A Mutual Fund’s Performance May Not Tell the Whole Story

Investors of individual stocks will review many aspects of a particular company before buying a specific stock. There is a lot data available about each company, including past performance, company financials, growth trends, competitiveness, product innovation, etc. Mutual Fund investors have less information available about the funds. There will be sufficient information about the fund itself and how it has performed, expense ratios, top 10 security holdings, and sector diversification.

Many investors focus on the past performance of the fund as compared to other funds as the primary means of deciding to invest. However, these investors may be shocked when the fund does not perform as expected in various stock market scenarios.

Look at what factors produced the Performance

No two mutual funds are exactly the same. In comparing two funds, an investor may find that both have the investment objective of investing in large companies whose shares are considered undervalued.  The description of the funds will be similar, leading the investor to think these funds are direct competitors. This investor will then focus on the past performance and select the fund with the better record.

Had the investor in this example looked further, he may find a wide divergence between the two funds. When reviewing funds, investors should always analyze the diversification of assets among Sectors. One of the funds may have the assets concentrated in Technology companies, while the other fund may be heavily invested in Industrial companies. The stocks in these two investment sectors will perform very differently depending upon the condition of the current marketplace. This does not mean one sector is a better investment that the other. It means that some sectors will outperform other sectors at a particular point in the economic cycle. The investor needs to understand which sectors are the most appropriate at the time of purchase and find mutual funds that are tilted toward those sectors.

Hidden Factor Affecting Performance

Along with not having sufficient information on all the companies held in the mutual fund, there is one factor that is difficult to totally understand when comparing mutual funds. This factor is confirmation that all the securities meet the fund’s investment objective. Every prospectus gives the manager some flexibility in the type of investments that will be purchased by the fund. In fact, the law states that a mutual fund may have up to 20% of its assets in securities which are unrelated to its investment objective.

The purpose of this provision is to allow the manager to use his judgment about the future direction of the market. For example, the manager of the funds described previously may have 90% of the assets invested in large companies whose shared are considered undervalued. He is following the fund’s investment objective. However, this manager may feel the stock market is in for a short term drop due to various factors. This manager may then use 10% of the fund’s assets to invest in securities which will guard against a drop in stock prices. He may use a combination of Put and Calls, or futures contracts which will increase in value should the market drop. Of course, if the market does not drop, this mutual fund will underperform since a portion of the assets would lose money if the market rises.

This type of information is quite difficult to ascertain when reading the prospectus. The prospectus will have general wording about the powers of the manager but not give specific information on what the manager is purchasing at a particular point in time. Accordingly, it is important that a potential investor search for more information about this manager.

Keep Looking for Fund Information

Additional searching can be done on the internet by reading fund reviews and participating in investment forums. While these sources may not give a complete or accurate answer, the information should give an indication of how the manager is investing and if further research is warranted. Knowing how the fund will perform vs. the overall stock market is extremely important in constructing a properly diversified portfolio of mutual funds.