Mutual Funds Explained: Options in Your Retirement Plan

No doubt about it, your options in your retirement plan are about to change. There could be some questions about whether they need to or not. But rest assured, the effort is under way and many of these changes will not be seen as beneficial for the majority of us.

Cost cutting is one of the ways businesses had hoped to survive the economic downturn that is now a year old. Payroll has been chopped (including paychecks), inventories have been reduced (to accommodate the skeptical and mostly unwilling buyer at the retail level) and in many instances, the matching contribution that so many companies offered as an incentive has been greatly reduced or eliminated (and there is no expectation that this will change before 2011 0 if ever).

All of these moves have resulted in a stock market that has risen since the turn of the calendar year (the Dow is up 3,000 points since January). This vote of confidence by investors has encouraged companies to continue to trim any portion of their balance sheet that might be too costly. Keep in mind that these moves do not grow a business; they merely sustain it. Keeping it propped up in this way is a topic for another discussion. But the trend is alarming.

This cost-cutting mentality has found its way into your 401(k). In the coming months, expect the recent trend to continue. One way of doing this is to add funds with lower costs. According to survey conducted with 85 senior level executives (downloadable pdf), whose jobs require them to find every nickel and dime on the balance sheet, the change is just beginning.

Over half of those surveyed have or plan to make changes to their 401(k) offering by the end of 2009. Those changes will result in less equity funds available than there were just two years ago. What they plan no adding is more funds with longer durations, such as bond funds with long maturities.

This change has resulted in the firing (and in some cases the hiring) of different fund managers. This change has seen a net decrease in the equity side of their offerings in favor of fixed income. Domestic equity funds were reduced as a result of such moves by almost 20%.

These changes have also impacted the default investment side of the equation. Ninety-three percent of those surveyed now offer a default plan for those who have not signed up with 71% of those plans directing their employees to target-dated funds.

These execs also plan on implementing a stress test to these plans in an attempt to insure that certain predetermined funding requirements are met. This move does not necessarily offer additional disclosures for plan participants, ebven as Congress is looking into requiring such actions.

While taking fiduciary responsibility has been lax in the past, numerous companies are looking at adding some sort of monitoring system to protect their risk of liability for not doing so. According to Carl Hess, global director of investment consulting at Watson Wyatt “The uptick in activity could be a sign that many funds were caught off guard by the crisis and are now trying to mitigate their risk exposure."

Mutual Funds: The Alternate Universe

Numerous investors are now seeking safety in their strategies, foregoing risk in favor of what is often referred to as value. Warren Buffet is often considered one of the great value investors, specifically looking for what is known as absolute value.

The strategy employed by fund managers in these types of funds does, in fact come with some risk, although the name suggests otherwise. Buying value is not as easy as it appears, requiring the fund manager to look at certain key aspects of the companies they are investing in before making a decision.

Absolute value funds look for stock prices that are selling for substantially less than what they perceive the company to be worth. This is no easy feat. It involves not just looking at the relation of the company's stock price relative to its peers on the S&P 500 but using a view of the assets involved, the business's balance sheet and the overall growth prospects. To do this might mean that a great deal of potential earnings in the share's price will be ignored in favor of the safety of basic material type investments. (A good example is the avoidance of tech stocks in the late nineties.)

Absolute Value fund managers pride themselves on ignoring market fads. Looking instead for out-of-favor p=companies, the manager of an absolute value fund will look to a long-term outlook as opposed to the short-term gains a market might offer.

Relative Value funds do something similar by looking at the dividend payouts for funds and using them to bolster the often slow rise of the company's share price. Dividends provide a big safety net for investors in these types of funds, even as a good many of the S&P500 companies cut them. Most fund managers will set a 2% dividend threshold when looking a dividend paying shares. (Rule of thumb for the average investor: a dividend in excess of 5% is often a warning sign of trouble ahead, even for value managers.)

Jean-Luc Nouzille, Portfolio Manager and Founder of Bristlecone Value
Partners, LLC offers this take on value investing: "The key emphasis for every absolute value investor is definitely the idea of investing when the
risk/reward situation is attractive. We believe that our first layer of risk management is the analytical work that we do on a company that we consider for
investment — looking at the balance sheet and the competitive situation and buying them at a big discount to what we think they are worth. Historically when you do that, the downside risk of those types of investments tends to be lower than the upside potential. So this emphasis on protecting your principal when you invest at a discount is a key to our process."

Be aware that this is not a stand alone strategy - a worry that many who look at the name, the idea of protecting principal, and the philosophy of this investment style - is not the only fund you should hold in your retirement portfolio. Newer funds claiming to be absolute value investments have seen huge inflows of mutual fund money. Some funds, like those recently launched at Putnam have offered targeted returns of up to seven percentage points over US Treasury bills.