Like any other smart investor, a mutual fund manager uses a variety of technical and fundamental indicators to assess the profitability of a stock before adding it to the fund's portfolio. However, what really drives fund managers' stock-picking decisions are the stated goals of the funds they manage. Different mutual funds are designed to achieve different investing goals, with varying levels of risk. The stocks a manager chooses are largely determined by the type of fund he manages and what he is trying to accomplish for shareholders.
Index funds, as the name implies, are built to track a specific index. Managers of index funds are required to employ a highly passive investment style because the goal of these funds is to match the index's returns, not beat them. To achieve this, the funds invest in the same securities as the underlying index. Any stocks selected by the manager, therefore, must be included on the index's roster. New additions to the fund's portfolio are the result of an identical addition to the index. If the fund sells its shares in a given stock, it is because the security has been removed from the index.
Dividend funds are popular among investors looking to supplement their annual income without much effort. These funds are designed to generate the greatest dividend yield possible each year. To accomplish this, fund managers must hand-pick the stocks with the best dividend histories and highest payouts. This may mean sticking to companies that have paid consistent or increasing dividends for a certain number of years, or attempting to pinpoint which corporate giants are poised to issue special dividends, such as the $3 per share dividend Microsoft Corporation doled out in 2004.
Growth funds are built to provide long-term gains for shareholders by investing in companies that are anticipated to increase in value over time. Growth fund managers focus on companies that are still expanding and expected to generate increased revenues, rather than those that pay dividends. Some growth funds are particularly aggressive, so managers must choose stocks based on how quickly the company is expected to expand, rather than its ability to provide long-term sustainable growth. These funds often trade securities frequently, choosing stocks or options poised for abrupt bullish spikes, and then selling after the initial price jumps and moving on to the next opportunity.
Value funds are also focused on companies with the potential for increased valuations, but the strategy of value fund managers is to select stocks currently being underestimated by the market. These funds primarily invest in stocks that are undervalued, meaning the current share price is low considering the company's financial health or dividend payment history. This often means investing in stocks that, while financially sound, have fallen out of favor with the market, often due to a poor quarterly report or changes in consumer opinion, or because investors have moved on to the next big thing.
Arbitrage funds are a newer type of mutual fund, called alternative funds, that utilize some of the strategies employed by riskier hedge funds to generate increased gains. Arbitrage funds seek to capitalize on the price differential between identical securities on different markets. This strategy requires the fund to simultaneously buy and sell identical holdings of the same security on different markets or exchanges to reap the benefit of price differences generated by market inefficiency. This can mean, for example, buying on the London exchange and selling on the NASDAQ, or buying on the cash market and selling on the futures market.
Managers of arbitrage funds must choose securities that provide the highest potential profits, meaning the price spread is as large as possible. This type of trading is most successful during times of increased volatility, for example with the stocks of companies whose futures are uncertain, are involved in merger or acquisition (M&A) proceedings, are poised to announce earnings, or are the subject of political or criminal scrutiny can be excellent candidates for investment.
The main goal of all mutual fund managers is to generate returns. However, the type of fund and the investment objectives of its shareholders are the primary factors determining how each manager picks the stocks in his fund's portfolio. Complicating matters further, each of the above fund types can be specialized to account for the risk tolerance, beliefs or market outlook of shareholders. For example, some funds invest only in companies with certain market caps, those in certain industries or those with specific corporate values or practices, such as funds that do not invest in so-called "sin stocks" such as alcohol and tobacco.