Archive for the ‘Investment Management’ Category

Over the coming months, mutual fund fees will come under greater scrutiny. Of course, there has already been a tremendous amount of attention devoted to fee structures, how the fund companies are compensated, how the adviser is compensated and so on. But what does this mean for the average investor whose financial planner suggests, say a dividend fund for them to invest in?

Well, there are several key areas that both regular and more serious investors need to be aware of when it comes to buying mutual funds. But first, let’s examine what the fee structure is all about.

For starters, the fees associated with mutual funds are called 12b-1 fees. This fee, at the moment, lumps all expenses into one, including what you pay to the fund company and ends up getting paid back to the adviser in the form of trailers. How much goes to whom is really anybody’s guess except for the fund company who manages collecting the fees and, in some cases, the adviser who might know what is being paid back to her.

Now, things get a little muddy when you consider that from the amount that the fund company gets to keep, how much of is compensation for the management team, how much is administrative and how much is sales and marketing. And, of those sales and marketing fees, how much gets paid back to the adviser responsible for successfully marketing that product?

The changes proposed by the SEC will eliminate a lof this confusion. To a large extent, this change is about as much of a shocker as disclosure of real estate fees might have been years ago. It makes sense to know what your adviser is earning, no? It also makes sense to know if Fund A that charges 0.90% and Fund B that charges the same thing are paying more toward management or more toward sales and marketing… which fund would you want, the one that underpays its management team or the one that pays them competitively? The implications are clear and, overall, these changes make for a more-level playing field for the industry.

Where the proposed mutual fund fee changes have a potentially greater impact is in how the fund companies can charge these fees. One of the changes recommend a maximum fee that the investor could pay. So while a 5.25% Front-End fee (the fee you pay to get into the fund) might charged on one class of fund for Mutual Fund Company C’s ABC Fund, the total Fund Company C can collect on all other classes class will also be 5.25% (or whatever the maximum is set at). So if your adviser suggests a no-load version of ABC Fund that charges just 0.9%, the most Fund Company C will earn is 5.25% (about 6 years worth of annual fees). Thereafter, the most they can charge for administrative-type fees will be 0.25%, good for the investor, not so good for the adviser.

Two Problems

The first problem with limiting fees is how will your adviser be compensated in those years after the maximum fee has been collected? Will this type of limitation encourage churning (where advisers recommend changes simply because of favorable fees — in this case, no fee vs. fee is heavily tilted on the fee side)? We argue that it will. And if fees are not paid by the fund company, then it is likely that advisers will start charging management fees… but at what cost? Will the average Joe be able to afford the advice and services of a decent adviser (today, trailer fees allow a relatively average investor to obtain fairly decent advice).

The second problem is how will fund companies change in terms of quality and sustainability? If fees are only to be collected to a maximum of x%, is it in the in anyone’s best interests to encourage buy and sell investing? And what will happen to funds that people traditionally bought and held for decades?

More Work Needed

Without question, added transparency is always a good thing. It often keeps key individuals and companies honest and allows for a more-level playing field. But will the changes to 12b-1 fees that the SEC is proposing actually limit competition and close the door on a segment of the investing public that needs access to good advice as well as the best-managed funds?

At the Mutual Fund Site, we believe more work is needed before such huge changes are put into force. As they stand, they could serious impact the quality of service individual investors receive at the fund company as well as adviser level and, in some cases, will probably result in a lack of access to a segment that needs it the most.

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.

The idea that one mutual fund company can be better than another is not a new one. Because so many investors remain on edge after the market “correction” that took place in the last few years, deciding to jump in bed with a small cap fund is even more difficult than normal. And small cap funds, as we have discussed elsewhere on this site, are really not all that risky in terms of their long-term performance track records. So just imagine how people with the right risk tolerance might feel about investing in other types of mutual funds; likewise, how low risk investors will feel about Balanced Funds or Income funds.

Can Big Fund Companies Eliminate Risk?

