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.

Time To Take A Step Back

Hello again. I know it has been some time since my last post, but I’ve been delving into the market trying to pull some nuggets of knowledge out of the craziness that presents itself before us. As a side note, I hate the word “nugget” when referring to knowledge or information. I’ve noticed that in the workplace, it is often used in this manner. To take it a step further, I find it strange that lingo, phrases and gestures are often adopted by all employees at a given firm. I’ve made it my goal to not fall victim to the brainwash that is apparent at these locations. People at my company, and I’m sure at many other companies, use the phrase “Going Forward”, which sounds so corporate. I prefer “From Now On”.

Anyway, back to business, if you want to call it that. I’m sure many of you are flying high over the recent 1500 point climb by the DOW from its 2009 low. Don’t get too pleased with yourself just yet. If you dumped all of your money in around the middle of March, then slap yourself in the face. That is irresponsible and you will most likely lose money in the long run, because you will stay in too long when the market drops. It would be a good idea now to take some of the profits you have made during this recent rally. The market has risen about 25% in the past month, but do not assume this is a sign of turnaround. There is still plenty of trouble on the horizon, but the one thing you can take solace in is that the worst appears to be over in the short-term.

Typically, the market turns around before the economy turns around. Even though the market has come back in a big way the past 4 weeks, the one problem with it is that it is still volatile. Companies are still reporting poor numbers overall (yes, there are a few that have come through very well, especially Wells Fargo) and the job market continues to decline. Will the market continue to rise, perhaps (in the short-term), but it can also crash back to the previous low as well. All it takes is some big companies coming up short on their quarterly numbers and a larger than expected job decrease and you could see this plane crash into the mountain. The market needs to stabilize first, before you can have warm, fuzzy feelings about the economy. We can’t have the 1%-3% daily swings up and down.

The financial health of the largest banks needs to be accessed before any hope of a recovery in the near future can be established. Yes, Wells Fargo posted a nice profit in the first quarter, but Bank of America, Citi, just to name a few need to show stability and the willingness to start lending again at reasonable levels. Once this happens, the gears will start turning and the economy should start the process of climbing back up out of this hole.

Remember, the market will recover before this process of economic recovery occurs. If you buy incrementally like I have been preaching, then your chance of buying at or near the bottom is much greater and it will help keep your cost per share down as well, thereby increasing your overall return. Make sure you do not take this strategy to the extreme, because you will rack up ridiculous amounts of transaction costs. Most online brokerages charge a flat fee for each trade, so the smaller your dollar amount, the more of a return you’ll need to establish in order to offset the commission costs. Everyone is different and has different goals. Find out what is the appropriate amount of money to use per trade and how often you will be buying. The way I look at it, is that the higher the amount of money you invest per trade, the more frequently you can buy in, because the percent gain you’ll need to offset the commission is much smaller.

I, for instance, use ING Direct, which you can set up auto-trades every Tuesday during the month and four bucks a pop (real-time trades are $9.99 each). I trade in $500 increments (usually). So my net investment is $496. In order to offset the commission charge, I only need to obtain a return of .081% on my investment. If you trade in $100 increments, you would need a return of 4.2% on your $96 net investment to break even. The biggest drain on long-term earnings are commission charges and taxes. Good luck navigating this market. Patience and cash rule!