Introduction to Mutual Funds

If you know absolutely anything about investing, then you have probably heard of mutual funds. Once an obscure investment vehicle, they are now popular with almost all investors. If you ask your average investor whether they have any of their investment dollars allocated to a fund, they will likely answer yes. There are literally trillions of dollars of American money currently invested in mutual funds.

Funds have made investing for the average investor a little less complicated. A person no longer has to sift through stocks individually in the newspaper or spend hours watching the financial news on television. You can simply select a diversified fund that contains a bunch of different stocks of companies that fit into a certain paradigm, such as a fund containing nothing but small cap stocks, mid-cap stocks, large cap stocks, technology stocks, bonds, etc.

A mutual fund is really an investment company in and of itself, with a manager and other officers who administer it. When you buy shares, you are buying a portion of the holdings of the fund, which contains many different stocks and bonds within the portfolio. And, just like with individual stocks and bonds, your shares increase in value when the share price of stocks within the portfolio appreciate, or when interest payments are made on the bonds. As with stocks, you can sell your shares in a mutual fund at any time.

There are many different types of funds. They vary based on composition (stocks, bonds, or fixed income securities such as money market instruments), and strategy. Some funds, as already mentioned, invest in companies that have a particular market capitalization (i.e. large cap, mid cap, small cap). Other funds invest solely in foreign companies, while some invest in certain sectors within the economy, such as the financial, technology, or industrial sectors. Also, some mutual funds may pick companies based on ideology, such as a socially responsible or environmental fund. There are also index funds that simply invest in companies that are contained within a certain index, such as the Dow Jones, or the S&P 500.

A mutual fund is really an investment company in and of itself, with a manager and other officers who administer it.

The most important thing to understand when looking for a mutual fund is the cost structure. There are four expenses you need to review before investing. The first is the management expense, which is a charge assed on your money to pay the manager of the fund. The second is the administrative fee, which is usually assessed annually to cover the costs of mailings, postage, etc. The next fee is the 12B-1 fee, which covers the cost of marketing and promotion. And finally, there are sometimes front-end loads and back-end loads. A front-end load is a sales commission charged as soon as you open the account and invest your money. A back-end load, also known as a deferred sales charge, is assessed on your money when you close the account. Back-end charges vary depending upon how long you have had the account.

I hope this information has helped you to familiarize yourself with mutual funds. Try to set aside some money for investing and start while you are still young. The earlier you begin, the more money you can potentially make down the road. Carefully examine the fee structure and investment strategy before investing and you should do fine.

The Best Mutual Funds to Diversify Your Investments

Almost any article you read about building your investment portfolio will tell that you need to build a diversified portfolio. They follow that up with some rule of thumb about putting some percentage in stocks and bonds, or buying 8 stocks from different industries, or putting 5% in precious metals and international stocks.

Here we will analyze the best mutual funds for diversifying your portfolio, and we will put try to quantify the impact, so you can see for yourself the improvement to not just the total return but the reduction in portfolio risk that you can get by properly diversifying.

The key to diversifying a mutual fund portfolio is finding alternatives to the mutual funds that you already have that not only have good returns, but are not correlated to your current holdings, that is their day to day fluctuations in value do not track another of your existing mutual funds.

For this example, we will use the Fidelity mutual fund family. There are over 100 Fidelity equity mutual funds alone, including the Fidelity Select Funds. This gives us a large universe of diverse options that should allow us to find the best mutual funds for our portfolio.

Let's start with a basic diversified portfolio of 70% Fidelity FSMKX, which tracks the S&P 500. Add to that a 30% holding of bonds, Fidelity Bond Index (FBIDX). This portfolio, if rebalanced quarterly from 1995 to 2005 inclusive, returned 11% annualized. The maximum drawdown (that is the most its value dropped from a previous peak) would have been 30% or almost 3 times the annual return. That of course was after the over 2 year bear market from March 2000 to October 2002 (note that the S&P 500 had a 50% drawdown. Steep as that was, it was better than the Nasdaq 100 at almost 80%).

Next we calculated the correlation of the Fidelity Equity Funds to that portfolio. We also screened out some of the more volatile Fidelity Select Family. The best Fidelity funds with a very low correlation to our portfolio were the Fidelity Real Estate fund and Fidelity Health Care fund. Both of these Fidelity funds have a long history (over 15 years) of providing above average returns with acceptable drawdowns.

We constructed a new diversified portfolio by adding 15% of each of these funds, and redistributing the rest. The allocation was:

50% S&P 500 index (FSMKX)
20% Fidelity bond index (FBIDX)
15% Fidelity Real Estate (FRESX)
15% Fidelity Select Health Care (FSPHX)

For the same 11 years 1995 to 2005 inclusive, the portfolio was again rebalanced quarterly. The return was 12.5% per year, 1.5% better than the basic portfolio. In addition, the drawdown was reduced to 24%, as opposed to 30% before. The drawdown is now only 2 times the annual return, a significant improvement.

The real power of diversifying your portfolio comes when we choose low correlation between our investment holdings. This is the key to making diversification work by increasing returns while reducing risk. Choosing the best mutual funds requires that we find a fund family like Fidelity mutual funds that has a broad choice of sector mutual funds to allow the choice of the best mutual funds to diversify our investments.

 

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