Is the Risk Worth the Reward in Mutual Funds?

Physician's Money Digest, April 2007, Volume 14, Issue 4

Mutual funds are one of the quickest, easiest, and cheapest waysto access broad markets and investmentsectors, and they can form the basis for a well-diversifiedportfolio, according to investment advisors. But, whilemutual funds may seem like a no-brainer when it comes toinvestment strategies and decisions, nothing should be takenfor granted.

In the wake of the tech bubble bust in 2001, many investorsdeveloped a bunker mentality—the focus turned to avoidingrisk as opposed to only maximizing return. Investors nolonger wanted to know just how much money a fund made,they also wanted to determine its volatility. Today, they wantto know if it is safe to invest in a particular mutual fund. Andeven experts agree, that is not easily determined.

"Mutual funds always contain certain amounts of risk,some more than others," explains Scott Mosley, managingpartner and chief investment officer for Texas-basedCimarron Capital Consulting. "No mutual fund has a guaranteeof performance."

Mutual Fund Safety

Mosley points out that one of the tricks to making gooddecisions about mutual fund investments is to understandthe specific risks fund managers are taking. There are a numberof excellent sources to determine that. The first is thefund's fact sheet and its prospectus. These documents tell aninvestor what instruments the managers are investing in,what types of strategies they are using, if they are borrowingmoney to fund their strategy, and the fees associated withinvesting in the funds. Investors can also use the Internet toexplore potential funds, Web sites, and investment-specificinformation services like Morningstar or Lipper.

"Mutual funds are only as safe as their underlying investment,"adds Nathan Mersereau, CFP®.

Mersereau explains that a stock mutual fund will only beas safe as the stocks that comprise the actual fund. He cautionsthat "a mutual fund should be viewed as a diversifiedinvestment, not one that is necessarily safe."

Safe is a relative term. As Charles Massimo, president ofCJM Fiscal Management, explains, "All investing comeswith certain risks that investors need to be aware of beforemoving forward, but there are ways to lower your risk whenit comes to investing in mutual funds."

Steps such as sector diversification, selecting funds that arenegatively correlated to one another, rebalancing your fundsannually, and understanding the standard deviation, whichhelps determine the amount of volatility a portfolio mightexperience in both good and bad markets, are just a few waysto reduce the potential risks of a mutual fund portfolio.

Practice Diversification

Diversification is the most important consideration when itcomes to successful and safe investing. Yet many investors failto distinguish between effective and ineffective diversification.

"Simply because one fund is called a growth fund, andanother is called a value fund, and a third is called a blendfund does not mean you have diversity," according toMosley. "It is a serious mistake to assume that because afund is labeled in one way that it will not perform like a differentfund with a different label."

In addition, Mosley adds, diversity does not come inlarger numbers of investments. "I have, unfortunately, seensituations where investors had 20 to 25 funds and believedthey had achieved diversity," Mosley explains. "The fact ofthe matter was that their underlying positions were highlyconcentrated, and they were very subject to the movementof one sector."

Massimo adds that ineffective diversificationis owning multiple funds thatall take on the same characteristics, suchas owning all US large cap funds. All thefunds in a portfolio of this nature willmove up and down at the same time.

"But if you build a portfolio offunds that are negatively correlated toone another, meaning each fund is different,such as US large cap and internationallarge cap, you will lower thevolatility while enhancing returns,"Massimo says. "This is one of thebiggest mistakes we see both investorsand advisors make—having portfoliosthat are ineffectively diversified."

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And more is not necessarily better.Michael Edesess, PhD, author of (Berrett-Koehler Publishers;2006), further clarifies that the numberof mutual funds held is nearly irrelevantto diversification. What is relevant,he explains, is the total numberof stocks held and whether the proportionsheld in those stocks are close tomarket proportions.

"The broadest possible diversification,by definition, is found in a cross-sectionof the total market," Edesess says. "It isonly necessary to hold a single mutualfund—a broad-based index fund—toobtain the maximum in diversification.On the other hand, it is possible to holdas many as a hundred mutual funds thatall hold the same small number ofstocks and still not be well-diversified."

Structuring a Portfolio

So, thinking long-term, what shoulda mutual fund portfolio look like?

Michael Halloran, CLU, ChFC,CFP®, AEP, director of the Society ofFinancial Service Professionals, saysit's important to consider funds in thefollowing areas: international, smallcompanies, mid-size companies, largecompany stocks, real estate securities,high-yield bonds, investment-gradebonds, and some cash.

Mersereau echoes those thoughts,particularly with regard to the internationalarena."I believe that the internationalmarkets have the most potentialfor mutual fund investors over the next2 to 4 years," Mersereau explains."This is primarily due to a low US dollarvaluation, globalization, and economicstimulus in other countries. I likeEurope and emerging markets. Theseareas should primarily be considered bythe investor who is more aggressive,willing to live with volatility, and has alonger time horizon. The internationalfunds should be carefully evaluatedbefore making an investment."

Maurice Wilson, senior advisor withWilson Wealth Management Group,LLC, suggests a 90% to 10% stocks-bonds mix for the physician-investorwho understands that the risk of outlivingyour money is greater than negativeshort-term market swings. The chartdisplays his suggested portfolio. Wilsonexplains that this type of portfoliostructure is intended to give the physician-investor a well-diversified, value-orientedstake in the market.

However, Edesess takes a more simplifiedapproach to his portfolio structure."I would recommend for thestock portfolio 50% in either Vanguard'stotal US domestic index fund orFidelity's Spartan total market indexfund, and 50% in the internationalcounterpart offered by either of thesame providers," he says.

Keeping Expenses Low

One thing all advisors agree on isthat professional fund management andkeeping mutual fund expenses downare the keys to long-term success.

The higher the internal managementfee, the lower the return the shareholderreceives. And a small reduction ininternal fees can lead to significantvalue for the shareholder when theeconomic value of these fee savings arecompounded over time.

"Low expenses mean more ofinvestors' money is going into the investmentsinstead of paying administrativecosts," Halloran says. "On the managementside, an investor should look andsee how long the portfolio managershave been managing that fund. If they'vebeen there long-term, say 5 years ormore, then the investor would knowthat the results of the fund are due to thedecisions of that manager."

Wilson echoes that professional fundmanagement and low expenses go handin hand. "Great management, and bygreat I mean management that consistentlyproduces market-beating returnsover a 10-to 15-year period, must becoupled with low expenses for theinvestor to reap the rewards," he says."For example, ABC mutual fund consistentlybeats the market by 1 to 2 percentagepoints a year, but the fund carriesan annual expense ratio of 1.5%reducing the net return to the investor."

With investing, just as in life, thereare no shortcuts. Advisors stress thatphysician-investors need to do theirhomework if they want to receive goodgrades on their investment-makingdecisions.