There’s around $10.5 trillion invested in mutual funds, according to the Investment Company Institute and tragically, many investors own funds with undesirable characteristics.
What are these mutual fund warning signs?
#1 – Rapid-Fire Trading
Financial hypocrisy abounds on Wall Street and mutual funds aren’t immune. On one hand, fund investors are told to be long-term investors, yet many mutual funds are managed like a quick game of poker. A gander at your mutual fund’s turnover ratio will tell you if your fund manager is investing or speculating.
The turnover ratio reports the fund’s trading activity by computing the lesser of purchases or sales and dividing the figure by the fund’s average monthly net assets. (Securities with short-term maturities of less than a year are excluded.)
“A turnover ratio of 100% or more does not necessarily suggest that all securities in the portfolio have been traded,” according to Morningstar. “In practical terms, the resulting percentage loosely represents the percentage of the portfolio’s holdings that have changed over the past year.”
Funds with a lower turnover rate of 30% or less point to a buy-and-hold strategy whereas funds with high turnover of 100% or more indicate a short-term trading mentality. The best source for turnover levels is to read the financial highlights section of your mutual fund’s annual report.
#2 – Underperformance vs. Benchmarks
Many mutual fund analysts lead their followers astray by focusing on mutual fund performance relative to its corresponding peer group, when the true measure of performance should be fund performance versus a corresponding benchmark index. Don’t make the same mistake.
“Peer group” comparisons are dangerous,” stated William F. Sharpe, Nobel Prize Winner in Economics. “Because the capitalization-weighted average performance of active managers will be inferior to that of a passive alternative, the former constitutes a poor measure for decision-making purposes. And because most peer-group averages are not capitalization-weighted, they are subject to additional biases.”
How would this work in real life application?
The performance of a popular large cap growth fund like the Fidelity Magellan Fund (NASDAQ: FMAGX) should be compared to corresponding large cap growth index funds like the iShares S&P 500 Growth Index Fund (NYSE: IVW), Schwab U.S. Large Cap Growth ETF (NYSE: SCHG) or the Vanguard Growth ETF (NYSE: VUG). Always make sure you compare performance over the same time period.
Also, don’t make the mistake of comparing everything to the S&P 500 SPDR (NYSE: SPY). For instance, you should compare international stock funds to international stock yardsticks like the MSCI EAFE index (NYSE: EFA). Likewise, small and mid cap stock funds should be benchmarked to small and mid cap index funds like the MidCap SPDRs (NYSE: MDY) or the iShares Russell 2000 Index Fund (NYSE: IWM).
Most active funds consistently underperform versus identically matching index funds, but you’ll never know it unless you check.
#3 – Straying Away from Investment Goals
Style drift happens when a mutual fund deviates from its primary investment objective to pursue something else. Not only is it misleading to investors but it’s equivalent to breaking rules in the middle of the game.
Sadly, style drift is quite rampant. It’s not uncommon to find so-called value funds owning growth stocks and so-called growth funds owning value stocks. In fact, style drift is so dangerous it’s even perverted fund classifications. Mutual funds erroneously categorized as domestic funds often have significant holdings in foreign securities. How could it be?
From a portfolio management angle, style drifting mutual funds complicate the job. You may own a domestic stock fund that holds 20% in foreign securities which throws your portfolio’s asset allocation out of whack. It may also increase your financial risk to assets you never planned to own. The best way to avoid asset style drift is to own funds that stick closely to their investment objective. Index funds and ETFs fit the bill.
For your own good avoid mutual funds with undesirable attributes. In the end, your money will be much happier and there’s an excellent chance you’ll be too.
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