Posts Tagged ‘investment management’

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.

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

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

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

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

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

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

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

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

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

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….

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

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

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

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

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

So where do these dividends come from, exactly?

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

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

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

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

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

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

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

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

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

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

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

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

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

You need to know what those underlying assets are!

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

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

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

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

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

Ivy Small Cap Value is a no brainer

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

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

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

The idea of using the yield curve to forecast the future of the economy is nothing new, not to mutual fund managers anyway and particularly not for people who are interested in, investing in or working for bond funds. It is an essential ingredient to cooking up the right investment management strategy for the quarter and year to come. But what can the yield curve tell people about other types of mutual funds, like growth funds, dividend funds and, gasp, small cap funds?

The idea that the yield curve is relevant only to bond investors is silly.

In fact, the yield curve can tell investors a lot. At the Mutual Fund Site, we believe that the Yield Curve can help confirm or refute areas of perceived value. And small cap mutual funds are potentially one area of great value. Why? Because even after a strong equity market that showed tremendous leaps of recovery in 2009, small cap shares remain somewhat unattractive. In fact, the average small cap growth fund will have returned -7.29% over a 3-year period as of February 11, 2010, while the average large cap growth fund returned -5.29 over the same period. The same story is told in the small cap blended and large cap blended categories according to Morningstar.com, but when looking at straight value plays, the opposite is true: small cap value funds have performed better than their large cap counterpart.

At any rate, what does the yield curve tell investors?

According to the definitions provided by Smart Money, the normal spread between 3-month Treasury Bills and 30-year Treasury Bonds is 3%. When the spread is greater than that, investors are signaling that they believe that the economy will improve quickly in the future. Long term investors become nervous that they will stay locked in at currently low rates (sounds familiar) and demand higher returns on their capital. According to the traditional definition, the yield curve is currently steep, as demonstrated by data available at Bloomberg.com.

How does a steep yield curve help small cap companies?

Well, small cap funds historically perform very well after a recession. That is because larger companies as well as retail consumers are more willing to try out the small guy. They can “afford” to experiment a bit. This could mean buying a home from a small-cap builder, using technologies developed by a small-cap company and so on, whereas in the past they have kept a close eye on their budgets and stuck to well-known, established providers who might have even undercut their small-cap competitors.

Additionally, as the economy improves, large cap companies that have been able to finance their survival through the recession may find themselves paying more for the money they borrow, particularly if they borrow on floating rates such as LIBOR or some derivative thereof. Small cap companies in comparison have been shut out of the credit system as lenders and capital sources became increasingly nervous about where they lent their money. So while larger companies juggle higher debt payments smaller companies will not have as much debt to worry about, resulting in lower debt/equity ratios which in turn means stronger financial statements.

Lastly, based on the above, small cap companies stand to enjoy grater profit margins. With less overhead, less debt, and more money flowing into their companies, small caps will seem “stronger” financially than their large-cap counterparts. Of course, this depends on the measures being used but with stronger profit margins and a conservative fiscal policy, small caps will be able to retain those earnings and build their equity base quicker (in percentage terms anyway).

The Yield Curve tells us this. It tells us that since December 2008, the outlook on the economy has been steadily improving to the point where it is at today (February 11, 2010) with the spread between 3-months Treasury Bills and 30-year Treasury Bonds greater than 3% (it is at 4.57% in fact). And the trend suggests this spread will only widen, meaning that small cap mutual funds a touch more attractive right now than their growth fund counterparts.

Note: we recommend that you speak with your financial adviser before investing in higher risk mutual funds such as small cap funds.

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%).

Mutual Funds are an interesting beast when you get into dividend funds. Some investors feel that dividend funds are where to invest any and all amounts of money and this argument actually has some merit. After all, dividend-paying securities usually generate enough cash to make dividend payments and they are typically the largest stocks by market capitalization (though not always). But talk is cheap when it comes to investment management, so we came prepared to back up our argument for why dividend funds can take you from zero to hero in one year.

Some of the sweetest statistics around involve securities. Where mutual funds become a lot more attractive is in their management levels — you do not have to find the best dividend-paying securities because the fund manager will do all of that work for you.

The S&P 500 is a great starting point. Of thee 500 securities included in the S&P 500, 73.6% of them (or 368 of 500) pay dividends. That means that an Index fund alone will pay dividends within the fund.While this is not impressive on its own, consider that dividend funds will choose the best companies and, most likely, the best companies of those that pay highest-paying dividends.

