What's a Mutual Fund Manager To Do?

This debate will never end. Actively managed mutual funds are not the easiest of animals to tame. Performance relies on a series of variables that few of us could deal with on a day-to-day basis. And in their defense, I want to offer some alternative thoughts to what you might be forming as an opinion.

Not all Index Funds or their counterparts, the ETF, are created equal.

I cringe every time I hear the description of who you are as 'the average investor'. To achieve average, you must have some comparative tool by which to determine better or best, and on the flip side, worse and worst. And of course, index funds have risen to the challenge. They pose a poor comparative tool at best. In Ruth Chang's "Making Comparisons Count" she begins with the philosophical difference between incomparability and incommensurability.

They are in fact, one in the same. These terms are often used when describing different values. In truth though, it is not the value but items that bear value. The problem is, how do you compare alternatives when you need to make a choice only to find out that the comparison of these alternatives, say Fund A, B, and C are not really comparable at all. This would leave you with no tool to make the decision.

When comparing two funds, which is more often the case - more than that and the differences become diluted - investors unwittingly employ the Trichotomy Thesis. Ms. Chang offers the following when making a comparison, "the first must be better than the second, worse than it, or the items must be equally good".

She also suggests that all comparisons may have an element of bidirectionality, a feature that allows some [of the mutual fund] to be better and some of it to be worse.

Comparing Likes

Index funds and the numerous ETFs or Exchange Traded Funds that plumb every corner of the invest-able marketplace with their version of indexing are not worthy comparisons for actively managed mutual funds.

Index funds essentially are trade-less platforms in theory and adjustable ones when the index creator decides to alter the make-up of the index. This keeps the costs down and fund in a passive state. When the whole of the market goes down, the index follows in lock-step. Sometimes. And this is where you compare likes. If the index falls and your index mutual funds falls more, you do not have the index you thought you did. If it costs more than next to zero, you do not have an index fund. If it costs more than $100 to gain access, it is not worth buying. (Note on this last item: Vanguard Group will charge you a fee if your fund falls below $3,000 in value and will continue to do so until the balance has regained that threshold.)

This is how you compare likes - similar products with near-identical traits and in the case of funds, underlying investments.

Since indexes are, for lack of a better term, alike, comparing actively managed funds to them is not only foolhardy, but a waste of time. No actively managed fund is identical to any other fund. Each is a species unto itself with the only similarities that they possess to other mutual funds is where they exist. Both humans and geckos share the same planet, but the comparisons more or less end right there.

The problems facing actively managed funds come from numerous directions. And most, if not all of these problems are a result of shareholder involvement.

Consider this problem specific to actively managed funds: The market goes up and the value of the companies in your portfolio does likewise, and because you have positioned your shareholder's money well, it does better than the whole of the market or any index. Now what? Chances are, the amount of money invested in your fund will increase, coming from current investors looking to make more than they already have and from new money. And the question might seem simple enough to answer: buy more stocks. But where?

Buying more of your winners will only propel the winner's higher. Buying an undervalued stock will also have the same effect and may, in the short-term distract your new investors when the cost of buying-in seems to be higher than they anticipated. These investors will squawk when they do not get the same returns from the previous quarter, received by the investors who were there at the beginning.

The fund has a charter and that should be followed. It is an outline of the fund's strategy and if it is a growth fund, they must find undervalued growth stocks in order to continue to... grow. What happens when they have no real good prospects? They often drift and purchase a value play or simply begin to become an index. Both are lazy moves on the manager's part but it is the investor who is forcing him in those directions.

The SEC does limit the amount of cash a fund can hold. So, it must be invested. This also generates costs in trading and research. Is it bad? Not if the fund has beat its peers. It is against similar type funds that we should compare actively managed funds.

Until that is done, the comparison between actively managed funds and index funds in simply incomparable.

