Mutual Funds

April 3, 2014

Investment Newsletter for the end of March, 2014

Last month I started talking about risk. I argued that there are two kinds of risk.  Individual company risk, which can be diversified away with mutual funds and market risk, which cannot be eliminated.   The example for the first would be BP when their oil platform blew up.  Since you have (hypothetically) 100’s of other stocks, BP’s crash did not upset your total very much.  The example for the second would be the towers getting hit.   If the whole market crashes, it does not matter how many stocks you own.

The profit for a portfolio is the weighted average of the pieces.  There is no reward for the portion of risk that you can rid of.  Since I can eliminate a portion of the risk by diversifying into many issues with no drop in average profit, I choose to diversify holdings.  I could buy many stocks of different kinds and self-construct a diversified portfolio.  This method is very common among the ultra-rich.   I choose to use mutual funds to achieve diversification.  Rather than buy 100’s of stocks for a client, I buy 4-10 mutual funds.

A mutual fund is just a big basket of investments.  Mutual fund “Dollinger” might hold $100 million in hundreds of widely diversified stocks (I wish).  As an individual investor, you are not rich enough to hold hundreds of stocks.  Instead you invest in .1% of the ownership of “Dollinger.”  You have invested $100,000 and hold INDIRECTLY hundreds of widely diversified stocks.

A stock or equity mutual fund holds many stocks.  A bond mutual fund holds many bonds.  A real estate mutual fund, etc etc.  Every mutual fund has a stated theme.  Think of the theme as a contract.  The mutual fund managers are claiming to you that they will only buy according to the theme.  All of my clients hold the DFA small cap value fund.  The manager is Dimensional Fund Advisors (DFA).  They have stated the theme for the fund to meet three qualifications.  They invest in US stocks, the stocks must represent the smallest 10% of the companies in the market, and the companies must have a high financial statement book value as compared to the fair market value on the market.  The last item cuts the growth stocks; stocks with minimal profits, minimal assets, lot of dreams, and a very high stock price.

If a mutual fund deviates from the stated theme, they need to be fired.  As an investor, I need to know what I am buying.  Mutual fund drift is common.  Using the DFA example, if a company suddenly grows so that it is no longer in the smallest 10%, it needs to be removed from the mutual fund.  Often mutual funds are tardy in making these changes.  It is a constant battle.   DFA is actually pretty good at staying true to theme.

A mutual fund is a private company.  They are in business to make money.  They make money by charging the investors a fee every quarter.  The fee can range from .2% to over 2% per year.  Sometimes they pay commissions to the advisors who recommend them.  Index funds buy a major section of the market, do not try to out-guess the market, and charge a low fee.  Active funds pick stocks according to what their expensive managers think best.  Active funds charge a high fee.  They are often sold by commission based advisors.  Since I do not believe it is possible to out-guess the market and I do not collect commissions, I do not use active funds.  I use index funds.

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