This week’s post is a summary of a fantastic article by Glenn Curtis at Investopedia. It gives advice on what to look for when choosing your investment strategies and how to properly look at potential funds:
Mutual funds work by pooling the cash from several investors to an investment product that invests in a group of assets.
What are you trying to accomplish?
- Decide what you are investing towards: long term gain, current income, etc.
- What is your risk tolerance? Can you accept dramatic swings in portfolio value?
- What is your time horizon? How long would you like to hold the investment?
- You want to have an investment horizon of at least five years to mitigate most mutual fund sales charges
- Growth funds
- Goal of capital appreciation. Long term investments with relatively high risk and volatility
- Time frame for this holding type should be five to ten years at least
- Typically, do not pay any dividends, so is not good as an income portfolio.
- Goal of capital appreciation. Long term investments with relatively high risk and volatility
- Income Funds
- Consist of Government bonds and corporate debt.
- Generally, have less volatility
- Low or negative correlation to the stock market
- Bond funds can incur risk from
- When interest rates go up, bond prices go down
- Credit rating lowering adversely impacts the price of bonds
- Risk of issuer defaulting on debt obligations
- Risk of bondholder paying off principal early to take advantage of lower interest rate. Investors likely to be unable to reinvest and receive the same rate.
- Bond funds can incur risk from
- Consist of Government bonds and corporate debt.
- Balanced Fund
- Invests in both stocks and bonds and is generally less risky.
Fees and Loads
- Fees are charged by the mutual fund company to make their money.
- Load will either be charged at the time of purchase or upon the sale of the investment.
- Front-End load is paid out of the initial investment when you buy the shares.
- Back-End Load is charged when you sell your shares in the fund.
- Back end load typically happens if the shares are sold before a set time period to deter investors from buying or selling too often.
- Front Ended shares are identified as A class shares
- Back Ended shares are identified as B class shares
- Typically charge between 3%-6% of amount invested, but can charge as much as 8.5%
- Level Load Fee
- Annual charge amount deducted from assets in the fund
- Class C shares carry out a level-load fee
- Annual charge amount deducted from assets in the fund
- 12b-1 fees are charged by other funds. These are considered to be the operational expense ranging from .25%-.75%
Passive or Active Management
- Actively managed funds
- Portfolio managers make decisions about which securities and assets to include
- Seek to outperform a benchmark index with expense ratios ranging from .06%-1.5%
- Passively Managed Funds (index funds)
- Track and duplicate the performance of a benchmark index
- Usually lower fees around .15%
- Do not trade assets often unless the benchmark index composition changes
- Could consist of thousands of holdings, resulting in a well-diversified fund.
Evaluating Managers and Past Results
- Is the fund manager’s results consistent with general market returns?
- Was the fund more volatile than the major indexes?
- Is there unusually high turnover?
Size of the Fund
Size of the fund typically does not matter that much
History often doesn’t repeat
Past performances do not guarantee similar future performances.
What really matters
- Look into factors that can influence future results
- Morningstar star rating based on risk-adjusted returns
- Such as the Alpha
- Strategy’s ability to beat the market (performance)
- Beta
- Measurers the overall volatility/risk
- R-Squared
- Percentage of a fund/security’s movements that can be explained by movements in the benchmark index.
- R^2 = 1-(Expected Variation/Total Variation)
- Percentage of a fund/security’s movements that can be explained by movements in the benchmark index.
- Sharpe Ratio
- Adjusts performance for excess risk that was taken by the investor.
- Such as the Alpha
- Morningstar star rating based on risk-adjusted returns
Looking at the information on a fund page can be overwhelming, hopefully this summary can simplify some of the more confusing points!
Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. Investing in mutual funds involves risk, including possible loss of principal. There is no guarantee that any investment strategy will be successful or that the state investment objectives will be achieved.