Mutual Funds: Friend or Foe?

Ah, Mutual Funds, what are we to make of them? On the one hand, they are a great and relatively inexpensive way to get a lot of exposure to the stock market without having to do diligent research on individual companies. Americans have been infatuated with mutual funds, ever since Mr. Bogle (founder of Vanguard) came out with the first mutual fund. I refrain from using the name of this mutual fund, not because I do not know it, but because I intend to prove a little known point about mutual fund names.

Here’s the skinny on mutual fund names…….the do not necessarily indicate the overall strategy of the fund and its holdings! Please, if you take anything away from this, take the previous statement with you. If a fund contains in the name the word “value”, do not assume that the strategy of the fund is to find large companies the managers of the fund deem as undervalued. If the fund name contains the word “growth” in the title, do not assume that the fund has chosen large cap stocks to help grow the net asset value (NAV) over the long term. A fund like that could be loaded with small and micro-cap stocks that are extremely risky. Many of the funds should be named “Cross Your Fingers and Hope Good Things Happen Fund”. That would be more accurate. The first thing to do when looking for mutual funds is to ignore the names. The names are a marketing ploy to get you interested and to assume a sense of safety. This is not a conspiracy theory, it is a fact, plain and simple.

What you want to look at first is the “asset class” the fund falls under. There are five different asset classes, Bonds, Large Cap, Mid Cap, Small Cap, International. These asset classes are listed in order from least risky to riskiest. The vanilla cousin (in my opinion) is the index fund. These funds mimic a stock market index (S&P 500, NASDAQ, Russell 2000, etc.). The turnover rate on these funds is low, so they more or less have a buy and hold strategy relative to mutual funds. This keeps the expense ratio down, thereby, allowing more money to stay invested. International and small cap funds tend to have higher turnovers (they trade stocks often), which increases commissions and these costs are passed on to the customer (you). The idea is that with these high risk funds; over the long term you will get a higher return than a mid cap or large cap fund.

Do not be fooled by “set it and forget it funds”, otherwise known as target date funds. These garbage funds are made up of the mutual funds that are available in your 401(k), 403(b) or 457(b) plans. They rebalance every year to become more conservative as you get closer to retirement. The problem with this is that their idea of conservative and your idea of conservative can vary greatly. Mutual funds are not guaranteed. The average 401(k) plan lost 1/3rd of its value in 2008. Some of these folks had these target date funds and now have to work 2-5 years longer before they retire in order to have enough to live on. Anyway, without further delay, I will examine three mutual funds that one of the three people who actually read this mentioned to me.

First up, CGM Focus Fund (CGMFX). To be honest, I had never heard of this fund until about an hour ago. The main things you need to look at are the asset class, the manager and the holdings. I have no idea who the manager is and really do not care. The biggest thing that jumped out at me was the holdings of this fund. I appears that the top ten holdings are mostly large cap companies, such as Abbot Technologies, Wal-Mart and McDonald’s (affectionately referred to as “Wack Arnolds”, thanks Snoop). The strange thing and alarming thing about this fund is the top ten holdings appear to make up about 75% of the overall holdings. Most mutual funds have about 75-250 stock holdings and rarely ever hold more than 5% of their assets in one stock. Abbot makes up close to 11% of the holdings. This fund actually goes against my statement of fund title having nothing to do with the fund itself. “Focus” appears to be dead on. This mutual fund is “focused” on relatively few companies compared to its peers. This fund contains financial companies, retail companies, medical companies and energy companies. The problem with so few companies is that it is feast of famine with returns. Hence, since 1999, it’s best one year return was 80% and the worst return was -49% both happened in 2007 and 2008 respectively. Also, during the past 12 months, the fund has shed 55% of the NAV. This is bad for the shareholders and good for the potential shareholders. The expense ratio is actually fairly low (.97%, 97 cents for every $100 invested), considering the turnover in the past 12 month was 504%. If you are inside 10 years of retiring or needing to use the money (remember, just because you retire doesn’t mean you have to draw on your 401(k), unless you are 70+ when you retire), I would not recommend this fund. It is way too risky for short term, but could produce some serious returns for someone 15 years + from retiring.

Second up, Fidelity Contrafund (FCNTX). This is a prototypical large cap fund. It has several recession proof companies in it’s holdings (Proctor & Gamble, Johnson & Johnson) and does not carry anymore than 5% of any one company. The fund has had the same return (or lack there of) as the overall market over the past 12 months. It has shed approximately 1/3rd of its value. The one folly I found was that is has Pepsi and Coke listed in its top 25 holdings. I guess they are using each company as a hedge against the other and are hoping soda consumption increases.

This fund has an expense ratio of .94% (94 cents for every $100 invested), however, compared to CGMFX, this fund has a lower turnover and lower volatility. Its return rage for the past ten years has been 28% to -37%. It’s up years and down years are about the same, so over the long term, the CGMFX fund might be a better bet, if you are at least 20 years out from needing the money. The major problem with this fund is that the market index it measures its performance with has beaten it handily six of the ten years. Considering you could be paying 1/4th the fees for an index fund, the index fund would undoubtedly be a much better investment over the long term.

The Contrafund name is a little strange to me. Typically, I would associate a contra anything related to investing as a fund that shorts stocks, but this one does not. Maybe the founder of the fund enjoyed the Nintendo video game contra. Too bad you can’t press up, down, up, down. Left, right, left, right, B, A, B, A, select, start and get 30 times what you started with.

Last up is the American Funds Capital Income Builder (CAIBX) (A.D., I hope this is the one you were asking about.). This fund has stocks which pay a decent dividend, which can actually coincide with the name of the fund as an income builder. The fund has a yield of 6.6%, however, do not be fooled by the dividend income yield. This fund can lose money. The good thing about this fund is that it has an expense ratio of .55% (55 cents for every $100 invested). The fund appears to be spread across the board in terms of holdings, which makes it less volatile and requires less maintenance, hence the lower ratio. This fund is also intriguing, because it has a mix of domestic and international stocks, which can make it more volatile, but the lower expense ratio makes it that much more attractive.

The bad thing about this fund is that the folks who think this fund is an income builder will view this fund as safe and loaded with bonds and cash. This fund took a 31% hit last year. Yes, it did do well during the dot.com bubble, but it is not invested the way the name advertises. If you want to build income with low risk, hit up the stable value funds. Every 401(k) has them. They basically give you an annual yield of about 4% on average. Of the three, I think this fund is the highest risk, simply because the name is misleading and the average investor would choose this without investigating.

Overall, these three mutual funds are just fine. Any mutual fund is fine to invest in, as long as you understand the holdings and risk involved. Filter out the names, because the are developed by the marketing department hoping to get silly, yahoo’s to buy in based on a name, rather than investigate the holdings.

Thanks A.D.