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Mutual fund investing requires the same careful investigation.  You need to do more than give a fund a surface level once-over before investing in it.  Knowing that the fund has been a good risk-adjusted performer in the past isn’t enough to warrant financial risk.  You need to understand what’s inside its portfolio today, or how it invests.  

Such information, which tells you how your fund will behave, helps you set realistic expectations for your investment.  A fund manager who quickly buys and sells a compact portfolio of high-priced, fast-growing companies will produce different results from a manager who owns 300 stocks of larger companies with lower earnings but cheap prices.  Unless you know what a fund owns, you can’t determine what role the fund fills in your portfolio.  For a fund to fill the large-cap growth portion of your portfolio, you need to know that it actually invests in large-growth companies.  Finally, examining a fund’s portfolio can tip you off to risks the fund may be harboring, risks that might not have surfaced yet.

Mutual funds are only as good as the people behind them, the fund managers.  Managers are the people who decide what to buy and what to sell, and when.  Knowing who calls the shots and for how long is a key to smart mutual fund selection.

Here are a few questions to ask before buying a fund: 

• How has the fund performed?

• How risky has it been?

• What does it own?

• Who runs it”

• What does it cost?

There is no ideal number of funds to own.  What is of utmost importance, is how diversified your portfolio is, regardless of how many funds are in it.  If all of your funds were growth funds or were overweighted in a particular sector, you could own dozens of funds and still not be adequately diversified.  Conversely, a one-fund portfolio could be better diversified than a multi-fund portfolio, if that one fund were an index fund covering the entire stock market.  

Building a Mutual Fund Portfolio 

How to invest depends on who is doing the investing.  There is just no one-size-fits-all.  There is no one “correct” way to building a mutual-fund portfolio.  Putting together a group of mutual funds is a matter of personal preference and personal goals.  But there are some universals you should think about when choosing and combining funds. 

Define your objectives and priorities.  This is probably the toughest part of the investing process, sitting down to figure out why you’re investing, what you’re investing for, and how much money you’ll need to reach that goal.  Your goals and your risk tolerance should then determine what your portfolio looks like.

Your goals and your tolerance for ups and downs might not be in sync.  You may find that you can’t image losing 20% in one quarter, but you need to invest aggressively to have a shot at accumulating the return you’ll need to reach your goal.  If so, you will need to compromise by either accepting the risk or changing your goal.

Time plays a part, as well.  If your goal is to retire in 30 years, you might be more willing to take on volatility, since you can spread your risk over a long time period.  If you suffer a loss, you will have time to make up for it.  But if your goal is just 5 years away, taking on more risk might not be a good idea, because you have less time to make up for any losses.

Avoid Portfolio Overlap  

You have determined your investment goals, figured out how much you’ll need to earn to reach them, and matched appropriate investments to those goals and your risk tolerance.  Your portfolio is built.  Now you need to monitor what you have created.

One of the first problems you may face is having one or two individual stocks, investment styles, or sectors over-represented in your portfolio.  After investing for a while, investors often find that though their funds may have different wrappers, many have similar content.  In other words, these investors have portfolio overlap.   Do you favor one or two sectors over others? 

Let’s take a look at technology as an example.  Technology is a wonderful long-term return story.  Many fund managers invest in them.  Growth funds usually carry large tech weightings, with their lofty prices and earnings expectations, tech stocks certainly qualify as a growth vehicle.  There is no wonder the average large-growth fund keeps more of its assets in technology stocks—37% as of mid-2000—than in any other sector of the market.  For comparison, the S&P 500 index has about 30% of its assets in techs.  Mid- and small-growth funds hold even more of their assets, about 40%, in tech names so if you own multiple growth funds, chances are you own lots of technology.

Do you own too many large-cap funds?  Large-cap offerings make great core holdings, but don’t overdo on them—especially large-cap offerings from the same fund family.  The large-cap universe is relatively small.  Less than 10% of all stocks can be classified as large cap and only 1% as large-cap blend.  A fund company’s managers tend to draw upon a unified research pool, so there is a high possibility of overlap if you buy multiple large-cap funds from a single family.  The odds of duplication rise astronomically if you stick to large-blend funds, the universe of the S&P 500.  In fact, it’s hard to think of any justification for owning more than one large-blend fund So once you have picked up a large-value and a large-growth fund, or a single large-blend fund, start looking at other options.

While most of us can agree on what to look for when buying a fund, good risk-adjusted returns, long manager tenure, etc., we part ways on when to sell.   None of us wants to be one of those investors who undermine his or her returns by buying and selling at the wrong times.  Yet some situations almost demand that we hit the sell button.

When to sell a fund 

• The fund loses more than it should.  For example, a fund loses more than 25% in a year in which its average peer suffers a much slimmer loss.

• The fund changes its strategy.  You buy a small-value fund because you want exposure to small-value stocks.  If the manager suddenly starts buying large-growth stocks, you may have a problem if you already have a large-growth fund in your portfolio.

• The fund underperforms for a long period.  While one year of underperformance may be nothing to worry about, two or three years of falling behind can get frustrating.  The urge to sell intensifies.

• Your goals change.  If you were investing in a bond fund with a goal of purchasing a house, and your partner already owns a house, you may decide to use that money for retirement instead.  In that case, a stock fund may be more appropriate.

• You just can’t take it anymore.  If your fund is so volatile that you’re developing ulcers, then by all means sell.

Buying mutual funds eases and investor's hesitancy to invest in bear markets.  An important reason for investing in mutual funds is the immediacy of diversification.  Hence, your financial risk is minimized.  Your investment professional can assist you in investigating appropriate mutual funds for your portfolio. 

This article was published in The Network Journal. Jodye Deal, contributed this article for the New York-based magazine.  If you have questions on investing, please send them to Investing@GazelleAssociates.com.

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