Make the Right Move with a Mutual Fund Strategy

Physician's Money Digest, March 2006, Volume 13, Issue 3

Given the hectic lifestyleof today's physician-investor,the opportunity to satisfy all of your purchasingneeds through one source is certainly appealing. Afterall, time is money. In the investing world, the sameapproach is often taken when it comes to mutual funds.Rather than having to buy stocks individually in 50 or100 different companies, mutual fund investing allowsyou to cover the bases in one shot.

Most experts agree that the heart and soul of successfulinvesting resides in diversification and asset allocation.The same is true when it comes to mutualfunds; investing in just one fund won't get the job done,and many options are available. "If you look at the USequity market by itself, you can easily make allocationsto growth, value, small cap, mid cap, and large cap,"explains Mark Holland of International Capital ManagementCorporation. "And then you can go into sectorfunds, like health care or technology."

Long-term Principles

Most finance professionals will tell you that mutualfund investing can be an extremely profitable, long-terminvestment approach. The key phrase here is "longterm." But according to Robert Millen, co-portfoliomanager of the Jensen Portfolio, recent trends indicateinvestors are not adhering to that axiom. "In 1980, theaverage holding period for an NYSE-traded stock was 8years," Millen explains. "Today, it's 11 months. Theaverage holding period now for a mutual fund is about18 months. In my view, even 18 months is way tooshort to get the value out of mutual fund investing."

Millen believes that the major factor influencing thistrend is the financial media, which focuses more onhow a stock is doing over the course of a week or amonth, as opposed to how a mutual fund might performover a 5-or 10-year period. "I think too manypeople chase performance," Millen says. "Investors aretoo short-term-oriented in their thinking. If they havea mutual fund that has 1 bad year or perhaps 3 badyears relative to a benchmark, they sell it and buyanother one, when in fact that might be the exact timeto stay with the fund they already own."

Millen says that most investors—with their desire tochase performance—have the unfortunate tendency ofbuying high and selling low, the exact opposite of successfulinvestment principles. Rather than looking atrecent performance, physician-investors are better off focusingon key aspects of a mutual fund: the people whorun the fund, its philosophy, its long-term track record,and whether the management teams invest heavily intheir own strategies. "Focus on those things," Millensays, "and you'll have more confidence buying into thefund and holding onto it for a long enough period oftime in order to realize the value of owning it."

International Capital's Holland says that investorsshould reexamine their portfolios on an annual basis,but cautions that it should only be a fine-tuningprocess. "Begin at the asset class level and make minoradjustments to those allocations, if appropriate,depending on your outlook for the future," he suggests."Keep your eye on the big picture, and stick to yourguns." He advocates a long-term approach, and pointsto studies that have shown how the top performingfunds one year are unlikely to be among the top performingfunds the following year. They are even lesslikely to be the top performers 2 years down the road.

Short-term Rotations

While not losing sight of their long-term investinggoals, many physician-investors may still desire superiorshort-term gains along the way. Short-term stylerotation, an investment approach used by the TopFlight Fund (TOPFX), might offer the best of bothworlds. Jonathan Ferrell, the fund's manager, pointsout that financial information about public companiesis more pervasive and accessible today than at anytime in history. As such, the uniformity of informationpossessed by most institutional managers makes itextremely difficult for active managers with a traditionaltime horizon to consistently outperform anappropriate benchmark via stock picking.

Instead, Ferrell believes that consistent excessreturns may be realized through superior, quantitativeanalysis of public companies—an advantage bestemployed over the short term (ie, less than 3 months),where tax considerations generate less competitionand the market is not as efficient. Ferrell explains,"Within this shorter time frame, we believe it is possibleto discover emerging trends in investor behaviorand thus exploit the ‘herd mentality'of institutionalmanagers and individual investors to predict the kindsof stocks that will outperform, and the kinds of stocksthat will underperform."

Ferrell equates the fund's strategy to scaling amountain. "You have to have a long-term strategy forhow you get to the peak," Ferrell says. "But the waythat you get from point A to point B is by solid executionover a short distance, reassessing the environment,and then executing a climb over a short distanceagain. That's the approach I take with investing."

Ferrell says a lot of money managers try to predicthow the financial health of publicly traded companiesis going to change over time. The philosophy heemploys for the Top Flight Fund, however, is lessabout trying to predict changes in the health of companiesand more about predicting the environmentand attitude of investors.

