The Unspoken Risk of Owning Mutual Funds – Fund Management

Many taught the benefits of owning Mutual Funds. Investing in such financial instruments allows you to diversify your portfolio at a fraction of what it would cost to invest in the individual company stocks yourself. Truly, they are one of the best methods for investors, especially for new investors, to build a great portfolio. But beware of the little spoken risk involved in owning Mutual Funds: The Risk of Fund Management.

Although Mutual Funds are constantly evaluated on a fund’s performance, such evaluations are based on how a fund manager performs as compared to a market benchmark (such as the S&P 500), or to another fund. Such analysis is actually an evaluation of the manager’s performance in the market. Great companies, such as MorningStar, have evolved reporting on just such analysis. But this is not the Risk of Fund Management.

The Risk of Fund Management involves events that are not necessarily analyzed, but still occur. The change in a Fund’s manager (for whatever reason), the “group think” (positive or negative) that may develop at the company operating the Mutual Fund, or the acquisition of a Fund by a larger Fund Company. In any event, there will be changes that occur. Often quick, these changes expose the investor to risk beyond just investing in the market.

In most situations, the change will be minor. A new regulation enforced in the industry would affect all. But how it is placed in service may be different for each company or for that matter for each Fund. Also, new company rules that a Fund company puts in place may impact how a Fund’s decides to buy or sell certain stocks, or how these decisions are processed can also have an impact. But one of the biggest adjustments is a change in the person or group that is running the Fund. As you can understand that two people don’t invest the same way, a change in a Fund Manager also means a change in the style of investing conducted by the Fund. Usually the adjustment period for such changes is about a month or maybe two. For the most part, if the changes were not announced to investors, most would not even know. However there are times when these changes do have a substantial impact on the Fund, and the direction that it will eventually pursue.

It is these types of changes that expose you to Management Risk. Unfortunately, being diversified in the market by owning Mutual Funds will not eliminate these types of risks. The risk comes with owning these types of investments. And having a large holding of your investable money in a fund during a transformation may result in a loss of significant portion of your money in the event the Mutual Fund experiences losses during its transformation.

So how do you protect yourself from such risk? Oddly, the answer is diversification. This time, not in just the stocks owned, but in the mutual funds owned. Buy several different mutual funds, preferably ones from different Mutual Fund companies. There are many Mutual Fund Companies out there. Fidelity, American Funds, Vanguard, Barclays, Franklin Templeton, Pimco, T. Rowe Price, State Street, Oppenheimer, Dodge & Cox, Putnum, Janus, BlackRock, Dimensional, JPMorgan, Van Kampen, Dreyfus, John Hancock, and Charles Schwab are just a few of the bigger, well-known names. There are countless other smaller funds, that perform just as good, and may even provide as good, if not better, service.

Second, each mutual fund has a particular style of investing. Some are growth oriented, some are value oriented. Some may invest in particular sector of the investing community, while others concentrate on location (region of the world) of the industry. Some seek income producing equities, while others prefer an increase in share value of the investments. And there also exists blends of each of these styles. Regardless, you would best be served by buying a variety of mutual funds, with different types of styles.

Third, the size of the mutual fund is also important. The general rule is the bigger the fund, the more stable it is. This is not always the case, but is generally true. However, the larger the fund, the less return on the investment may be encountered. It would benefit you to have a variety of big, medium and small size mutual funds. You may want to consider, that for each three mutual funds you select, you may want to pick on big fund, one medium size fund, and one small fund.

Keep in mind, that any portfolio you develop, no single investment should constitute a majority of your holdings. If you own 4 mutual funds, then no single investment should be over 50% of your portfolio. If you own 5 mutual funds, then no single investment should exceed 40% of your portfolio. A simple guide that may help is to take the number of different investments you currently have in your portfolio, divide it into 100, then double that number. An example would be say you have 8 different investments. Divide 8 into 100, which gives you 12.5. Then doubling it will give you 25. This is the upper limit for the size of the holdings as a percentage of your portfolio. In other words, no single investment, in your 8 investment portfolio, should exceed 25% of your holdings in that portfolio. If such is the case, then consider selling portions of the large holdings until the investment approaches the 12.5% of your portfolio. This is often called Portfolio Rebalancing. But in reality it is taking the profits of a successful investment and hopefully buying more successful investments for the future.

Ideally, a great portfolio has about 8 to 15 different investments, or more likely about 10 to 12 investments. Usually, more than 15, and an investor does not have the time necessary to follow up on each investment. A portfolio with less than 8 different investments may raise concerns of less than adequate diversification.

Also to ensure you are not blindsided by poor performance. Check your portfolio at least once a month. More frequent if possible. Since changes like those mentioned above usually occur in periods lasting only about 3 months or less, checking only once a quarter may not be adequate to detect performance issues before it is too late. Don’t let that happen to you.

Protect yourself and your investments. Diversify your portfolio, whether stocks, bonds, mutual funds, or other investments. Rebalance when you determine appropriate. And don’t worry, if you have a good investment, it will continue to perform for you. However, if the investment encounters a turn, such as Management Risk, you could save yourself a lot of heartache by spreading the investment money around.

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