We work with many women who are relatively new to investing and often want to know more about the investments that make up their portfolios. With literally thousands of investments from individual stocks like Google and Apple to bonds and mutual funds, the best way to know what to look for is to understand the basics of what the investment pros look for when investing money.
To keep things simpler, we will focus on mutual funds. There are certainly other appropriate investment vehicles that we use in building our clients’ portfolios such as individually managed securities, exchange traded funds (“ETF”), private real estate and equity deals, but overall, mutual funds comprise the largest share of our clients’ portfolios and are what many investors are familiar with when investing their 401k or retirement accounts.
What is a Mutual Fund?
Simply put, mutual funds are professionally managed portfolios that pool money from multiple investors to buy shares of stocks, bonds or other securities. Each fund has different and well-defined investment objectives. For instance, the managers of a fund may decide to focus on US large cap stocks, high yield bonds, or short-term debt. Each investor is a shareholder in the fund and the fund’s total market value is the sum of all the underlying investments.
Individual stock (or bond, etc.) prices fluctuate throughout the day and can be bought and sold at any time during the day over exchanges, like the New York Stock Exchange. Since mutual funds are made up of many securities with many values, trades must be made directly with the fund once per day after the market closes so that the prices of the securities that make up the fund can be calculated. If you decide to sell shares in a mutual fund at any time during the day, your trade will be executed at the next available net asset value (“NAV”) after the market closes and can be higher or lower than the previous day’s closing NAV. Think of ‘NAV’ as the book value or share price which is just the total market value of the underlying portfolio holdings (less any liabilities) divided by the total number of shares.
The Pros and Cons of Investing in Mutual Funds
The primary advantages of investing in a mutual fund are diversification since the funds invests in multiple securities, not just one like owning a single stock; skilled professional management; lower trading costs since transactions costs are spread out over a large pool of shareholders and liquidity (most mutual funds have daily liquidity, and should you decide to sell, you can usually get your cash within 3 business days).
Disadvantages typically relate to potential tax-inefficiencies. Since you don’t control when the underlying investments are being sold, investors in a mutual fund may not be aware of capital gains triggered by sales until they receive a 1099 from the fund. This can make tax planning more difficult. There are also also the costs of creating, distributing and running a mutual fund that are passed on to investors.
Before We Dive In – Know Your Investment Goals
It goes without saying that before an investment advisor begins selecting mutual funds for a client’s portfolio, they would sit down and discuss specific goals, risk tolerance, time horizon (the longer the better) and the importance of combining multiple asset classes to create a well-diversified portfolio.
Combining Passive and Actively Managed Mutual Funds
There’s a lot of debate about whether it’s better to have an equity portfolio that is passively managed—to track market indexes (such as the S&P 500) at a very low fee or actively managed—to seek outperformance and greater flexibility (such as a specific emerging market or concentrated portfolio) at a higher fee. We believe there’s room for both in a well-constructed portfolio. While passive indexing is best used to capture broad market returns, there are certain markets that are inefficient enough to create opportunities for outperformance by highly skilled managers. The challenge is finding an exceptional active manager who is able to outperform their benchmark over the long term.
How To Analyze a Mutual Fund
There are several ways to obtain detailed information on most mutual funds – you can go directly to the mutual fund’s website to pull a specific fund factsheet, use the research tools on your custodian’s website or use an independent research firm such as Morningstar that compiles and analyzes data for thousands of mutual funds it covers. At a minimum, you should review an updated fact sheet of your specific mutual fund to analyze different data metrics. Many investment advisors do extensive due diligence including regular calls with the fund’s portfolio team, comparative analysis with peer funds and of course, review of the fund’s prospectus and annual report which contain a lot of valuable information.
So, what should you consider when evaluating the funds in your portfolio? I’ve provided a few broad guidelines that an Investment Advisor looks for when selecting a mutual fund. While these don’t represent an exhaustive list of all the research criteria that can be done, they will familiarize you with what to think about and an explanation of some of the terminology used by investment advisors.
Thinking like an Investment Advisor when constructing portfolios using mutual funds is both an art and a science. While most people don’t have the time or resources it takes to do all the analysis required to create a sophisticated investment portfolio, it’s important to be aware of the terminology and the quantitative and qualitative tools when deciding what to invest in.
One final note—once invested, it’s critical to regularly monitor your results, make changes as warranted and rebalance asset classes as they get out of alignment. Hopefully, your Investment Advisor is doing the detailed fund research so that you, as the client-investor, can benefit from their expertise.
Consider this your training manual to get and stay financially fit for life!