Monday, August 12, 2013

Mutual Funds: Behind The Curtain (3)

WALL STREET SMARTS, THE BLOG, IS NOW WALL STREET SMARTS, THE BOOK.  FULLY EDITED AND REVISED WITH NEW MATERIAL ON AMAZON

John C. Bogle, the founder of The Vanguard Group, decried some investors' habit of only focusing on past performance when looking for a mutual fund.  He labeled it, "a flawed and counterproductive way to select a mutual fund."  He recommended looking at a fund's structural characteristics as well as performance in his 1994 book, Bogle on Mutual Funds New Perspectives for the Intelligent Investor.  He suggests every investor check the following when looking for a suitable mutual fund.

Three of the most obvious characteristics are the size of a fund, its age and the tenure of the managers.  Bogle suggests investing in funds in existence for at least five years which have more than $50 million and less than $1 billion in assets.  you should also look to see how long the portfolio manager or the team of managers have been running the fund.  Assume that the past performance of a fund is due for a change if the managers who generated those returns are no longer in charge.  Another characteristic to consider is the cost of owning shares in a fund.  Are there sales charges when you buy and redemption charges when you sell?  Search for "no load" funds.  Funds are required to publish their expense ratios, so an investor should compare them when deciding between a number of funds.  The lower the ratio, the more money remains for the investor.

Of primary importance is the fund's portfolio of stocks.  The investor must learn a fund's cash position, since all funds have to keep some cash reserves.  As Bogle points out, it makes no sense to pay advisory fees to someone just to hold cash.  Avoid funds with cash positions of more than 5% of total assets.  Portfolio concentration is another area to investigate.  The investor should look at the top ten stock holdings of a fund and determine what percentage of the total portfolio these ten holdings represent.  If the top ten stocks comprise more than 50% of the total holdings, Bogle feels that there is a good possibility of the fund providing extraordinary performance.  Unfortunately, that performance can be either positive or negative.  Also check to see if the fund is really a disguised "sector" fund, with a concentration in only one or two industries.  Another important characteristic is the market capitalization of the stocks in the portfolio.  Bogle points out that an average market cap of $5 billion to $8 billion is what you will find in a typical stock fund.

Since taxes and expenses must be considered, the investor should also confirm a fund's turnover rate.  How often are the securities in a fund purchased and sold?  A fund devoted to a long term strategy will have a lower turn over rate than a fund devoted to quick trading profits.  The more trading, the higher the costs and the larger the tax bill for capital gains.

In short, investing in a mutual fund requires as much research and study by an investor as when he or she is purchasing an individual stock.  If an individual must work just as hard for either type of investment, is there an easier way?

The answer is yes.  Look to index mutual funds.  We will consider these in the next post.

Comments are always welcome.

 

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