While large mutual fund companies will have more assets under management than smaller companies, it does not necessarily mean they will eliminate risk better than small fund companies. This statement is supported by the following:

• it can be argued that smaller fund companies (based on assets under management) have “more” to lose than larger companies and will therefore take a more conservative approach to security selection.
• large mutual fund companies might have better access to top talent, but like all big companies they will be more heavily focused on their own bottom line profitability. This can translate in underpaying their talent or working with less progressive and astute analysts and managers.
• large mutual fund companies are often able to offer better incentives to the sales force; smaller companies will be restricted by their budgets.
• at the end of the day, both large and small companies worry about beating the index and their peers. Failure to do so will often result in cash outflows. Therefore, smaller mutual fund companies will be more sensitive and therefore more intent on making the right investment decisions.

So does it make sense to choose a Fidelity mutual fund over, say, an Adirondack fund?

Tough to say. The best performing Fidelity small cap value fund (which is unrated by Morningstar.com) actually under-performs against the top performing Adirondack small cap fund. Both funds have the same risk profile.

However, many people will find things with each fund that either works or does not work for them. Which makes the argument that choosing the best fund for your portfolio should really boil down to how well the fund, its management and performance compliment your own asset management strategy. Taken one step farther, the best mutual companies will be two different companies for two different investors. And, of course, this is why it is impossible to say, one way or another, whether bigger mutual fund companies are better or worse than smaller mutual fund companies.

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.

A mutual fund’s expense ratios essentially tell an investor how much money the fund spends in terms of, well, expenses. And when all of us in the rest of the world are so concerned about expenses, how we spend our money, should we not be concerned about the way people who come up with our investment strategy spend theirs? Or does the expense ratio even matter, especially if the mutual fund itself provides spectacular returns?

There are plenty of arguments that suggest one over the other. And it makes sense that expenses, regardless of the business (whether you invest in mutual funds, equities, or even your own business), be kept under control. But in reality, a fund’s returns are measured post-expenses. Take the following as an example:

Fund A has an expense ratio of 1.25% yet its 3-year annualized rate of return is 12.5%. Fund B has an expense ratio of 0.55%, yet its 5-year annualized rate of return is just 8%. Is Fund A worth the premium, or is Fund B the better fund?

Measured strictly on rates of return (RoR), Fund A is the better performer. However, there could be many different considerations that need to come into question before deciding whether one should invest in Fund A or Fund B. Assuming each fund is in the same category and sub-category, one would have to consider the number of securities under management and the fund’s turnover ratio (the higher these numbers, the higher the expense should be), the level of risk (maybe a better performing fund is not what an investor wants if it means considerably more risk) and the tenure of management (a longer, more tenured management team suggests positive returns are more sustainable than a fund that has just recently returned good rates under a new management team).

Yes, these other considerations are the very reason for why sites like the Mutual Fund Site (a watered-down conversational site) and Morningstar (a straight, by-the-numbers site), etc., exist.

In our opinion, expense ratios do not matter when rates of return alone are an investor’s main concern. However, expense ratios do matter when one investigates why it is seemingly higher or lower than its competitors’. Because above the expenses, an investor needs to make sure that any mutual fund, regardless of expenses, aligns with his or her overall investment strategy.

To find get started, find out what your Asset Allocation Model is, right here at MutualFundSite.org.

It appears that a lot of people who find the Mutual Fund Site are looking for help with investing $10,000. Although we cannot “tell” people how to invest 10,000 dollars, we can certainly help them along in their investment journey, whether through our Free Asset Allocation Model service or our specific fund recommendations like our Small Cap Fund Top Pick for 2010 and our High Yield Investment Top Pick for 2010.

Ultimately, figuring out how to invest $10,000 (why 10K and not 20K or 50K, I don’t know) wisely will involve a lot more than visiting just this site. It will involve spending some time at Morningstar and sifting through the data there, particularly when it comes to your core holdings. It could also involve spending time at Fundalarm, a website that “warns” people about the fund they have invested in or are considering investing in. But first things first:

Start with your Asset Allocation Model

Knowing what your asset mix should look like will obviously provide a great starting point for all investors. Whether you are a Balanced investor, a Growth Focused investor or even an Income investor will tell you just how much money you should be “risking” in any given asset class, starting with Cash, then moving on up to Income and then finally Growth, with the risk levels increasing correspondingly. And then, if your risk tolerance allows it, consider specialty funds.

