Archive for the ‘Learn To Invest’ Category
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.
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It is not easy to find mutual funds that have earned double-digit returns on a year-to-date basis. But it seems that this small cap fund has done just that, earning 12.5% since January 2, 2010 even though its investment strategy might seems a little, well, unique compared to others in its category. But before we dig into three of its top 10 holdings, here is a small review of the ING Small Cap Opportunities Fund (NSPAX).
The ING Small Cap Opportunities A fund is a Small Cap Growth Fund with a great track record.
With just $109,500,000 under management, the ING Small Cap Opportunities fund has outperformed its category in 4 of the past 5 years, including its YTD returns. This coincides with Steve Salonek’s arrival on the fund in 2005, suggesting that the change in management at that time was a profitable change for ING.
In addition, this fund ranks in the Top Quartile for its YTD, 1, 3, and 5 year performance track record, another great achievement given how broad a category this is. Currently, Morningstar ranks this fund as having AVERAGE risk, and it has held this rating since Morningstar has started rating this fund. Currently, it has a risk-adjusted rating on this fund of just 3-stars, even though the fund has consistently held 4-star ratings in all periods except for its 10-year period where it held a 2-star rating, and its overall rating is, again, 3-stars.
On paper, this small cap mutual fund does not look all that inviting. But let’s take a closer look at its holdings. At the Mutual Fund Site we believe that the underlying portfolio of any mutual fund should motivate an investor into taking a long-term investment position, a short-term position, or no position at all. This highlights, therefore, the importance of portfolio, and in the case of the ING Small Cap Opportunities fund, the portfolio has a fairly aggressive (+18%) position in the Healthcare sector. Its next closest sector is the Software sector at 11.56% and third up is the Consumer Services Sector at 11.35%.
While Healthcare will certainly see its day, we believe it could be a little premature at this point to be so heavily invested in that sector when there are others that stand to see a quick, solid rebound with favorable economic news.
As a fund of just 145 underlying securities, this small cap mutual fund places relatively low importance on its top 10 holdings — which make up just a little more than 12% of the total holdings. In fact, its largest overall holding is a money market fund, and aside from that its first Healthcare security (at 1.28% of assets) is number 5 on the Top 10 list. At any rate, let’s take a look at 3 of its top 10…
1. Solera Holdings (1.47%). This company provides software and services to the insurance industry, assisting with the claims process. Overall, this industry is a growth industry given the increasing number of claims that insurers face on an annual basis — not including recent increases in fraudulent claims on account of the recession. With strong, consistent earnings growth over the past 3 years, it comes as little surprise that analysts polled by Thompson/First Call rate this stock as a strong buy.
2. Bally Technology (1.44%). Bally provides gaming machines and solutions for casinos. Although the company has seen a slight bounce in revenues since its 2007/8 levels, its Q1 levels are below 2009 Q1. We have commented elsewhere on whether gaming stocks are a good idea in our review of the Buffalo Micro Cap fund and the bottom line is that they should probably be avoided until economic data supports people spending and wasting money on this type of entertainment. We will elaborate here and warn investors that Bally Technology could be a long-term investment for this fund, a view that seems supported by the analysts at Yahoo!, this “HOLD” stock.
3. Gymboree Corporation (1.14%). As a children’s retailer, Gymboree operates over 620 retail stores in North America, competing with companies like GAP, Carters and the Children’s Store. This is some pretty stiff competition, yet Gymboree has weathered the economic storm extremely well. The company is very well managed, having achieved revenue growth over the past three years when so many others have suffered in this segment. Ultimately, we like Gymboree for its innovative branding and revenue growth in such tough periods. The biggest threats, which have been well documented, is the ease of entry into this segment from newcomers that may be able to offer similar product at a fraction of the price, not to mention alternate retailers who offer similar product — such as Wal-Mart.
Overall, the ING Small Cap Opportunities fund may be a small cap mutual fund that many people would be nervous about owning. However, with its AVERAGE risk rating and ABOVE AVERAGE returns, the fund has a well balanced portfolio in terms of risk diversification, as evidenced by its low concentration in its Top 10 holdings, the small/low percentage of total assets of its top 10, as well as its strong diversification (despite healthcare, as a whole representing nearly 1/5 of total holdings).
At the Mutual Fund Site, we like this small cap mutual fund and believe it would recommend it for investors who need a relatively neutral holding with smart investment management and good diversification.
