Investments

January 26, 2018 / Timothy Grove

Types of Mutual Funds We Like to Avoid and Why

Here at HFA, we believe that asset allocation is the main determinant of investor returns and we therefore take great care to construct portfolios to provide proper exposure not only to the major asset classes (stocks and bonds) but to sub-asset classes within the major asset classes, as well.  We also believe in rebalancing both the major asset classes and sub-asset classes to target allocations when they get out of balance; this is in keeping with the proven strategy of selling high and buying low.

In order for us to evaluate the asset allocation of a portfolio, we need to know, with complete confidence that each fund is filling the role we intend for it; in other words, it is indeed focused on a single sub-asset class and remains focused only on that sub-asset class.  For example, in every portfolio we need a certain allocation to mid-cap value stocks.  We must be certain that the funds we choose for that sub-asset class are always investing in mid-cap value stocks and only mid cap value stocks.  This strict discipline enables us to properly evaluate the performance of a given fund against a well-defined benchmark for that sub-asset class, thus providing a fair “apples to apples” comparison.

The first type of funds that are problematic in this regard are what we call “hybrid” funds.  They have substantial (not incidental or inconsequential) underlying allocations to more than one major asset class or sub-asset class.  While they are touted as a simple way to create a diversified portfolio, they cause unnecessary difficulty in the analysis of a portfolio’s true asset allocation and are all but impossible to benchmark for performance as the indices that are used for comparison represent only a single sub-asset class. 

One type of “hybrid” fund invests in both stocks and bonds; a common example being the so-called “target date” funds.  A second type has allocations to both U.S. and international bonds or stocks; these typically have the word “global” in the fund name, while funds that invest only outside the U.S. typically have the word “international” in the fund name.  A third type has allocations to stocks across the market capitalization spectrum; that is, allocations to large, mid, and small cap funds.  These are typically known as “all cap” funds.  “All cap” funds present a unique problem, because they usually average out to be mid cap funds and are categorized as such.  In selecting mid cap funds, we must take particular care that the fund is indeed a true mid cap fund, which only invests in mid cap stocks.  Using an “all cap” fund where a true mid cap fund should be used will result in overlap with the existing allocations to large and small cap stocks.  A true mid cap fund usually has the term “mid cap” in the fund name, which is a good clue to look for. 

Of course, when selecting a fund we always meet with the fund portfolio managers and carefully read the prospectus and analysis by third-party providers such as Morningstar to truly evaluate how well the fund adheres to a set discipline.  However, a fund’s name alone often does convey a great deal about its strategy if one knows what to look for.  A fund name that is vague about what the fund invests in is often (but not always) a red flag.

The second type of fund that we like to avoid is a stock fund that exhibits an inconsistent style or market cap as shown on the Morningstar Style Box.  Like a tic-tac-toe box, it is composed of nine squares.  The rows show market capitalization; from top to bottom, large, mid, and small cap.  The columns show style; from left to right, value, blend, and growth.  So, for example, a large cap value fund will land in the upper left square.  We prefer funds that always land in the same square, which shows that the fund manager stays true to a sub-asset class, even if that sub-asset class is out of favor.  Sometimes a fund manager whose strategy is out of favor may try to add some stocks that are in favor, which may be indicated by the fund not staying in the same place on the style box.  Another common cause of style box wandering is a small cap fund that has allowed itself to become too big and is forced to invest in mid cap stocks.

The final type of fund that we wish to avoid is the kind that has too narrow a focus.  These are funds that invest in stocks only from a certain sector or industry (such as technology or pharmaceuticals) or a certain country or region of the world.  Similar to investing in individual stocks, we feel that these funds represent more of a “bet,” which we believe is best left to the managers of diversified funds within a sub-asset class. 

At HFA, we place great importance on proper asset allocation and a well-thought out portfolio construction process.  It is therefore necessary that we avoid the investment vehicles that make this more difficult to accomplish. If you have any questions on this or anything else related to your portfolio, please give us a call (610-651-2777).  We are happy to help!

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