ivy Small Cap Value fund stand to profit. What emphasizes this fact is that a lot of regional banks are better positioned when financial service reform will start to take shape.

Okay, this entry is not intended to regurgitate what we wrote in our release or in the post. With that in mind, we will examine one area that makes this small cap mutual fund one of the most intelligent mutual funds available to the investors with the right risk tolerance, time horizon and investment objectives. Why? Because its dividend yield!

We have spoken at length about dividend funds and the importance of dividends in helping boost earnings withing a mutual fund. In fact, we have gone so far as to suggest that dividends can make the difference between what people perceive as a smart investor and an unlucky one. Where the Ivy Small Cap Value fund makes such a great investment is in its dividend yield of 2.8%.

Remember, value funds’ primary area of focus for returns lies in the abilities of the mutual fund manager to pick up underpriced assets. If the fund manager wanted dividends to prop up returns, he or she would be managing a dividend fund. With Ivy, the point is clearly in the “value” its assets offer. This can be supported by the relative low average P/E for the fund of just 15.7. This tells us that the underlying securities are clearly undervalued.

So where do these dividends come from, exactly?

We mentioned yesterday that three of its Top 5 holdings are Wintrust, IBERIABANK and East West Bancorp. Their dividend yields are 0.6%, 2.5% and 0.3% respectively (as of Friday’s closing price). Now, IBERIABANK’s dividend is clearly the highest, but still falls short of the fund’s average dividend yield. And with just 77 securities in its portfolio, obviously some of the other financials are paying much higher dividend yields. Look at First Niagara Financial Group as an example; they pay 4.1%.

And all of these financial services companies are strong. They have solid and/or growing equity positions, they are profitable and, well, they pay decent dividends.

Let’s look at some of the bigger financial services options out there.

• Citigroup. Its dividend yield is 0%.
• Wells Fargo. Its dividend yield is 0.7%
• Goldman Sachs. Its dividend yiled is 0.9%

The point here is that so many value investors will throw money at the big guns. Those are the large financial services firms listed here, two of which are terrific “buys” according to the well respected analysts surveyed by Thompson/First Call as well as other prolific stock analysts. But what about First Niagara, IBERIABANK and a handful of other in Ivy’s small cap fund?

These are what people call as investment “Secrets.” They are those dividends that people chase (within reason of course; no sense in buying a bankrupt stock even if it pays a 10% dividend!). The dividends that people wish they knew about.

Is there risk in a small cap fund? Yes. Is there risk in the Ivy Small Cap Value fund? Yes (although Morningstar lists its risk as low compared to its peer group). But when you have a small cap fund that pays 2.8% in average dividends, the fact remains that dividends are not only an important part of smart investment management, but are an essential contributor to a mutual fund’s returns.

When most people think about small cap mutual funds, the music from the Twilight Zone starts to play in the back of their mind. They know that small cap funds are an important investment management strategy, something that needs to find a place (even a small place in percentage terms) in their asset allocation model, but this part of portfolio building is arguably one of the toughest (next of course to specialty funds). I am also one of those apprehensive investors when it comes to Small Cap Funds. So let’s examine why they are so scary. Ultimately, what makes small cap funds a scary, dark corner is their underlying assets, which are small cap stocks.

…what makes small cap funds such a scary, dark corner is their underlying assets…

And those stocks, thanks to the credit crisis that began in 2007, have become under-capitalized (it has been tough enough for big, AA-rated corporations to secured funding), profit-margin pressured (the big guys need to survive, the small guys need to make money), quarterly, trailing losses (price cutting to compete for smaller opportunities means losses), and we could spend a whole page rhyming off what makes so many small cap so darn scary. But perhaps the next paragraph will really hammer home the reality about this niche category.

One more thing worth noting is that so many small caps are now officially “bankrupt,” meaning they owe more than they own thanks to the list noted above, plus the sharp decline in demand for their products over the past two yeas. This not only makes small caps a really scary place to invest, but it leaves the investor waiting at the edge of their seat for each quarterly announcement. Will this bankrupt company finally start making money or will this be the quarter that gets their bank line yanked, stripping them from any source of capital and forcing them to shutter up? Those fears are very real and they are a lot more common in small caps than any other segment.

So where does that leave investors? How can one pick a small cap mutual fund that will not get hammered by failures?