One of the things that a site like the Mutual Fund Site should aim to provide is sufficient analysis of mutual funds. With that in mind, we will endeavor to analyze a couple of mutual funds every week, starting with small cap mutual funds in the month of May 2010. We will post our analysis in a new area of our website, probably titled “Mutual Fund Analysis” or some such truly unique heading.
When evaluating these small cap mutual funds, we will take a look at its risk rating, rate of return and a few other key features that can help investors decide whether such a fund is where to invest. Of course, these will not change our current Top Pick 2010 funds, nor will favorable reviews necessarily lead to a Top Pick rating. We simply would like to provide commentary on the funds, highlight the risks and provide details on what we see those risks as noteworthy enough to help shape an investment decision one way or another.
With our objective in mind, we will aim to review the following types of mutual funds for the next few months:
May 2010 – Small Cap Mutual Funds
June 2010 – Value Mutual funds
July 2010 – Real Estate Mutual Funds (we are looking forward to seeing how the summer month’s housing reports will impact this sector).
The reason for the change is simply that we want to provide even more value to our site visitors. We do not want to be a purely investment site (there are plenty of those around). And given that our site is called, well, the Mutual Fund Site, we figure we should post more about mutual funds, less about investment management concepts and investment strategy.
Please feel free to post your comments at the end of this post… we look forward to receiving your feedback!
Christopher Fitch
Mutual Fund Site
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 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:
- Investing in Index fund for the best-performing asset class (e.g. large, mid and small cap stocks or funds)
- Investing in Index funds for the three investment styles for that group (e.g. value, blend and growth)
- Investing in actively managed funds for the poorest-performing asset group (e.g. large, mid and small cap stocks or funds)
- 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….
As an investment strategy, putting $12,000 into a mutual fund today versus spreading that $12,000 over the course of twelve months (or $1,000 per month) is statistically not such a smart move… well, unless of course you invest $12,000 per month or at some kind of regular interval. This has nothing to do with the mutual fund in question. Instead, investing regularly has its share of perks, in fact enough of them that investors would be silly not to take advantage of them from Day 1.
To illustrate just how powerful regular investments can be versus single, lump-sum investments, consider that even if a security value drops, you can still come out with a gain if you make your investment purchases on a regular basis.
To add credibility to our little illustration, we will look at S&P 500 values for 2009. Our first investor will invest $12,000 on the first business day of January while our second will invest $1,000 every month on the first business day of that month. By December 2nd, they will have both invested at total of $12,000.
As we can see from the chart below, the investor who invests every penny at once will be ahead by 19% on December while the investor who puts $1,000 aside every month is only marginally ahead of that investor at 20.57%. The difference of $200.10 hardly seems worth it in the end… or does it? Putting yourself in the shoes of the two investors might tell us a different story as we work our way from month to month.
Take look at the Investor #1 who goes “all-in” on January 2, 2009. How would this investor feel one month later on the first business day of February when that $12,000 investment is down 11.41%, a loss of nearly three thousand dollars. Would Investor #1 be getting sick to her stomach on the first business day of March when that investment is down 24.79% or a heart-stopping $2,974.63?
In comparison, after that first business day purchase in March 2009, Investor #2 would have put $3,000 away and lost just 13.3% or $398.86. In absolute terms, Investor #2 would probably feel a lot better than Investor #1 at this point. And any sinking feeling of loss would be gone for the rest of the year for Investor #2 by the time the first business day in April rolls around and he see his investments roughly at a break-even point (a 0.26% gain actually) while Investor #1 is still not eating or sleeping because they are still down nearly 13% or $1,554.67.
In fact, while Investor #2 watches his investment gain throughout the rest of the year (except in July, when they slip from being “up” 12.27% in June down to being “up” only 8.53% in July), Investor #1 has to wait two extra months before they break even again… and that victory is really short-lived because in July they will have seen their investment swing back into the red again. Talk about an emotional roller-coaster ride for Investor #1 — while Investor #2 recorded just 2 “down” periods for the year Investor #1 was in the red for 5 of the 12 periods, a little more than 40% of the time!
And what if either Investor had lost part or all of their regular income and needed to draw on their investment after 3 months? At that point, only Investor #2 showed a gain of any type meaning Investor #1 would have been cashing in at the absolute worst time possible.