The average dividend yield on the S&P 500 as of February 8, 2009 was 1.89%. Understandably, this is not a rate that would knock most people off their feet. The US Treasury Bond term that comes closest to such a yield is the 3-year Treasury. Go to 5 years and your Treasury Bond yield exceeds the average dividend yield on the S&P 500. Why does this matter? Well, nobody has ever been considered a hero by investing in 5-year Treasury Bonds and turning an “easy” hands-off rate of return that would make many people jealous (that being said, people who do pull off great returns investing this way are actually called genius or lucky, or probably both).

That average yield of 1.89% takes into account all S&P 500 securities, including the 132 that do no pay any dividends at all. The average dividend for those 368 securities that do pay dividends is actually 2.43%, better than the 5-year Treasury Bond rate of 2.31%. Now, 2.43% is a little better (much better than banks and investment houses will pay on a 1-year term deposit), but definitely not enough to make someone an investment “hero.”

So, how can one improve their dividend yield to something that would not only put even the 30-year Treasury Bond investor to shame, but would make all of your friends at the golf club blush with envy? Take a peek at the top-25 highest dividend companies where the average yield is actually 6.89%. Now we’re talking; that alone represents a more than one third of the 19% that the S&P 500 returned in all of 2009 (Jan-Dec).

Now, however, comes the question of “quality.” What do these top-25 dividend-paying securities have to offer? Are they on the brink of reducing their dividends? What do analysts think?

Well, Frontier Communications which has the most aggressive dividend yield is rated as a Hold on average by the 10 analysts surveyed by Thompson/First Call. On a year-over-year basis, Frontier is seeing growth in their quarterly earnings, although this is definitely nowhere near substantial enough to base an investment decision. What mutual funds hold Frontier outside of an Index fund? Reaves, DNP, and MFS are the largest holders.

Some of the other companies in this Top 25 include Verizon, Leggett & Platt, Eli Lilly and Integrys Energy. Obviously, these are all companies that most people have heard of, but whether they are worthy of hard-earned investment dollars is a decision often best-left to the mutual fund managers who have the resources to study every little detail of these securities.

So, in answering how dividend funds can take an average investor from zero to hero, consider that as of February 2010, these Top 25 securities in the S&P 500 are paying an average yield of 6.89%. That does not take into account any growth, which many of these shares have already given back. Next step is to short-list the dividend funds that actually perform and exceed standard performance levels.

Despite all of the press out there that suggests that high yield investments are not where investors want to invest, there is a small group of professionals (including those of us at the Mutual Fund Site) that believe that these mutual funds are indeed still favorably priced. But not everyone is well suited for high yield investments. Those people will typically chasing growth rather than income. For those investors, dividend funds might be where to invest.

The interesting thing with dividend funds is that they provide income, much like a bond fund or high yield investment would pay income (the difference is dividend income versus interest income). With dividend mutual funds, investors can expect yields around the 5% range, some higher and some lower depending on the fund you are considering.

But the kicker with dividend funds is that investors should be more focused on the growth prospects of the securities held within that mutual fund. The Vanguard High Dividend Yield Investment as an example pays roughly 5% but is also invested in large-cap value stocks. While that yield is certainly nice, the underlying holdings have an average P/E ratio of 15.7. This suggests that the future gains will come more from the growth of those underlying securities than the dividends themselves.

While we have not completed our full analysis of the Vanguard High Dividend Yield investment, this fund illustrates the difference between high yield funds and dividend funds. That key difference? Where the future returns are most likely to come from.

As for risk, the investor will need to determine the proper level of risk he or she is willing to assume. This will ultimately determine the type of fund (growth versus value, large cap versus mid- or small-cap, etc.) and can help create something of a short-list for the investor. In essence, however, dividend funds are similar to high yield bond funds. But the bottom line is that bonds will pay income and dividend funds pay dividends as a bonus; the key is in the long-term growth prospects.

So when it comes down to it, dividend funds are not the new high yield investments. They are merely different beasts co-existing for different investors with different needs.

One of the most e-mailed op-ed columns in the NY Times was published on February 1, 2010… a few days after the Mutual Fund Site released its write-up on the Dryden Financial Services Fund, a mutual fund that has a strong reputation for its investment management prowess and stunned investors with staggering returns in 2009.

Why is this important and why should you care?

Let’s take a look at the column in question. In it, Nobe Prize winner, Paul Krugman describes how the Canadian banking system, which was coincidentally modeled after the first American secretary of Treasury, Alexander Hamilton, is remarkably the soundest system in the world (versus the US system at 40th). More specifically, Krugman points out that the banking reform currently pushing its way through the system will substantially Canadian-ize the domestic banking system.

In addition to the obvious statements by Paul Volcker (who advocated in early 2009 that his vision for the banking system “looks more like the Canadian system…”) and those by President Obama (let’s not get started), it seems that the US banking system may some day soon resemble Canadian system.