In fact. our Top Picks for 2010 are both specialty funds — the High Yield fund is not considered a core fixed income holding by any stretch (even though it offers a below average risk profile, it is still focused enough to fall outside the mainstream) and evidently our Small Cap Value fund is nowhere near being part of the main “Growth” class (even though it is consider low risk among its peers).

Once you have your asset allocation model figured out, you can further drill down and see how much of your $10,000 can be invested in the types of investments we look at fairly regularly. But keep in mind that the bulk of that investment should be in core holdings — a fixed income component, a growth component as well as (usually) a small cash component.

So, to get started simply click on the link titled “Asset Allocation Model Recommendation” as shown below:

Withing a couple of days, we will have your Free report to you so you can get started to see just how much of your $10,000 can be invested in which asset class and, of course, how much can go into those terrific specialty funds (whether they are the ones we recommend or not) that have the potential to improve your portfolio’s performance tremendously.

Best of luck and we hope to see you back again soon!

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.

As a follow up to our former Contrarian Investment Practices post, we want to take a closer peek at exactly where to invest if these contrarian theories have any merit. Of course, we will look at mutual funds specifically.

In a recent article published by Russel Kinnel, the Director of Mutual Fund Research over at Morningstar.com, it became quite apparent that Contrarian Investment practices actually do work. The methodology that Kinnel used involved investing in funds that were seeing cash outflows (the “unloved” funds) rather than those funds that were deemed most popular based on the dollar amounts of inflows (the “loved” funds).

What Kinnel discovered was that investing in the unloved funds yield returns that were better than not only the “loved” funds returned, but the S&P 500 as well. In some cases, those “unloved” returns were substantially higher — 8.1% for 3 years versus the “loved” returns of 6.24% and the S&P returns of 6.96%.

The same trend holds for a five-year period as well, with the “unloved” mutual funds outperforming (8.08%) both the loved funds (4.25%) and the S&P 500 (5.76%).

The Question becomes one about finding out what the “unloved” are.

Finding out what the unloved funds are poses something more of a challenge. Kind as he is, Kinnel pointed out in his article that the “unloved” funds or categories were the large-cap growth, large-cap value as well as world stock. Easy enough to find the top performers in these categories; simply visit Morningstar.com and use their free fund screener.

But what about those times when finding these unloved categories is more difficult than finding them in an article so kindly published by someone like Kinnel? Well, let’s take a look at Kinnel’s statistics once again. In terms of best performing mutual funds, the following trend emerges quite easily:

• Unloved categories will outperform the Loved categories
• The S&P 500 will outperform the Loved categories, but not the Unloved categories.
• The Loved categories will not outperform either the Loved categories or the S&P 500.

So, if you cannot figure out what the “unloved” funds are (or even what the “loved” funds are for that matter, meaning you can’t figure out what to sell), there is one option. Consider that the S&P 500 outperforms exactly what your friends buying and likely what the advisors are recommending… why not buy Index Funds?

Index Funds might not beat out the top Unloved categories as a whole, but will definitely outperform what your advisor is recommending (or even what your friends are buying). This is particularly convenient if contrarian investing is something that investors are unable to fully agree with (e.g. cannot stomach being possibly wrong with their contrarian choices as they fluctuate and fail to return a positive number for a couple of years). While this is not the absolute best way to achieve the best returns, it definitely is where to invest if you do not want the hassle and potential expense associated with learning about mutual fund inflows and outflows.

Ask nearly every professional mutual fund manager what they do for a living and their response might surprise you. While normal people like the rest of the world see (many) mutual funds as fine examples of investment strategy, security picking and so on, the professionals who pull the trigger on trades actually see their roles in the investment management quite differently. In fact, they see their jobs more as risk managers than investment managers.

Their view makes perfect sense, of course. They are risk managers, no question about that. Take the AIM Diversified Dividend Fund, a 5-star fund as measured by Morningstar. That fund has $1.5 Billion worth of other people’s money… you bet they are risk managers! If Meggan Walsh, who has been managing this big fund since 2003 thought otherwise, the fund would not have made the investments it has made, it would not have achieved the high returns it has enjoyed and it would not have done so with average or below average risk.

Risk is the investor’s greatest consideration when throwing money at a security.