Mutual Funds: Rookie Mistakes

Beginning investors are often confronted by numerous descriptions of what mutual funds actually are. Some have even gone so far as to suggest that "A mutual fund is simply a firm that collects money from investors and invests them on stocks, bonds, and other money market instruments. If you invest in one, you will be considered a share holder and your portfolio will consist of a diverse investment."

This is a very simplified description of what mutual funds are. Consider this: a mutual fund is an investment whereby like-minded individuals (those who are looking for the same exposure to risk) hire a mutual fund manager who focuses on those investment goals and seeks to grow their money. Yes, they are shareholders. But unlike folks who buy individual stocks or bonds, they only own a portion of the investment with the group rather than owning a voting share.

You will also find that numerous financial planners and professionals also oversimplify the process by touting Fidelity or Vanguard, both of which are too big for their own good as the simplest way to enter this type of investment. This overlooks numerous other funds that do just as good a job, often at a lower entry fee and with better strategies.

Index funds, such as Vanguard's 500 can be less expensive fee-wise than most of its rivals but the $3,000 to get started will keep most beginners away.

Beginning investors (who are buying funds for their retirement, a tax-deferred situation that is best suited for actively managed funds and not for passively managed ones like indexes) should look to actively managed funds for low fees and expenses compared to their peer group, managers with tenure and low entrance fees. Index funds should be kept outside of tax-deferred plans due in part because they create no real taxable situation that would be worth putting off until the future - considering the capital gains tax for long-term investors is still low and worth paying as you go.

Seeing but Not Seeing: How What You Own May Not Be What You Want.

Diversification is what we are told to do. What we usually end up doing is owning a wide variety of funds and making the assumption that we are diversified. In many instances, we could not be farther from the truth.

The problem with mutual funds, more specifically with actively managed funds is the available basket of stocks to purchase is much smaller than you might imagine. While there are thousands of companies available to buy on any one day, the majority of those companies are too small to buy in a large enough quantity and be able to do so without forcing the price of that equity higher.

This has to do with liquidity. If there are not enough shares available, a fund manager's purchase might actually increase the stock price simply because of interest in the equity. So, by default, many fund managers who look for price stability must by much larger companies. This increases the chance that your portfolio, the one with several mutual funds may actually be invested in the same stocks. This defeats the diversification opportunity and makes all of the funds you own susceptible to the same market changes.

There are some simple rules for you to follow in order to diversify your portfolio.

The easiest way to do this is to purchase funds that invest across a variety of asset classes. To cover all of the available asset classes may create diversity, it is best to focus on just three or four and stick with them. Aside from large-cap stocks, small caps and international stock funds spread the equity risk. Mid-cap funds also do this as well. But during tough economic times, the line between mid-cap and large-cap can often blur, where a large-cap might be beaten down enough that it actually qualifies as a potential purchase in the mid-cap range.

Inside a a defined contribution plan such as a 401(k) sponsored by your employer, numerous fund families are not always offered. By when they are, you should take advantage of the opportunity. In numerous instances, the cost of research is often prohibitively high. Because of that, research may be shared among fund managers within the same family increasing the chances that your fund will carry similar, if not exact holdings in different funds.

Mutual fund managers all come with a different set of investing ideas that need to form fit within the fund's charter. Once again, look for fund managers that offer you some track record, good benchmark comparisons for their performance and tenure.Use different fund companies.

Avoid filling your portfolio with winners. This type of investor behavior is often called herding and is more common than you think. All markets sectors do not perform the same at any one given time. Spread the risk among growth and value, domestic and international and large-cap and small cap funds. This will require a little due diligence on your part. In other words, open those statements. Compare the holdings side-by-side and consider the overlapping investments carefully.

I often suggest that S&P 500 index funds be owned outside a retirement account (better to pay those taxes now while the tax break is still good and because these funds do not have much in the way of turnover or high fees), freeing those investments for increased diversity and better tax-deferment. It will also allow you exposure to a little more risk (which is needed for sustained growth) and better fund diversification (across all the available asset classes).