Of course, in the end, Investor #2 actually ends up being $200.10 ahead of Investor #1, thanks entirely to their regular contributions allowing them to purchase more units. After understanding the probable emotional turbulence that Investor #1 experiences, the extra $200.10 seems like only a single piece of what is really much-larger bonuses — these being the reduced stress levels, the added units and the lower dollar-value losses when things turn South.
This is not magic. You can run the figures yourself using S&P 500 closing prices found at Yahoo! Finance. But remember: investing regularly in mutual funds really can make a big difference.
Illustration A (S&P 500 values; Invest One-Time vs. Invest Monthly)
Illustration A
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%).
Generally speaking there are two school of investment management techniques. One is Tactical and the other is Strategic. The latter involves picking and sticking to a particularly asset allocation model from day one, based largely on risk tolerance, maximum time and investment objectives. In other words, if you have 20 years to invest, you have a moderately aggressive risk profile and your objectives are largely income, then you might have an asset allocation consisting of 50% Income, 40% Growth and 10% Cash Mutual Funds. As one asset class grows or shrinks based on market fluctuations, you will then shave the larger asset classes to add to your deficient classes. This brings the portfolio back in line with your strategic asset allocation model.
With Tactical Asset Allocation, the objective is a little different. You will need to determine whether you are growth or value oriented. In other words, do you want to discover the next-best opportunity in the market by shifting from defensive, growth-oriented mutual funds to more speculative, sector-specific small cap funds because the belief and research suggests doing so is a slam-dunk decision? Of course, with mutual funds, where the tactical component is ideally taken from the investor’s shoulders and the burden placed on the fund manager, it becomes much more difficult to adopt a tactical approach to investment management.
It is not impossible, however. Most mutual funds are examined for their management style. Morningstar will provide a cute little grid that shows the fund’s investment management style as either Large, Medium or Small Cap with either a Growth or Value approach or a Blend of both. Therefore, deciding on the underlying securities (tactical investment decision) is a task that the fund’s management team can undertake while you, the investor, can decide on the actual tactical asset allocation.
In other words, you do not need to know to buy Johnson and Johnson and McDonald’s during periods of economic stress; you simply need ot know to invest Growth-oriented, Large- to Mid-cap mutual funds where the specific investment directions will be made.
Of course, most balanced funds illustrated exactly how tactical asset allocation works where a fund manager makes all of the tactical decisions, everything from where to invest (i.e. asset class right on down to industry and sector), to how to invest (i.e. what specific securities to purchase) and when to invest (i.e. based on yield curve analysis, P/E analysis and other key research). For the individual investor who relies on a portfolio of mutual funds, the term tactical asset allocation means something entirely different. It means choosing the different funds for their management style and incorporating those funds successfully in his or her portfolio.
Complicated? Indeed it is.
Time consuming? You better believe it. Not only are you monitoring your funds, the changes in investment management of those funds, the fundamental changes to those funds and so on, but you need to know where to invest once key changes are made within those funds. It’s not really fun unless you enjoy that kind of research and can dedicate the time to it.
So for most mutual fund portfolios, tactical asset allocation is normally left to the Balanced Funds. For portfolios of funds, a strategic approach is more common, simple and recommended.
Investment management is one of those things that crosses many investment territories, from a basic term deposit laddering strategy to a more complicated mutual fund investment strategy to complex, corporate strategies involving bought deals, derivatives and other exotic investment vehicles. But ultimately, investment management can be broken down into two simple camps:
- Strategic Investment Management
- Tactical Investment Management
These two approaches are recommended for individual investors as well. Choose one and follow it.
Investment management boils down to either Strategic or Tactical Investment Management.
Strategic Investment Management
The strategic school of investment management involves making a decision at the beginning of the investment journal and sticking to it. For example, an investment manager might choose an investment strategy that involves earning fixed income through interest and dividends for 1/2 of the portfolio and actual capital growth for the other 1/2. That means that, all things being equal, 1/2 of the portfolio will be made up of income-generating investments and the other 1/2 will be made up growth investments.
In other words, the strategy calls for a 50/50 split between income and equities. As equities grow more than income, part of the equity class will be trimmed back so that there is no over-exposure to equities and the strategy remains intact.
Problems arise with this strategy throughout the investment process. At the start, it is often difficult to decide on the strategy in the first place. Throughout the program, the investor often has a tough time keeping to the strategy, trimming where needed (it is tough to sell off assets that are performing well), and again throughout the program it is difficult to adjust the strategy to meet changing life circumstances (such as raises at work, increasing net worth, upcoming retirement, and so forth).