Consider that — average or below average risk while achieving high returns. This is key because returns can be quite easy if one is willing to take the risks. And that risk is loss of capital. Which sounds simple in many ways, but how many of us felt that taking on risk was a reasonable thing to do before the market correction of 2007, 2008 (ouch) and the first quarter of 2009?

Even though higher risk is frequently synonymous with higher returns, we often forget that higher risk often means higher probability for loss. And those losses are very real when they happen.

So the recommendation is really to shift our thinking from high risk = high rewards to one where we aim to achieve above-average returns by taking on less than average risk for those returns. The idea is to achieve more than the risk levels dictate. That means earning 10% when the Beta or assumed risk suggests we should only enjoy returns of 7% or 8%.

To illustrate, consider high-risk derivatives. While it might be nice to achieve 5% returns, if you could achieve these returns with guaranteed and insured term deposits, why bother with the high risk derivatives? It makes little sense, right? But if we could achieve 10% returns with those same term deposits, why not give up the excitement of the market? (Of course, this rarely happens, so we have no choice but to accept that higher risk).

Mutual funds help us achieve above average returns while enjoying below average risk. This is because mutual funds so something many of us fail to do on our own — they diversify. (They also measure risk better than we do because they have the staff to analyze financial statements, perform site visits, call up management and so forth). Ultimately, diversification saves these mutual funds when risk rears its ugly head more than anything else — after all, no amount of analysis and over-management can eliminate market risk; but diversification can surely reduce all other risks.

While individual investors might opt for a dozen or so investments, mutual funds like the AIM fund quoted here, hold over 75.  And with 78% of those assets as large cap or giant cap, they really are achieving better returns for less risk. And this is important especially when markets sour. Again, referring to the AIM fund, its performance has outpaced the S&P 500 for its YTD, 1-year, 3-year and 5-year periods. The performance speaks for itself.

And this is just one fund. Most properly managed funds will evaluate risks and trade accordingly. The result? Those total returns outpace the broader market and, just as equally, other funds in its category. For investors this means less losses in market downturns and greater returns when the markets turn around.

As far as mutual funds go, the Cash and Cash Equivalent asset class has got to be the most unattractive for many investors. It lacks the wild swings that the specialized, small cap funds enjoy, it doesn’t even have the high yield that a lot of dividend funds can brag about and, well, it’s cash. Can anything cool be said about cash? Well, no, not really. But investors need to care about cash equivalent funds. Here is why:

• The obvious. Cash equivalent mutual funds generally do not depreciate in value. Their benefit comes neither from price fluctuations and volatility nor from interest earned, but from liquidity and safety. When Warren Buffet managed to stash away over $86 Billion during the market downturn of 2008, he was not whining about a lack of interest being paid on those funds. Instead, he knew that unlike his equity investments in the companies he felt had great long term capital growth prospect, he could draw on his cash reserves whenever he wanted… it would always be there waiting for him.
• Cash equivalent funds need not be “boring.” Since investors should always have a minimum of 5% invested in cash (even our most aggressive Asset Allocation Model recommends a minimum of 5% in Cash and Cash Equivalent Funds), it makes sense to explore a little. This means taking on a little more risk if such a position fits your investor profile. Some alternatives to straight Money Market funds, for example, could be Vanguard’s Short-Term Bond Index fund. This fund invests primarily in US Treasuries, yet its yield is actually 2.64%. Not bad for a bond index fund and given its short-term nature, even mild fluctuations are not something one can expect. And with $16.5 Billion under management, it seems to me that Vanguard will not have trouble meeting your redemption request. Plus, this fund in particular has never seen its value deteriorate over the course of a 12-month period. In other words, even if you were to experience a temporary pull back in this fund, simply holding on for a few more months will return any losses. By adding a bit of spice to your Cash portfolio, you can actually enjoy the benefits of Cash liquidity and safety and take advantage of bond-like and dividend-caliber yields.
• Cash is a perfect place to park funds earned on gains. Let’s face it. Markets rise and they fall. When one crystallizes gains on equity funds or even bond funds, logic often leads folks back into the same asset class from which they are exiting. This makes absolutely no sense! If you were to pull out of an equity fund because it returned a hefty 30% over, say 3 months, why jump back into equities? If equities were expected to keep rising, why pull out at all? The idea is to hold onto one’s gains and if core- and high-yield bond funds do not offer the promise of a good return, then why no park those funds in Cash? Looking back at Warren Buffett, that is exactly what he did. He did not simply wake up one day with $86 Billion in cash; he built those reserves, trimming gains as he went along during the market expansion period. This reserve allowed him to invest in companies he believed would have great prospects for gains, like Burlington North Railway.