The first place to start is the underlying assets. While this is important when investigating all mutual funds, it is particularly important when sifting through potential small cap investments. Why? Because if those underlying assets are at risk (such as some housing stocks, some small-cap biotech, some small-cap alternate energy, resources, etc., etc., etc., etc., you get the point) then the fund’s risk profile will skyrocket as well.

You need to know what those underlying assets are!

This then begs the question: what sectors are more apt to prosper in times of economic recovery? We already looked at small cap mutual funds that invest in housing and discussed how this sector can be profitable but also involves some risk. And we already looked at a Dryden Fund that invested in financial services, a segment, we believe, that stands to benefit from financial services reform.

Now if we take a step back and explore what needs to happen for housing to recover the way some of these housing-heavy mutual funds need them to, what needs to happen? Of course, lenders need to start spending money. Some government officials (namely the President) have expressed a demanding sense of urgency in getting big banks to lend more (while simultaneously increasing reserves and adopting safer lending practices, which is the finest example of a paradox to be uttered). But before those big banks start screwing up again, what really needs to happen?

Regional banks and other financial institutions needs to start lending again. And not big-time lending; we are talking about safe, retail lending, the kind that really depends on capacity to repay and borrower creditworthiness. We firmly believe that regional banks can get this right, they can control their lending practices and they can have a solid impact on economic recovery, the kind that will help those home builders and individuals alike. And solid impacts are important; without them, we have superficial growth aka stimulus that dries up once the funding is spent.

One fund that has all of the right underlying assets is the Ivy Small Cap Value fund. The bulk of their holdings (a staggering +34%) is in financial services assets. Companies like East West Bancorp, IBERIABANK Corporation and Wintrust Financial are included in their Top 10 holdings (note: all three of these financial services companies also pay dividends with the fund’s dividend yield at 2.8%, another bonus: see also Why Dividend Funds Can Take You From Zero to Hero….). While this is a strong weighting in an area that the Mutual Fund Site believes will be instrumental in economic recovery, consider that there are only 77 holdings in the fund. This allows for tighter management, which we believe is necessary when you have such a heavy weighting in one given sector.

Ivy Small Cap Value is considered a LOW RISK small cap mutual fund with ABOVE AVERAGE returns, the perfect recipe for long-term capital appreciation. This speaks to the skill of the fund’s management team, led by Timothy Miller since 2008.

Ivy Small Cap Value is a no brainer

But the numbers here are what impresses us the most. Average Price-to-Earnings is an attractive 15.7. Price-to-Sales is 0.4 while price-to-sales-growth is 7.5. And we already discussed that pretty little dividend yield of 2.8%. This becomes a no brainer. Plain and simple. Low risk, properly priced assets, and tremendous future growth potential all highlight just how well this small cap mutual fund can perform.

The risks with this fund lie in its heavy financial services weighting. While is offset to a large extent by its Industrial Materials and Consumer Services weightings, we believe that if financials disappoint, then Consumer Services probably will not be far behind. Notwithstanding this, Ivy Small Cap Value has outshone the category and benchmark while minimizing risk and, more importantly, picking up assets at great prices

Even with its relatively high Expense Ratio of 1.42%, the Mutual Fund Site has chosen the Ivy Small Cap Value fund as its top Small Cap Mutual Fund pick of 2010. An easy decision, actually, once all of the other small cap mutual funds were cut from the short-list.

While mutual funds by themselves offer tremendous diversification potential within sectors, industries, market capitalization and so on, unless you invest in balanced funds, proper asset allocation is usually only achieved by holding different types of asset classes. Understandably, giving up the potential for aggressive gains in growth funds (which are usually suggested through historical return data) in favor of more stable returns in bond funds is not an easy thing  for most investors to do. However, while those historic gains might seem attractive at first sight, proper asset allocation is paramount if one wishes to achieve long-term growth and income.

All investors need to do is look back to 2009 to see just how powerful proper asset allocation can be. For example, the S&P 500 returned roughly 20% throughout all of 2009 (over 60% since its impossible-to-predict low in March 2009). Investing in a 30-year Treasury by comparison would have returned roughly 65% a staggering amount of return for that same period.

While 2009 was undoubtedly one of those “off” years, the data from 2008 tells a similar story about the importance of proper asset allocation through asset class diversification. Arguably a devastating year for equities, 2008 was also a painful (a much more painful in fact) period for long-term Treasury bonds. For that year, equities gave up a touch more than 35% while 30-year Treasury gave up marginally more. While both were evidently “losers” in terms of total return, equities actually outperformed the 30-year Treasuries.