"Our philosophy is about understanding what'sgoing on inside investors' heads," Ferrell explains."We look to see what investors are rewarding andpunishing in the marketplace. We have over 100 differentstyle factors—earnings estimates, internal workingsof a company—that we define as any reason whya person would buy one stock instead of another. Sowe can see in real time when investors are starting toreward a particular style factor more than another."

Diversification Value

Investing in a mutual fund provides instant diversification.To be properly diversified, investing in justone or two funds is not an effective strategy. Neither,however, is investing in too many funds. The endresult here is overlap and overdiversification.

Ensuring that investors have a properly diversifiedmutual fund strategy takes a bit of work. "Sometimesyou have to dig a little deeper to see if you're really gettingdiversification across the board," says Dan O'Lear,executive vice president, retail sales channels, forFranklin Templeton. "As you integrate funds, you wanta correlation that's not too tight. If you have an up market,that's terrific, because everything will go up. But ina down market, everything will go down. You want tobuild a portfolio that covers downside risk."

Franklin Templeton's Founding Funds invest equalallocations in three underlying funds: FranklinIncome Fund, Mutual Shares Fund, and TempletonGrowth Fund. The funds invest in stocks and bondsin both the United States and abroad that are tradingat a discount. While the three underlying funds arehoused under one portfolio umbrella, the funds' portfoliomanagement analysts do their own research.

"If you're looking for diversification, you're gettingthree groups looking at stocks and bonds on theirown, so you get very little overlap," O'Lear explains."If you buy a growth stock fund and a blue chip fundfrom the same fund family, you may think you'rediversified. But if you dig down deeper into the portfolio,as much as half of the stocks are the same." Atthe end of 2004, the Founding Funds portfolio comprisedof 570 securities, but only three stocks could befound in each of the underlying funds.

Millen agrees that proper diversification is one ofthe keys to managing downside risk. He explains thatthe strategy the Jensen Portfolio employs is to findbusinesses that can grow their earnings and free cashflow by low double-digit annual rates, and then purchasestocks at a discount to what they may be worth.To protect against possible errors and risk, a safetymargin is important. "It's really impossible to preciselyknow what a company is worth, given all the estimatesand variables that you have going into the calculation," Millen says. "You want to have a marginof safety in case you're wrong, and that margin ofsafety protects you on the downside."

He also says that preserving capital is one of thebenefits of managing risk over a long period of time."One of the great things about long-term investing,particularly if you do it right, is that if you manage thedownside, then you don't have to make as much onthe upside to be ahead. The idea is to not only growyour capital, but also preserve it."

Timing Is Everything

It's easy to say that emotions should be kept out ofthe equation when making investment decisions; it'sanother thing to put that strategy into practice. Manyinvestors seem to employ the method of market timing,a trading system that uses fundamental or technicalindicators to determine when to buy or sell. One of thecompanies serving this area is TimingCube ( This Austin, Tex-based company offersa market-timing service that signals long-term investorswhen to buy, sell, or cash out of the stock market usingexchange-traded funds (ETFs) or mutual funds thattrack major market indexes such as the Nasdaq 100,Russell 2000, and S&P 500.

TimingCube uses a trend-timing computer modelbased on a proprietary formula to send signals toinvestors 3 to 5 times per year on average. The modelremoves emotions and opinions from the investmentdecision-making process that typically affect investorsnegatively. "With a system like this, which is completelymechanical, you don't have to worry abouteverything you hear on the news, or what you mayhear about the performance of a company," explainsSerge Dacic, cofounder of TimingCube. "Instead, youcan rely on a system that excludes emotional types ofaffirmations, which do not add anything to the bottomline. It's less stress for more money."

The proof is in the numbers. TimingCube wasintroduced in 2001. As of May 2005, this mathematicalmodel has recorded an annualized return of252% on the Nasdaq 100 index, compared with aloss of 7.4% for the traditional buy-and-hold strategy.Over the 4 years since its launch, a $10,000investment using a TimingCube Long and Shortstrategy would now be worth $35,229. A buy-and-holdposition for the same time period would havelost $743, for a total of $9257.

The use of mathematical-based trading tools isgrowing in popularity, according to a recent report byCelent, a Boston-based research consulting firm.Today, 14% of all trades made by mutual and pensionfunds traders employ such methods. This number isexpected to grow up to 25% by 2008.

Mutual fund investing might not be as simple asit sounds. If you do your homework and pay attention,investing in funds can be very profitable andrewarding.