Construct a Solid Mutual Fund Strategy

Physician's Money Digest, August15 2003, Volume 10, Issue 15

If you're a doctor looking to invest in mutual funds, there's no shortage of choices. There are currently more than 6000 mutual funds to choose from. The key is how you allocate those choices.

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In (HarperCollins; 2001), author Stephen Pollan points out that when you buy an individual stock, your fortunes rise and fall with the stock's performance. If the stock goes up, you make money, and if it goes down, you lose money. But the strategy behind mutual funds is one of strength in numbers. By grouping 30 or 40 carefully selected stocks together, you improve the chances that the majority of the stocks will do well and that the overall value of the fund will increase.

"Mutual funds are a great way to tap the expertise of some fund managers who do a great job," explains David Bendix, CPA/PFS, president and founder of the Bendix Financial Group (www.bendixfinancial.com). "And the mutual funds provide investors with instant diversification."

Most mutual funds invest in stocks. Other mutual funds invest in bonds and money markets. Still other funds invest in real estate, gold, and almost every type of security you can imagine. Understanding the different types of mutual funds that are available is the first step in making wise investment decisions and building a portfolio that meets your individual needs.

1. Stock Funds

Stock funds are the most common type of mutual fund, accounting for approximately 42% (or $2.67 trillion) of total mutual fund assets as of December 31, 2002. Over the past 3 years, new cash flows into stock funds have been declining; however, advisors suggest that when mutual fund cash outflows are at their highest, it's a good sign that the market has bottomed.

"Certainly stock funds have taken a hit in terms of market value, and over the past couple of years, most investors have trimmed back on their equity holdings," notes Greg Brown, CFA, CPA, senior vice president at Payden and Rygel (www. payden.com). "But recently, we're seeing more positive flows back into stock funds."

Mutual Funds for Dummies

The benefits of stock mutual funds are well documented. Writing in , Eric Tyson points out that over the past 2 centuries, investors holding diversi- fied stock portfolios earned an average rate of return of 10% per year, or 7% higher than the rate of inflation. In contrast, the return on bond and money market investments has historically been about 1% or 2% over the inflation rate.

Of course, stock prices in general tend to be more volatile than their bond or money market counterparts, so investing in stock funds exposes you to more risk. However, given the wide range of funds available, you can minimize your risk by diversifying your investments.

"Funds are very style and size specific," Bendix explains. Fund managers specialize in large cap value stocks (ie, large public companies whose stock is priced cheaply in relation to the company's assets and profits) or small cap growth (ie, small public companies that are experiencing expanding revenues and profits).

Funds also specialize in different sectors. You wouldn't want to have 50% of your investments in 1 sector fund; 10% is a more realistic goal. "Sector funds can provide that added value, that extra return that a plain vanilla fund won't," Bendix points out. "They're like a shot of adrenaline."

Perhaps the best reason for investing in stock mutual funds is that they're no different today than they were 5 years ago during the height of the bull market. They offer diversification, professional management, and ease of administration.

2. Bond Funds

In 1975, there were only 35 bond funds with a total of $2.2 billion in assets. Today, there are more than 2000 bond funds with total assets exceeding $635 billion.

Bonds work similar to CDs, except they are issued by corporations or governments as opposed to banks. You can purchase a 5-year bond from a company that agrees to pay you a set percentage. As long as that company doesn't have a catastrophe, after 5 years of receiving interest payments on the bond, the company will return your original investment.

Bond funds, Pollan explains, invest in a variety of bonds that have similar maturity dates. Hence, they are categorized as short term (2 to 3 years), intermediate (5 to 10 years), or long term (20 years or more). Bond fund managers regularly shift the bonds they manage to maintain the fund's desired average maturity. And because bond interest rates are set, short-term bond mutual funds carry much less risk than stock funds.

However, that doesn't mean bond funds are without risk. Every year, Tyson notes, bondholders are left with nothing when the bonds they own default. The key is to purchase bonds that are high-credit quality bonds. Bonds rated AAA and AA are considered high-credit quality bonds and are unlikely to default. Bonds rated A and BBB are considered moderate-credit-quality bonds. Bonds rated BB or lower are known as junk or high-yield bonds and are more likely to default.