This is key, and also brings us to the importance of the publication dates for these two pieces. Less than a week prior to Krugman’s op-ed column, the Mutual Fund Site gave “top marks” to the Dryden Financial Services fund. And guess what makes up their core holdings. That’s right, Canadian banking stocks.

More than 11% of their meager $162 million under management is invested in Canadian banks. In fact, three of their top 25 holdings are Canadian banks, all of which have among the lowest P/E ratios in the fund’s top 25. What makes this interesting is that the Dryden Financial Services mutual fund has outperformed, by a long-shot, the S&P 500 as well as its peers in the last year, proving that their investment management strategy and, most importantly, their attention to detail has really paid off. Some of this might have to do with the Canadian banks’ ability to maintain dividends and, in many cases, increase those dividends. If bought at the right time, some of those yields would have exceeded 8%. Still, even with an 8% dividend yield, another 60% in return had to come from somewhere…

Does Krugman’s popular piece provide support for investing in a mutual fund like Dryden’s? Not necessarily, although it certainly provides some credibility to why we, at the Mutual Fund Site, gave Top Marks to the Dryden mutual fund. More importantly, given the amount of attention the New York Times piece has attracted, it seems that, if governments start modeling their financial services firms after the Canadian system, and it seems they will, Dryden could see some good, long-term growth provided their investment management team and strategy remains intact.

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

2010 has provided something of a wake-up call.

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

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

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

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

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

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

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

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

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

Questions about where to invest money invariably come down to finding the right asset allocation model for the investor. The process of asset allocation normally becomes a tad simpler when the investor is looking at mutual funds as a way to not only secure solid returns (good and bad) but proper investment management.

Defining the right asset allocation model is not a two-minute process. As the cornerstone of your investment management strategy, it should never be taken lightly given the variations from one model to another.

Ultimately, any portfolio that incorporates equities into its program will fall under three different types of asset allocation models; conservative, moderate and aggressive, with conservative being the least risky and aggressive being the most aggressive.

Taking a closer look at each model, we will see the following:

Conservative Asset Allocation
25% Cash, 60% Income and 20% Equities.

With the exception of cash, the bulk of the investor’s attention (or the adviser’s) will be spent analyzing the quality of bond funds or other types of income-producing investments to incoporation in the model. With equities at just 20%, breaking the total portfolio into specialized growth funds would be futile. In most cases, the 20% Equities would be properly diversified by number of shares and type of shares and possibly even geography.

The Income component however will need to draw on several specific funds in order to be properly invested. This can include a small amount (say up to 10%) in high yield investments with the balance being spread around different bond funds (government bonds, muni bonds, etc., etc..). The point is that the income-heavy Conservative portfolio really puts a lot of attention on the Income aspect.

Moderate Asset Allocation
10% Cash, 30% Income, 60% Equities.

The greatest area of focus in a Moderate portfolio is shared by the Equities and Income areas. Some specialization will occur in the Equities portfolio (perhaps 10% to 20% in highly specialized funds, such as Real Estate, Energy, Healthcare and so forth) while the balance can easily be spread among domestic growth funds, value funds or a blend of both (up to 20%) with the balance being further diversified by geography.

Of course, the bond funds held in such a portfolio will also demand investor attention. A smaller amount of specialization is needed here (say 5%), but investors would be wise to consider high yield investments for this small percentage with the remaining 25% being gobbled up with high quality bond funds including a good spread between government and corporate bond funds.

Aggressive Asset Allocation
5% Cash, 15% Income, 80% Equities.

The Aggressive portfolio becomes an Equities-focussed portfolio. The investor will typically incorporate highly concentrated equity funds for up to 50% of the total portfolio in areas like Real Estate, Healthcare, Energy, Resources, Small-Cap, Venture and so forth. This represents a tremendous risk to the overall performance of the portfolio in terms of overall strategy. As such, the strategic asset allocation may shift on a micro level (shifting from 50% in specialty funds during boom periods to a more defensive 20%, and vice versa).

The Cash and Income components of such a portfolio then become secondary and normally represent the liquidity portion of the portfolio. Many investors are simply looking for safe parking spots for such money in order to take advantage of opportunities in equities and to earn income on funds they know they will not want to reinvest for some time.

These three asset allocation models evidently take a look at three types of investors insofar as equities holdings are concerned. Of course, these portfolios can become even more conservative once equities are removed. These models show the difference between the most conservative portfolio and the most aggressive and illustrate just how important the asset allocation process really is, even when (or especially when) dealing with mutual fund investments.