And one year earlier, 2007, also teaches a valuable lesson. While equities ended the year up nearly 5%, 30-year Treasuries were down nearly that same amount.

By incorporating an asset allocation model that touches all asset classes (we are simply looking at the S&P 500 and 30-year Treasuries here), investors will not only sacrifice some of the “wild” gains by being 100% invested in equities, but they will mute those losses in one classes by offsetting them with investments in another.

To illustrate this, consider that same period from 2007 through to 2009. While the year-by-year playbook shows favorably for equities, in fact the 2009 gains in 30-year Treasuries would help produce positive (or less negative) returns for an investor who purchased an S&P 500 Index Fund as well as a long-term bond fund. With a long-term bond fund that imitates the returns on 30-year Treasuries returning nearly nothing over that same period, the other fund, which follows the S&P 500, would still be down roughly 20%. In other words, an asset allocation model that splits the assets 50/50 between an index fund and a long-term bond fund would have only lost a little more than 10% (instead of the full 20%).

It seems that any time positive news comes out about the state of the economy, growth funds and small-cap funds in particular get a nifty little boost in value. It stands to reason, of course, that as the markets react to such positive news, so too should mutual funds. But what mutual funds stand to benefit most? This is a question that a lot of investors, like those who want to know where to invest $20,000 or so, have.

Homebuilders
One area that gets a nice boost (or gets tanked) every month relates to the housing market. Since this sector was blamed for many of the problems relating to the latest recession (if it was not the bank’s imprudent lending practices, then it was housing for its hyper-inflated values and the subsequent flooding of inventory), it makes sense that housing stocks will be particularly, positively influenced by positive news for the sector.

For example, on February 2nd, positive news about housing  had the impact of bumping one particular housing company’s stock price by as much as 10% in the session. Other related shares got a nice boost of no less than 5%. A nice little return, wouldn’t you agree?

Risks
The risks with such big moves is twofold. First, this has the effect of increasing volatility for these types of shares, making them more difficult to trade individually. An investor needs to exercise displine to realize the gains he or she wants and not stay in too long; otherwise, they will record an immediate loss.

What Mutual Funds Own Such Stocks?
The best way to find the funds that invest in these types of sensitive shares is to visit Yahoo! Finance and search under the security’s Major Holder’s section. This gives a fairly accurate snapshot of what companies are owned by what mutual funds.

In the case of housing stocks, Vanguard has taken a fairly large interest in several of the housing stocks in its Small-Cap and Mid-Cap funds. It makes sense. Housing continues to be out of favor and these types of out-of-favor stocks are often what turn regular investors into astute investors.

As well, housing is one of those areas that will need to improve before the rest of the economy improves. That means that it is quite likely that the sector could receive a boost through some type of government incentive that sees people buying more and more houses and in the interest of keeping people employed (or hiring more people back), some of these incentives are likely to incent or at least benefit the homebuilders. Vanguard has taken an interesting approach (among others).

Does this suggest that mid- and small-cap mutual funds is where to invest $20,000 (getting back to that question)? Probably not for the whole $20,000. But 20-25% of an aggressive portfolio that can benefit from a mid- to long-term investment period, sure… no, absolutely. In fact, they can be expected to easily outperform growth funds held for that same period.

Choosing the right growth funds for 2010 is not an easy task. Normally, this might not pose such a problem because growth funds tend to perform over the long-term, unlike some other mutual funds which perform better at certain times in the year or economic cycle. But after a fairly remarkable 2009 to follow up the turbulent credit-crisis-inspired 2008 and 2007 years, 2010 has provided something of a wake-up call to most investors.

2010 has provided something of a wake-up call.

In fact, most growth funds opened the year with an average return of -2.55% (that’s right, a negative!). And most of the best-ranked funds have returned even less.

What this tells a lot of investors is that growth funds not only have to be held for roughly 5 years in order to realize the type of returns one has come to expect of such funds. But that’s not all. In fact, the stuttering start to the year has led even the highest paid and most respected portfolio managers to wonder whether there is more bad news to come. In an interview with Morningstar, Rudoph-Riad Younes of Artio International Equity claims that by bailing out the banks and not letting them fail, government have simply delayed the inevitable. In that same piece, Oliver Kratz of DWS Global Thematic commented that his fund has taken a less aggressive position globally, investing as little as 10% in one of the hottest economies of the world, China.