Bond funds have grown considerably more popular with investors. "Falling interest rates have made bond funds very attractive," explains Bard Malovany, CFP®. "As interest rates drop, generally speaking, bond prices increase. So investors have been getting both the interest from the bonds and the price appreciation as interest rates have fallen."

If interest rates rise, bond funds probably won't perform as well. And there are advisors who believe it's already too late to be putting money in bond funds. "Going forward, if you have any new money, you should be looking at stock funds," Bendix says. "Investors going into bond funds should be looking at shorter-term duration funds, anywhere under 3 years."

Tyson writes that there are 2 common financial goals for which bond funds are well suited. The first is for a major purchase that won't happen for at least 2 years, such as a new home. The second is to generate current income. If you're retired or planning for retirement, bonds are better than most investments for producing a current income stream.

3. Hybrid Funds

Hybrid funds are a mixture of different securities, most commonly stocks and bonds. A hybrid fund is less risky than a pure stock fund but will generally provide a higher return than an all-bond fund. So, if the stock market has given you too many stomachaches, a hybrid fund might be a good alternative for you.

"We find that people who are beginning investors and don't have the money to purchase a significant amount of equities are apt to invest in a hybrid fund because they view it as a good way to obtain the diversification they need," says Mark Jacobs, director of product management for New York Life Investment Management. "Also, older investors or those who have been out of the market are more comfortable with these blended-type funds."

According to Tyson, there are essentially 2 main types of hybrid mutual funds: balanced funds and asset allocation funds. Balanced funds seek to maintain a fairly constant percentage of investments in stocks and bonds, such as a 60/40 split. Asset allocation funds adjust the mix of investments in an attempt to get the most value. But, Tyson notes, most fund managers have done a poor job of trying to beat the market by shifting money. Sometimes, staying put is the best strategy. Flexibility, however, does have its advantages.

"Hybrid funds give the manager the flexibility to invest where they see the most opportunity," Malovany says. "Most stock mutual funds will have specific objectives. But most hybrid fund managers can buy stocks or bonds depending on where they see the greater opportunity for yield and/or price appreciation. And to some degree, they allow investors to incorporate asset classes they might not have in their portfolio."

Bendix agrees, and points out that hybrid funds provide a valuable service. In fact, some fund families market their hybrid funds as lifestyle or age-based funds, targeting specific time frames.

But while hybrid funds have performed very well over the past 3 years, relative to their stock fund counterparts, if the stock market begins to rally, the average hybrid fund is probably not going to perform as well as the average stock fund. Hybrid funds represent only 5% of total mutual fund assets.

4. Money Market Funds

When investors talk about mutual funds, money market funds are the segment that is most often overlooked. However, when viewed on a broader scale, money market funds accounted for 36% of total mutual fund assets as of December 2002. That's more than bond funds and hybrid funds combined.

Pollan writes that money market funds are virtually risk-free. Fund assets are placed in short-term money market investments. Just as with a savings account, you get back your investment plus whatever interest it earns. However, money market funds are available in a variety of tax-free versions, paying dividends that are free of federal or state tax (or both). They're not FDIC-insured, but they tend to have a steady net asset value.

"In some respects, the recent attraction to money market funds has really been a reaction to the drop in the stock market," Malovany explains. "They're a safe haven. So as people sell their stocks and stock mutual funds, the money goes into these funds and sits there until investors decide what to do with them."

However, with interest rates at historic lows, money market funds might not seem as attractive. "With money market funds there's a certain expense ratio, and the yields are under 1%, probably around 70 basis points. A lot of advisors say that they're just not worth the investment right now," Bendix notes. "The question is, what do you do with your cash and short-term investments? A lot of my clients are looking at alternatives, such as 1-year CDs."

Keep in mind, however, that money market funds can purchase CDs as well. And by investing millions of dollars in bank CDs, they can command a higher interest rate than the individual investor.

An additional source to consider, Bendix suggests, is principal-protected funds. These funds guarantee an investor's money in the seventh year. "Year 7 comes along and you've put in $100,000, but the market has brought it down to $80,000. The fund will still give you back the $100,000 initial investment at year 7," Bendix explains. "It provides investors with peace of mind."