Now it is true that Cash Equivalent Mutual funds are not hot and sexy. Even the Vanguard Short-Term Bond Index fund quoted here has little to offer in the sex-appeal department, and that fund is considered above-average risk among its category! In fact, this fund’s 52 week range is a narrow $10.17 to $10.56. So if it is not yet clear why you should care about Cash Equivalent Mutual Funds, just think of Warren Buffett and ask yourself what he might add to the three bullet points above. Most investors will realize rather quickly that Cash really is an important element to a successful investment portfolio. Sexy or not.

When we have so many mutual funds to choose from, we often get lost in some of the irrelevant details. We seem to want to chase the next trend, the biggest or hottest sectors and so on. Bond funds, value funds, dividend funds; we talk about these specific investments right here on our site just as planner do with their clients. If we were looking at economic figures, we would call it micro-economics. But when it comes to investments and mutual funds in particular, taking a macro-economic approach might actually help tell us about where investors should steer their money.

If we look globally, for example, we see that the Japanese Yen has been taking a hit over the last week or so because of that country’s position on interest rates. Unlike the US where the economy is (finally) starting to grow and rates have increased (Fed Funds Rate) and are expected to continue to increase, Japan is looking to reduce rates so that people will borrow and therefore buy more. While this fiscal policy will devalue their currency, the implications for Japanese corporations, particularly those that export their goods, are actually very positive.

In fact, a devaluation in currency combined with increased foreign spending will have a turbocharging effect on Japanese companies that report their financial results in Yen. Not only will sales revenue increase, but if foreign dollars are being used to purchase goods, the currency conversion results in a forex gain on the financial statements.

This could be a bad thing in the long-term. As the Yen stabilizes and starts gaining in value again, the company may have forex losses which can offset or more-than-offset stable or even climbing revenues.

What this means for mutual fund investors that is that Japanese-heavy value mutual funds might be a safe bet for shorter-term gains. Why? Because the premise of a value mutual fund is that the securities held within the portfolio are undervalued. This can be based on any number of criteria, but are normally price-to-earnings, price-to-book (value), price-to-cash and so on and so forth. Ultimately, the fund manager will determine whether to include a security in his or her value fund, but the qualifying criteria will come down to one thing: the security is underpriced.

This security, mind you, can be equity or income based. Right now, investors would gain either way. Japanese bonds can very easily increase in value if rates start dropping. Japanese equities can also increase, but it could take more time before revenues start to increase and translate in to balance sheet strength.

Our next step is pick a value mutual fund that meets our specific investment objectives (with time and risk as the driving force behind such a decision).

Now this is a top-down investment approach. It is how the Mutual Fund Site comes across mutual fund recommendations. A financial planner and/or investment advisor will work this way as well. Except they do this by also understanding your goals and matching up your goals and beliefs as best as they can to the macro-economic situation.

A long-term investors who has a decent appetite for risk will be ill-served to keep all of his or her investments in domestic securities. It normally “fits” to incorporate foreign or global investments into the plan. It never (or it should never) involve finding a value fund and then justifying a reason why it makes sense.

With that in mind, buying any kind of mutual fund because of a recommendation is often the wrong approach. Taking a bottom-down, birds-eye approach to your investments always makes more sense.

Index funds are a hot topic for mutual fund investors because there is a growing belief that index funds will outperform actively managed funds within their respective categories (e.g. a fund that invests in small cap funds would underperform a small cap index fund). A lot of academic research has been done on this topic — more than the scope of this post (and site, in fact) can bear. Between the Efficiency Hypothesis and the Purity Hypothesis, most people can find the answers to their questions.

