Mutual Funds (part G)
by
Charles Lamson
The reason so much time goes into classifying mutual funds in these posts is that it is the only way to compare two or more funds. If you want to buy an aggressive growth, mid-cap stock fund, it would be nice to line up several candidates so you can pick the best one for you.
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What we are walking through in this analysis is not a system but a survey of what makes one fund different from another. There are several systems out there that will do the classifying for you, but they will be more meaningful if you understand why it makes no sense to compare a large-cap value fund with a small-cap aggressive growth fund.
A note of caution. Just as you cannot judge a book by its cover, you cannot judge a mutual fund by its name. A common marketing trick is to name a fund something that sounds like it is in a currently hot classification when it really belongs in another based on its holdings and investment style. In the next couple of posts, we will look at a variety of fund types to get a feel for what makes one different from another.
Index Funds
As we learned in an earlier post, index funds seek to mimic a particular stock or bond market index or indicator. They do this by mirroring the holdings that make up the indicator.
For example, an index fund that tracks the Dow Jones Industrial Average (DJIA) would buy the 30 stocks that make up the DJIA in the same proportion that makes up the indicator. An S&P 500 index fund would look like the S&P 500 and would try to hold the same weight of securities as the indicator.
However, their results can be a mixed bag. Index funds that track small-cap stocks are subject to poor results due to the volatility of small-cap stocks. In addition, actively managed funds can and do beat index funds at different times.
The bottom line is that if you want an investment that is basically on auto-pilot. Pick an index fund tied to a major indicator such as the S&P 500. You should have fairly low fees and few ugly tax bills at the end of the year.
On the other hand, a young person would probably do better investing in an aggressive growth fund sheltered in a retirement program where tax issues are not as important.
The reason index funds typically beat actively managed funds is their low expense ratio. Index funds spend considerably less on research, as a rule, and much less in commissions.
Growth Funds
Ken Little relates the following story about growth funds on page 157 of his book Alpha Teach Yourself Investing in 24 Hours:
I once was involved in some market research for a mutual fund company. We used a focus group which is a small number of customers sitting around a table with a facilitator. The purpose of focus groups is to determine what your customer thinks about the product in a casual atmosphere that invites more than "yes" or "no" answers.  We were trying to get information on how our investors viewed us and what we could do to improve their perception, since we were getting ready to roll out some new funds. Along with several other people, I was behind a large two-way mirror, just like you see in the police shows. After a short time, it was clear we had a problem. Several of the folks that had invested in our growth fund had not done well. One investor summed it up quite succinctly: "Your growth fund didn't." Ouch! However, that pretty much nails the investment strategy of growth funds. These funds look for companies that are on growth tracks with consistent increases in sales and earnings.
Growth funds hope the company's stock will continue to appreciate, thus benefiting the fund and its investors. When growth companies do not grow, they get dumped from the fund. This demonstrates one of the cautions about growth funds. They can generate hefty tax bills and fees. As stocks are dropped from the fund, there is often a gain.This profit is subject to income tax or capital gains tax.
Growth funds tend to be on the risky side because of the type of companies they buy for the portfolio. Growth stocks can achieve significant gains---and suffer significant losses. The only reason for owning growth stocks (they usually pay no dividends) is their appreciation.
Within the growth category are many variations that involve more or less risk, depending of how the managers structure the portfolio. For example, an aggressive growth fund invests in only, or predominantly, small-cap stocks. These types of stocks can be highly volatile.
Growth funds often distinguish themselves by the size of the company they invest in and whether they narrow their selection process to particular industry groups or geographic areas.
Growth funds are probably best housed in a retirement account, where they will have many years to grow and tax consequences will be deferred.
*SOURCE: ALPHA TEACH YOURSELF INVESTING IN 24 HOURS, 2000, KEN LITTLE, PGS. 155-158*
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