One of the only growth funds we could find that outperformed the average, the Monetta Young Investors Fund (MYIFX) which has been managed by Robert S Bacarella since the fund’s inception in 2006, holds a five-star rating from Morningstar. In digging deeper into its portfolio, it seems that Mr. Bacarella has taken to domestic securities as well. Where has he invested? Consumer Goods and Consumer Services with Apple Inc. Wal-Mart, Proctor & Gamble and McDonald’s ranking among their Top 25 holdings (they actually only hold 25 securities). Many of these are the same securities that Younes and Kratz cite in the Morningstar article, hold in their respective funds or they belong to sectors where these two managers invest heavily.

What does this tell investors looking at growth funds this year?

It could be that funds investing in domestic, large-cap securities are part of a growing crowd of institutional investors who believe that there are plenty of risks that are expected to materialize outside of the domestic, North American markets. Does that put global growth funds in the penalty box? It certainly seems that is the message for 2010.

So where should investors put their money? What growth funds are expected to perform in 2010?

Unfortunately, that will be a topic for another day, but the underlying message here is this: even growth funds have a tough time deciding where to invest. So if you have the courage to pull the trigger on investing, remember a couple of things:

• Invest regularly if you can — ten monthly contributions of $1,000 each will average out your $10,000 investment.
• Stay the course — stay invested for a period of 3-5 years (preferably 5 years as the performance on nearly all of these growth funds really starts to shine after 5 years).
• Choose funds that you believe in. Right now, you might believe in a high concentration of domestic securities (the big mutual fund managers seem to as well) but don’t pick a fund that must, by virtue of its Investment Objective/Statement stay invested this way.

This is certainly one area that needs further exploration and we will get into what we believe will be characteristics of the top growth funds in 2010 within the next 30 days.

Our site has seen a lot of traffic coming in to see what our 2010 Top Pick has been… and why. Although more and more investment sites are starting to see the true potential in high yield investments, there is still a lot of negativity when it comes to these types of mutual funds particularly for this year (2010). A lot of the uncertainty might have to do with just how well these bond funds have performed over the past year (2009), some returning just as much as the S&P 500 (and some returning even more). While there is a fair amount of risk associated with the types of funds, we are at a point in history that may never repeat itself for the balance of our lives.

…we are at a point in history that may never repeat itself for the balance of our lives.

At the Mutual Fund Site, we believe there are two things working in the favor of investors who look at high yield investments for 2010 (and our High Yield Investments: Top Pick for 2010 in particular). We will outline the advantages briefly:

1. As markets improve, so will yields on these high yield investments. While this statement runs contrary to the academic studies of the past, consider this: The credit crisis of 2007 – 2009 pushed rates on all types of non-government borrowing sky high. Government rates of course fell through the floor due to demand, and this high demand for government bonds and low money supply for corporate bonds created a wide spread between corporate and government rates.

As the economy improves, rates typically increase in order to keep the economy from overheating. This time is different because corporate rates are already high, meaning they will either stay the same or drop marginally. We see a few common reasons for this. The first being that with there being less perceived default risk, more money supply will head into the corporate side. As supply rises, rates will start to drop (or in the case of rising rates, stay the same). This will have the effect of narrowing those spreads between corporate and government rates. As well, default risk will tangibly reduce because as the economy recovers those companies that were seen as “suspect” will become healthy again while those that were expected to fail will have already failed and be gone.

2. High income, high market value. Probably the most persuasive reason to hold high yield investments today is that the rates story (outlined above) will provide bond holders (again, visit our Top Pick story) will benefit from higher income. And if turns out that those rates start to drop rather than staying the same, then the other part of this equation is that the bonds in question will start to appreciate in value (remember, as rates drop, prices rise). This presents high yield investors with a double-bonus system of enjoying higher income derived from those original, inflated rates and the added bonus of higher market prices that the markets will pay for such high-rate bonds.

Remember, the primary motive to invest in bonds is the income (hence the “income class”). Unless the economy makes a miraculous recovery and starts providing returns that are far in excess of expectations, then those rates will not skyrocket. They will, at the very least, remain level, making high yield investments a great place to invest for 2010. And if your income class knowledge is sub-par (or you want to properly invest in this class) the only way to play this game well is through mutual funds or ETF’s.