However, strategic investing is also considerably simpler as it does not involve continuous evaluation of the underlying investments. You decide on the strategic asset allocation and stick to it. It’s that simple.
Tactical Investment Management
This school of investment management forces the investor to make ongoing investment and investment class decisions. Since our site is dedicated to Mutual Funds, we will look at tactical mutual funds. In its simplest form, the tactical school will mostly consist of Balanced Funds that are allowed to shift from one extreme to another. For example, a tactical balanced fund might hold 90% equities one month and then shift their portfolio to consist of 90% bonds in the following month.
Tactical investment management involves consistent portfolio and asset management. Additionally, it involves reading, evaluating and calculating the market, economy, and individual market sectors. For example, Tactical asset managers might decide on fundamental portfolio changes based on an industry sector publication. A real-life illustration might start with a manager reading a manufacturing report that suggests higher raw steel sales. This report might lead the manager to a business article that interviews a 2nd Tier automotive manufacturer who might comment on his company’s inability to obtain raw steel to meet customer demands thanks to large orders in the farming sector. As the trail progresses, the manager might find that instead of holding automotive-company bonds, he or she should actually be buying Caterpillar and John Deere stock.
Problems with the tactical investment model is that it relies heavily on research and decisions made by the management team. If that management makes the wrong call, it could result in devastating losses for the fund and, ultimately, the investor.
Conclusion
Understanding the two different schools of investment management allows the individual investor a bit of an edge when coming up with his or her own investment strategy. Even with a mutual fund investment, some strategies will involve regular review and monitoring, rebalancing and research. These investment management schools are not exclusive to mutual funds, but to all investment types and to all levels of investor, whether individual or corporate.
If you have the problem of not knowing where to invest $10,000, you have a problem that many people would love to have. But not knowing where to invest is not the true problem; it is a symptom of the problem of not knowing enough about investments and the optimal investment vehicles. While some people might understand the basics of mutual funds (they are pools of funds where hundreds, thousands, or even hundreds of thousand of investors write checks to these fund companies, who then take all of this collective money and purchase securities on the open markets and then return the gains, proportionately, to the people who invested in the funds), fewer yet understand the different asset classes — Equity, Income, and Cash/Cash Equivalents — and even fewer understand how the different funds operate in terms of investment management strategies.
Not knowing where to invest $10,000 is a great problem to have… but that is not the problem. The problem is investment knowledge.
The easiest way to understand investment management is by understanding how the following chart below works. Ultimately, there are three areas; red, blue, and yellow.
Asset Allocation Model
This chart illustrates the basis of asset allocation. Each color represents an asset class; equities, income and cash. Understanding your risk tolerance, investment objectives and time horizon will allow you to allocate part of your $10,000 to specific areas at specific, pre-determined ratios.
For example, if you have a medium risk tolerance with an investment objective of income and some growth, with a time horizon of five years, then you might consider an asset allocation model as follows: 25% Equities, 65% Fixed Income, and 10% Cash. In this chart, the Equities would be the Blue portion, Fixed Income would be Red, and Cash would be yellow.
The fundamentals of a strategic investment management suggest that all you need to do now is ensure that these assets stay within their limits (65% Income, 25% Equities, and 10% Cash) through period rebalancing.
So, where does that leave you when it comes time to invest $10,000? Depending on your level of investment knowledge and how well you know your stuff or how much you trust your financial advisor, then you could easily develop your own plan using a well-defined asset allocation model.
If you would rather not have much involvement with your investments, then you are probably best served by a Balanced Fund. This is a common choice for people who need a place to invest $10,000 and they need a little more time to educate themselves on the different investment options they have.
Why Balanced Funds? These types of mutual funds offer active investment management from top investment managers at a reasonable price. Most of these managers would not normally deal with people with less than $1,000,000 in investments… yet here you can access them with 1/100 of that amount.
Balanced Mutual Funds offer active management from investment industry leaders.
So where does that leave the average invest with his or her $10,000? Starting with a Balanced Fund that aligns with his or her investment objectives, risk tolerance and time horizon is ideal. While the fund operates on its own, the investor will be able to learn more about other investment options, if the desire is there. Of course, many investors will remain invested in Balanced Funds. In fact, many private bankers will use their institution’s balanced fund portfolio managers to manage their high-net worth clients’ funds. The only difference is that private bankers will deal with people who have extremely high net worth; balanced mutual funds will help people invest $10,000.
