Stock Based Mutual Funds—Section 4

As noted in the previous section, the main advantage of mutual funds is that most, but not all funds, provide immediate diversification. Diversification is the primary method of controlling most types of asystemic risk and some types of systemic risk (see section 3). Another advantage is that they offer professional management. Fund managers are usually well trained, have many years of investment experience and often have better access to important financial information than the average investor.

Mutual funds come in all shapes, styles and colors. Some are broadly diversified investing in many sectors and industries while others focus on a single industry. The most common way of classifying mutual funds is by the size of the companies that they invest in and their style of investing. There are small, medium and large cap funds which invest in small, medium and large companies respectively. Cap is an abbreviation for market capitalization which is the number of stock shares outstanding multiplied by the share price.

The two basic styles of investing are growth and value. The growth style involves investing in companies that are growing rapidly. The fund manager is not overly concerned about what the stock costs now because he or she believes it will be worth more in the future. To illustrate, if you bought shares in a company currently worth $1 billion, your shares would probably be worth a lot more if the company grows to be worth $10 billion.

With the value style of investing, the fund manager is looking to invest in companies and industries that are currently out of favor, but where he or she believes a turnaround is imminent. Here the fund manager is looking for bargains. This is the Warren Buffet style of investing.

Funds classified by asset size and investment style are usually diversified over many sectors and industries. However, at any given time, they may be more concentrated in one area than another. The fund’s investment parameters are described in the fund’s prospectus (see section 5).

Mutual funds are also categorized based on the broad areas of the economy that they focus on. The broad areas are known as sectors and include:

Even more specialized funds focus on particular industries within a sector. For example, some funds invest primarily in the stock of gold mining companies which is an industry within the materials sector.

The more specialized the fund, the greater the risk. Not only are you assuming the risk associated with a particular industry, but you may also be assuming a higher level of asystemic risk. This, because, at any given time there may only be so many companies in a particular industry worth investing in. This can lead to a larger percentage of fund assets being invested in fewer companies. The problems of a single company could, therefore, have a greater effect on the fund’s performance.

Another popular type of fund(s) are index funds which try to duplicate the performance of a major market index such as the S&P 500 or the NASDAQ 100. Index funds usually have lower expenses because the fund manager is only trying to duplicate an index’s performance, not beat it. This means less research and lower transaction costs which translates to lower fund expenses.

Mutual funds can also be categorized by the part of the world where their investments are focused. This can be a single country, such as Japan, or an entire region like Europe. Some funds specialize in emerging markets such as India, China, Latin America, and Russia. The world economy is expanding at an unprecedented rate. Countries that were considered to be part of the third world only a few years ago are rapidly joining the modern industrial world. You need to be careful, however, because these funds can involve substantial political risk. In the event of political upheaval, emerging market funds could lose a great deal of value very quickly.

Hybrid funds are also known as growth and income funds, total return funds or balanced funds. Their objectives vary as to specifics, but the general idea is to provide a combination of growth, current income and relative price stability using varying combinations of stocks, bonds and cash. A problem with these funds is that it is sometimes difficult to determine what the fund’s actual objectives are. One growth and income fund may be much more growth oriented then another fund listed under the same heading. If you intend to invest in this type of fund, you must read the fund’s prospectus very carefully to determine how the fund assets will be invested.

A fund that has become popular recently is the target retirement date fund. These funds use a combination of stocks, bonds and cash which are rebalanced each year as you approach retirement. A target retirement date fund, with a target date 25 years in the future, may begin with an allocation that is 80% stocks and 20% bonds. Each year as the target date approaches, fund assets would be gradually shifted out of stocks and into bonds and cash. At the target date, the initial allocation could be reversed with 80% bonds and 20% stocks.

Target retirement funds are often made up of other funds offered by the same company and are in effect a fund of funds. Theoretically, this can provide a sufficient level of diversification so that the fund can act as a stand alone investment. The advantage of target retirement funds is that they are simple. You decide when you want to retire and the fund company does the rest. The disadvantage is that they use a one size fits all approach. They operate under the assumption that young people can assume more risk than older people. This is usually true but not always. Many times younger people have a lower risk tolerance than do older people. This can result in the younger person assuming too much risk, while the older person assumes too little risk, unnecessarily sacrificing return in the process.

To review, the diversification inherent to stock based mutual funds greatly reduces your exposure to asystemic risk. Broadly diversified funds that invest in many sectors and industries will also help to reduce some types of systemic risk, particularly industry risk. Diversification through stock based mutual funds alone, however, will not protect you against market risk. If the market goes down far enough and for long enough, virtually all stock based funds will lose money.

Quiz—Section 4

1. Mutual funds are classified based on the following criteria. Select all that apply.

A) The size of the companies they invest in.

B) The style of investing employed by the fund manager.

C) The broad area of the economy where their investments are focused.

D) The area of the world that they invest in.

2. With the growth style of investing, the fund manager is primarily interested in:

A) Companies and industries that are currently out of favor but where the fund manager believes that a turnaround is imminent.

B) Companies that are growing rapidly.

C) Specific areas of the economy.

D) Providing a combination of growth and current income

3. Small cap funds invest in:

A) Large companies

B) Medium size companies

C) Small companies

D) Companies that invest in China

4. Funds that invest in a single industry are __________________ than funds that spread their investments over many industries.

A) more risky

B) less risky

C) the same as

5. Index funds attempt to ___________ the returns of major market indexes.

A) exceed

B) duplicate

6. Funds that invest in emerging markets often have an additional risk when compared to funds that invest in developed countries. This risk is:

A) Market risk

B) Interest risk

C) Political risk

D) Credit risk

7. A well diversified portfolio of stock based mutual funds will reduce all of the following types of risk except:

A) Business risk

B) Valuation risk

C) Credit risk

D) Market risk

 

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