Why Index Funds Matter

Index funds are an interesting breed and a lot of people swear by their cost to performance ratio. Since index funds simply mirror an index (there is no real research involved, no “intelligence” since it has already been done by the appropriate index, like the S&P 500, the Russell 2000, etc.) these funds are the cheapest in terms expenses.

Cost is a huge factor when it comes to index funds.

What many investors argue is that actively managed mutual funds try to beat the index. Sometimes they win, sometimes they lose and statistically speaking it becomes less and less likely every year that they beat the index to repeat their performance. So, since sometimes they win and sometimes they lose, why not simply own the index and enjoy steadier returns?

So Why Bother With Actively Managed Funds?

Indeed, knowing the above information may make an actively managed fund seem like a big and expensive risk. However, there is a lot to be said about active management, particularly for people who believe in the fund manager who operates and oversees the fund (see our archived post about Anthony Bolton, arguably one of the sharpest investment managers around). When investors have such faith in a manager, they realize that they can employ that person for a fairly low price… even if it is a two, three or even four times the cost of a bland, regular index fund.

The prolific managers are not the sole reason why some people will choose an actively managed fund over an index fund. Since many funds can shift their positions fairly easily, they can often take advantage of market inefficiencies, whereas index funds are stuck owning whatever it is that they own. There is no flexibility to safeguard investors against security specific risks.

Not that these are exhaustive reasons, but they provide the starting point as to why so many investors might chose one type of mutual fund over another.

What The Purity Hypothesis Tells Us

That brings us to Beta. Now, according to William Thatcher, a Senior Consultant at Hammond Associates in St. Louis, MO, Beta can tell us whether or not our actively managed funds will outperform an index fund. But there is one catch: that the performance strength index in particular is a known factor.

How this works is as follows: Suppose small cap stocks are a strong performer in a given year. Based on the Beta of your small cap fund, you will know whether your fund outperformed or underperformed the index funds for small cap stocks. If your fund’s Beta is less than 1 (considered less style pure than the index) then it will underperform the index (and vice versa if Beta is greater than 1).

This makes sense of course. But what it also tells us is that an investor would need to accept a fair amount more risk in order to invest in a fund that has a Beta greater than 1.

The Purity Hypothesis takes things one step farther in demonstrating how to invest, whether in Index funds or actively managed funds. The problem again is trying to determine ahead of time what asset classes will perform strongest for any given year. Because if that much can be determined, then an investor can minimize risk while simultaneously improve returns by:

1. Investing in Index fund for the best-performing asset class (e.g. large, mid and small cap stocks or funds)
2. Investing in Index funds for the three investment styles for that group (e.g. value, blend and growth)
3. Investing in actively managed funds for the poorest-performing asset group (e.g. large, mid and small cap stocks or funds)
4. Investing in actively managed funds for the three investment styles for that group (e.g. value, blend and growth)

The theory presented here finds it support in Thatcher’s research and for the most part can be substantiated by back-testing (I say for the most part because I did not go back to every single period in history to back-test). And of course it makes a great deal of sense because on a risk-adjusted basis, the Index will always outperform active funds when that asset class it outperforming other asset classes. (Click to read the Full Report).

So, whether your mutual funds invests in small cap stocks or follow a particular index, if you can determine which asset class will outperform the market and which classes will fall behind, you can actually achieve great returns (and save a few bucks) by choosing index funds for the top-performing classes and actively managed funds for the poorest-performing classes.

Sifting through the reels of available mutual funds to include in your portfolio is no easy task. Investors are faced with so many options that it is literally very interesting to try to figure out why one person chose one fund and another with the same tolerance for risk, available time and investment objectives chose a completely different fund. That could be why some people who disagree with our Top fixed income pick (a high yield fund) and our top small cap pick might have different ideas (although we can’t imagine why).

But one of the things nobody can really argue is the following: to pick a mutual fund, whether it is one we like or one we have never even mentioned on this site, one needs to study the MAPS (Management, Assets, Performance, Strategy) of the mutual fund in question. These are just the basics, folks. Spending ten minutes or so to say you understand them will reward you will less stress between the day you invest and the day your statements arrives in the mail.