Ultimately, the question about where to invest $10,000 can be answered introspectively. If you have high investment knowledge, then mutual funds are probably not your ideal investment. If, however, you have moderate to no investment knowledge (like most people), then mutual funds work well. If you feel you need to learn more before making a permanent investment decision, then balanced mutual funds are the best place to invest $10,000 after all.
Insofar as mutual funds are concerned, balanced funds are those all-encompassing funds that can meet an array of investment management requirements. In many cases, people who are new to investments and want to know where to invest with the least amount of risk while still enjoying an accurately built asset allocation model will start out of with balanced funds.
The reason for this is simple. Most of the balanced funds available to investors will invest in all three asset classes (cash, income and equity). Actively managed balanced funds will modulate their asset allocation in an attempt to take advantage of market pressures one way or another. This mostly means increasing income-class investments while simultaneously reducing equity class investments when equity markets are considered overbought (hot) and vice versa when equity markets are oversold (underpriced).
If we call the above types of balanced funds tactically managed funds, then we can consider another type of balanced fund where the asset allocation is already determined and the fund’s mandate is to stay the course with its asset allocation design. For example, consider a fund that promises a steady 25/75 income to equity ratio. This type of balanced fund will rebalance its asset each time the weighting exceeds a predetermined deviation from the original ratio. For example, if equities are strong and grow more than the income portfolio so that the weighting is 20/80, equities would be sold off and income investments purchased with those gains so that the weighting returns to 25/75.
In both instances, these balanced funds exist to achieve different results, therefore they exist for different investors.
Ideally, the investor who is just starting or learning to invest might prefer actively managed balanced funds where asset allocation can swing freely from one extreme to another at the discretion of the fund manager. This allows the investor to enjoy a professionally managed portfolio with little up-front investment (many of these professional fund managers would deal only with institutional investors otherwise, or people with well over $1 million in investible assets, so to take advantage of their expertise is really a treat for the novice investor).
Investors who have built a larger portfolio will begin to understand the value of sticking to a particular asset allocation model and may therefore prefer to adhere to their specific model. This means a fixed asset allocation fund will make more sense for this type of investor. That does not mean that this type of investor will need to abandon actively managed balanced funds in favor of this type of investment. However, as asset size grows, so must the attention to details insofar as the portfolio is concerned. As such, it is normally recommended that investors who have accumulated wealth under an actively managed balance fund will be urged to minimize their risk by investing in other asset classes or other investments so that there is no over-exposure to a single fund.
Ultimately, balanced funds are ideal starting points for beginning investors or people looking to enjoy the benefits of active asset management at a fraction of the cost. Likewise, strategic balanced funds where the asset allocation is strictly adhered to also make sense when investors accumulate a relatively substantial amount of wealth and wish to protect against management exposure.
It will probably come as a surprise to many investors that Bond funds offer as many practical options as many of the equity funds on the market. As far as bond funds are concerned, you can have core bond funds that are high quality, low risk and you can high yield bond funds that offer mid quality and medium/high risk.
For many people, bond funds offer a great alternative to term-deposits. Not only do bond funds offer liquidity as well as higher rates of returns (than comparable term deposits), but they are an asset class all their own that allows investors to tactically shore up their asset allocation model.
For a limited few, bond funds present a tremendous opportunity. Since bonds do offer growth potential, there are tax advantages to owning bonds over other income-paying investments. In its most basic format, bonds bought at a discount and held to maturity allow for capital gains rather than straight income. In some (okay, most) jurisdictions, capital gains offer benefits at taxation time. (However, if taxation is a primary concern when it comes to your investment strategy, you should consult your tax accountant to determine the best income source).
Since bond funds offer investors the opportunity to properly diversify their holdings, it has a considerable importance when it comes to your asset allocation model. The problem is that most investors have a tough time understanding the intricacies of bond funds. For example, bond prices will fluctuate based on many of the same factors that affect equity prices like currency, geopolitical, commodity as well as corporate risks.
The difference is that most bond funds will respond differently to those influences. As such, investors whose knowledge falls short on bonds need to align themselves with an advisor who does have something of a decent knowledge base when it comes to this asset class.