Is Now the Time to Reconsider Investing in Mutual Funds?

In recent years, the phrase "one-stop shopping" has become very popular among businesses seeking to service their customers'every need. Convenience stores probably started this trend, offering a little bit of everything for their customers on the go. More recently, large insurance carriers feature products tailored to suit an individual's lifestyle, providing coverage for everything from cars and homes to business interruption.

But for the ability to grab something quickly at a convenience store, customers often pay a premium price. And can one insurance carrier provide adequate coverage being a jack-of-all-trades rather than a specialist?

When it comes to investing, mutual funds offer the physician-investor a similar convenience: the ability to conveniently and cost-effectively assemble a diversified investment portfolio. In reality, however, there's a lot more to having a well-balanced, diversified portfolio than simply investing in one mutual fund—or 10 funds, for that matter.

"Choosing the right mutual fund to invest in requires more than picking a fund from the Top 10 list of the best past performers," notes Dennis Barba, Jr, PhD, managing partner of The Oxford Group of Raymond James & Associates. "Choosing a mutual fund requires careful thinking about numerous factors."

What Are Your Goals?

Before investing in a mutual fund, it's important to know why you're making the investment. In other words, what are your investment objectives? "If you're a physician and at the end of the year you have a $100,000 distribution that you're going to receive and you're making a decision to invest, understand what your objectives are with that pool of money," Barba explains. "Is it to save for the education of one of your children? Is it to contribute to your retirement? Is it to save for a second home, or a boat? What's the specific objective of the investment?"

Once you identify your investment objectives, it's equally important to understand the kind of risk you're willing to take with that investment. There are literally thousands of different ways to earn a given rate of return, but the key is how much risk you, the physician-investor, are willing to assume for that potential return.

For example, don't buy last year's leading fund. "By doing that, you're hoping that lightning strikes twice," explains Bruce Fenton, founder and president of Atlantic Financial Inc. "Sometimes it does, but more often than not it doesn't. You'd almost be better off if you picked the worst performing sector of the previous year." That's the cyclical nature of investing.

As a case in point, 2 years ago assets were flowing out of stock mutual funds and into bond mutual funds. Investing in bonds was a no-brainer, explains Brian Boyle, CFA, and principal of Boyle Capital. The Federal Reserve almost had to lower interest rates in order to get the economy back on track.

"Today, we're at the other end of the spectrum," Boyle explains. "There probably isn't a lot of room for interest rates to go down and bond prices to go up. And so bond returns over the next couple of years are going to be low, and it will be pretty hard for investors to make a whole lot of money investing in bond funds."

Similar to avoiding last year's big winners, Fenton points out that too many investors follow what's hot. He says that's unfortunate because they're following the trend and not preceding it.

"I think it's very dangerous right now," Fenton cautions. "We're seeing a huge amount of interest and even speculation in the real estate market, and that's concerning. It's the same type of irrationality we saw in the stock market in the late 1990s when people were expecting extremely high returns. That's definitely not something that you plan on."

Mutual Fund Criteria

A key factor to consider when doing your homework on mutual funds is historical performance. In other words, how has the mutual fund performed over various time periods? This is not the same thing as chasing a trend. Ted Jarvis, senior portfolio manager and senior vice president with Indiana Trust and Investment Management Co, says that his firm considers four different time frames in order of diminishing importance: 10-year, 5-year, 3-year, and current year results.

Mutual fund companies, Jarvis points out, tend to move their money managers around quite a bit. The more a manager moves, the more likely there will be volatility and underperformance in a fund's results. "Investors forget that economic cycles last at least 3 to 5 years, if not longer," Jarvis explains. "If you have fund managers moving every 3 to 5 years, you really don't know what you're getting with that person. With a fund manager who has been there about 10 to 15 years, they have been through a couple of cycles. You can gauge how the manager does across economic cycles of both boom and bust, and how that will affect you in the long run."

The fund manager is the key, Fenton emphasizes. If a fund has great 10-year returns but the manager has only been there 6 months, the 10-year return records are fairly meaningless. "Likewise, if you had a terrible fund but Peter Lynch took it over tomorrow, the past performance wouldn't be as relevant," Fenton says.

A key criterion when contemplating adding a mutual fund to your investment portfolio is correlation. According to Barba, correlation is how two things or groups of things move together, either in the same or opposite directions. A correlation of one means the two funds are perfectly correlated and would tend to move in tandem. A zero correlation would mean that the funds move at random—one could be going up and the other could be totally flat. And a negative correlation of minus one means the funds move in exactly the opposite direction.

As an example, Barba suggested that a physician purchase the S&P 500 Index Fund. In contemplating adding another large cap fund to their portfolio, the physician is debating between the T. Rowe Price Equity Fund, Calamos Growth and Income Fund, or the Davis New York Venture Fund.

"One of the things the physician would want to see is how these three mutual funds are correlated to the S&P 500 Index Fund they already own," Barba says. He points out that the Calamos fund has a correlation of 0.71 relative to the S&P, the Davis fund is 0.93, and T. Rowe Price is 0.81. "You would want to purchase the fund that has the lower correlation relative to everything else that's in your portfolio." In this case, that would be the Calamos Growth and Income Fund.

Mutual Fund Trends

According to Boyle, the big trend in mutual fund investing over the next couple of years, outside of stocks and bonds, is going to be alternative asset classes. He points to the stock and bond markets of today and notes that stocks are still priced high. "I think the lid's on the kettle for the next several years," Boyle says. "I don't think you're going to get a whole lot of great returns in the stock market for the risk that you take on."

That's why Boyle says that alternative asset classes make more sense. As evidence, he points to the 2004 Yale Endowment Report. The Yale Endowment is an investment pool composed of thousands of funds with a variety of designated purposes and restrictions. In 1984, approximately 75% of the endowment was allocated to domestic marketable securities. However, by the end of 2004 the endowment had done a complete flip-flop, with about 75% allocated to alternative investment strategies and 25% in domestic marketable securities.

"The reason [for the reversal in strategy] is that it increases the return potential while at the same time lowering the risk," Boyle points out. "Much like Yale and some of the larger endowments, over the next several years some of these alternative asset classes should provide better risk-adjusted returns to investors. We don't recommend investors abandon the stock and bond market, but it makes sense to enhance what you have in your portfolio by adding some of these asset classes."

Boyle says that an investment his own firm has made is in timber, an asset class which, historically, most investors have never had in their portfolios. It's also an asset class that, according to Boyle, probably offers greater potential over the next couple of years than some other asset classes.

The caveat is that when investors start to get into alternative asset classes, whether they are timber, private equities, or international investments, you really have to know what you're doing. "You either have to align yourself with someone who does know what they're doing, or you need to bring yourself up to speed and do a considerable amount of homework," Boyle recommends. "And sometimes the best way to access some of these investments is to work with professionals who specialize in those areas, because the minimum investment requirements for some of these classes can be pretty substantial."