M – Management: Arguably the least exciting part of your review process, getting to know the management team behind a mutual fund is important. Why? Because management dictates the fund’s style, how the assets will be invested. This is also important to know if you are going to base your investment decision heavily on some past performance record. The thing with management is that as it changes, so does the investment style and often even the fund’s strategy; what might have been a small cap domestic value fund one year can change to a small/mid cap blend fund with a management change. So, management is very important. Google the manager’s name, visit the fund company’s website to see what he or she has published there. Again, not very exciting, but it will reveal more than you think.

A – Assets: Possibly the most exciting part of your research will involve digging into the fund itself and finding out what underlying assets make it tick. Our High Yield Fund pick for 2010 for example has a very pretty asset list, with strong companies and a strong yield. In fact, those assets were probably one of the driving forces behind our taking a much closer look at the fund. But to date, that fund has underperformed its peer group. The reason this does not concern us, however, is that we believe in the strategy of the fund and its management team is strong enough to keep to it. But still, if we did not know what those assets were ahead of time, we never would have looked at what we believe is going to be one of the best-performing high yield funds this year.

P – Performance: We all know that past performance is never indicative of future performance. However, it does give us a scorecard for how the fund has performed. This is increasingly important now because the market turmoil of the past 2 years and some can help us gauge whether the performance has kept up or lagged the benchmark. While important from a trending perspective, however, past performance is never something that alone should dictate whether to purchase a mutual fund.

S – Strategy: A mutual fund’s strategy is a lot like a contract. If a fund manager states that the strategy is one thing but the fund goes ahead and gets involved with something completely off-side, then it makes sense to “fire” that manager and find another. For this reason, you should get to know the mutual fund’s strategy rather intimately because it will form the standard to which you hold the fund’s management team accountable for its performance. And if that fund manager should stray from the stated strategy, then it becomes necessary to re-evaluate your relationship with that fund and fund company.

MAPS. Not hard to remember and not all that time consuming to execute. By keeping this abbreviation in mind when evaluating possible investment avenues, you will gain a fair level of comfort and knowledge about the mutual funds your planner might be pushing and know whether they make sense for you.

Recently, the Mutual Fund Site presented a post about the easiest and smartest investment strategy: investing regularly on an automated contribution plan. This investment strategy is also (or better) known as Dollar Cost Averaging and makes perfect sense when used with mutual funds, whether more-volatile funds that invest in small cap stocks, index funds, or even bond funds.

Aside from buying more units when the markets are down (and less units when the market is up), Dollar Cost Averaging strips the issue of “market timing” out of your investment strategy. This can be fairly important because virtually nobody can “time” the market with absolute accuracy. That means only luck and no amount of research can help an investor buy at the absolute lowest.

Likewise, even the unluckiest investor will have difficulty buying at the absolute highest, but we often feel that way – that we bought at the highest and now our investments are doomed to fail.

This is where Dollar Cost Averaging makes great sense. Not only because it takes the “guess” work and “luck” out of the situation, but because historically it errs on the up-side. That means that if you use dollar cost averaging, your returns are more likely going to resemble the returns of someone who has the great luck and skill to buy at the absolutely lowest days.

This may seem strange because one would think that, statistically, you are more likely to buy the “average” or median between the best and worst possible days to invest. This would be true in a flat market, but historically markets have risen. Therefore, in a 10-year rolling average, even the “worst” possible day will be the best day at some point.

In fact, a Canadian Financial institution actually ran these numbers based on their market, the S&P TSX index. In their illustration, if you were to invest at the absolute worst days over the period of 1989 through to 2009, your returns would still be positive at 5.42% annually. The absolute best days: 7.36%.

And by employing a Dollar Cost Averaging strategy and invested each month on the first business day of the month, your return would have been 6.38%, less than 1% lower than if you had invested at the absolute best time possible for the year but nearly 2% better than if you had invested on the absolute worst days.

Interesting that a simple, more-affordable strategy could yield such positive results. But again, when you look at the historically rising market, it makes sense. In a declining market, the rates above would probably be reversed, but ultimately, investing through an automated investment program (dollar cost averaging) allows you the benefits of not having to worry about the impossibility of market timing, especially when it comes those riskier mutual funds, like those investing in small cap stocks. The investment strategy, however, can be used with other types of investments as well, even those in declining market-value environment such as bond funds.

Give it some thought….

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.