The father of value investing, Benjamin Graham once wrote that making money on investing should depend “on the amount of intelligent effort the investor is willing and able to bring to bear on his task” of security analysis. He defined the intelligent investor as an enterprising individual that has the time and energy to do his or her own investment research. In contrast to the intelligent investor is the defensive investor who would prefer to have another individual pick stocks, bonds and other financial assets on his or her behalf. Hiring a financial advisor is certainly one alternative, but most retail investors (and also many institutions) prefer to hire a manager through the purchase of a mutual fund. Below is an overview of when it might be a good time to invest through the purchase of mutual funds.
Buy and Avoid These Pitfalls
There is money to be made in mutual funds, but investors fall into several pitfalls that keep them from maximizing their profits when investing in funds. Getting too focused on short-term results can be a big problem. As with individual securities, chasing performance can be a large negative when buying mutual funds. For starters, there is little evidence to suggest that a mutual fund manager that performs well for a quarter, or even a couple quarters in a row, has investment skill. As Ben Graham also points out in the Intelligent Investor, short-term fluctuations are arguably random. The only surefire way to determine if a mutual fund manager has more investment skill than luck is to measure his or her performance through a full market cycle of three to five years. A manager with a few bad quarters, but a great long-term track record, could still end up being a great mutual fund to buy into.
Investors also have a track record of chasing performance and this can have significant impacts on mutual fund performance. As alluded to above, buying into a fund following a strong short-term run and great performance is unlikely to be repeated unless the manager has a solid long-term track record. Fund flows can also end up hurting performance. Mutual fund managers in small-cap stocks can start to lag if they become too popular; with high asset levels it can become too difficult to find opportunities in smaller companies. Rapid inflows and outflows can also hurt performance because the mutual fund manager may be forced to invest new funds or sell to meet redemptions, which means she or he is forced to make buy or sell decisions that may not be based on if a stock or bond is a good value at the current price.
After Thorough Due Diligence
A defensive investor doesn’t have the time or interest to find individual securities to buy. However, he or she must still spend considerable time finding the right mutual fund to buy. This adds a layer of complexity, because instead of having to focus on an individual investment, the individual must also research the mutual fund manager, and that “manager” can turn out to be a full investment team. This research includes management’s performance track record, its reputation, how long the team has been together, and an opinion on the reputation of the mutual fund company they work for.
There are many other metrics to study before deciding to invest in a mutual fund. Mutual fund rater Morningstar (Nasdaq:MORN) offers a great site to analyze funds and offers details on funds that include details on its asset allocation and mix between stocks, bonds, cash, and any alternative assets that may be held. It also popularized the investment style box that breaks a fund down between the market cap it focuses on (small, mid, and large cap) and investment style (value, growth, or blend, which is a mix of value and growth). Other key categories cover a fund’s expense ratios, an overview of its investment holdings, and biographical details of the management team, how strong its stewardship skills are, and how long they have been around.
For a fund to be a buy, it should have a mix of the following characteristics: a great long-term (not short-term) track record, charge a reasonably low fee compared to the peer group, invest with a consistent approach based off the style box, and possess a management team that has been in place for a long time. Morningstar sums up all of these metrics in a star rating, which is a good place to start to get a feel for how strong a mutual fund has been. However, the firm admits the rating is backward-focused, which means an individual must synthesize the information into a prediction for how a fund is likely to perform in the future, which is defined as an upcoming market cycle.
The Fund That Is Hard to Beat
Jack Bogle founded Vanguard on the premise that most active mutual fund managers fail to add value for their mutual fund investors. This is largely true and has been covered at length in the financial press. It is due to a couple of key factors, one of which we identified above. Namely, many funds charge fees that are too high and eat into performance. Another key factor is whether a fund is a closet index fund. If it holds more than 100 stocks, it is highly likely that its performance will track its underlying index closely. If this is the case, it is silly to be paying a higher active fee.
For this reason, index funds may make great sense for most defensive investors. They charge low fees and are designed to match a market index. Active managers lament that this strategy represents guaranteed underperformance given the low fee must still be netted out of the index return, but it can still represent a strategy capable of beating the majority of active fund managers over the long haul.
When You Have No Choice
Of course, there are going to be times when a mutual fund is the only investment option available to investors. In this case, the decision isn’t whether to buy at all, but to pick the best fund of the bunch. Again, the starting point should be an index fund, with due diligence performed on any active fund options available. Most retirement plans are going to offer only a mix of funds, though they are slowly starting to let investors self direct into individual securities over time. The plans, including 401(k) for most corporations and, 403(b) plans for non-profit organizations are highly likely to only offer funds. Also, plan sponsors can’t provide investment advice, so you will have to go it alone and pick a mutual fund manager, based on the due diligence approach recommended above.
Active mutual funds sometimes get a bad rap as a group overall, but, when combined with index funds, they can represent a great way to get diversified exposure to just about any asset class. For instance, many international markets, especially the emerging ones, are just too difficult to invest in directly. A mutual fund can specialize in smaller markets and offer investment expertise that is worth paying an active fee for. Surprisingly, many European markets are not highly liquid or investor friendly. In this case, it pays to have a professional manager help wade through all of the complexities.
The Bottom Line
When it comes to buying a mutual fund, investors must do their homework. In some respects, this is easier than focusing on buying individual securities, but it does add some other areas to research compared to enterprising investors. But overall, there are many reasons why investing in mutual funds can make sense. In some instances it is the only choice available to investors, meaning it is indeed important to figure out how to buy the best ones.