Thursday, February 23, 2012
International
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Investor
Funds come in all shapes and sizes, ranging from billions of USD to millions of USD. Most of them work this way: A sponsor company like Fidelity or Vanguard rounds up money and pays a portfolio manager to buy groups of securities according to a specific investing strategy. The company then sells shares in the fund to the general public at a price reflecting the value of the pooled securities. When someone buys a share of the fund, and he or she owns a small percentage of the total portfolio, meaning he or she participates in any of the fund's investment gains or losses. Depending on the fund, client can own a piece of 20 to 500 different companies for a minimum investment of $1,000 to $5,000 – sometimes even less.
Investor may have to pay a fee for the service, but a good fund offers plenty of advantages. Ideally, the pros have years of experience and are given access to piles of industry and company research. It's also true that unlike a bank certificate of deposit or an annuity, a mutual fund investment is completely liquid, meaning client can get in or out simply by picking up the telephone.
Funds, of course, are no panacea. While diversification can buffer them from the tyranny of one errant stock, they're still subject to market risk. If the broad market drops, in other words, client’s fund will usually sink right along with it. Worse yet, there are plenty of lousy funds out there that charge client a lot in fees, and do badly even when the market does well.
As was mentioned in the introduction, roughly 55% of all equity mutual funds routinely fail to beat the returns of the benchmark S&P 500 index. That's why it's essential to choose client funds wisely and strategically.
A fund manager's job is to create a portfolio that blends different types of stocks and bonds to achieve the maximum return for a given level of risk. Some managers are more willing to roll the dice on risky stocks in search of high rewards. Others are more defensive, seeking reasonable gains without the threat of big losses. Some invest only in foreign stocks, some favour small companies, some like utilities – the list goes on.
Technically, index funds do have managers, but they don't have a heck of a lot to do. They simply buy all the stocks or bonds in a chosen index with the goal of matching that group's performance.
Index is a grouping of stocks chosen to represent a certain market segment. The S&P 500 index, for instance, consists of large stocks. The Nasdaq Composite index is heavy on technology companies. And the Russell 2000 is a benchmark for small-cap companies. By purchasing an index fund, the portfolio tries to mimic the returns of that particular segment.
Index funds have other advantages: tax efficiency and low expenses. Low turnover limits tax liability. And since the manager doesn't have to look actively for stocks, these funds are relatively cheap to run. The Vanguard 500 Index fund, for example, has an incredibly low annual fee of 0.18% of your investment. The average large-cap fund charges more than six times that much.
While index funds might not look all that attractive over the short term, they are one of the best options around for long-term investors.
Stock funds are often grouped by the size of the companies they invest in – big, medium, small or tiny. By size we mean a company's value on the stock market: the number of shares it has outstanding multiplied by the share price. This is known as market capitalization, or cap size. Big companies tend to be less risky than small fries. But smaller companies can often offer more growth potential. The best idea is probably to have a mix of funds that give you exposure to large-cap, midsize and small companies.
Large-capitalization funds generally invest in companies with market values of $8 billion or more. Some, like the Vanguard 500 Index fund, merely mimic the index and invest in all 500 companies. Others, like Fidelity's huge Magellan fund, try to beat the index by picking a mix of large caps that will outperform the broader market.
Large-cap funds are typically less volatile than funds that invest in smaller companies. Historically, micro-cap funds tend to have the greatest volatility, but as one can see from the applet on the right, the recent market turbulence has boosted large-cap funds to a nearly equal level. Nevertheless, over the long term, a fund that invests in well-established companies should offer a smoother ride. The trade-off is that client can expect slightly smaller returns.
For most investors, a large-cap fund is their core long-term holding. For younger investors, a good one is a reliable place to park your retirement savings.
These funds fall in the middle. They aim to invest in companies with market values in the $1 billion to $8 billion range – not large caps, but not quite small caps, either. The stocks in the lower end of their range are likely to exhibit the growth characteristics of smaller companies and therefore add some volatility to these funds. They make the most sense as a way to diversify your holdings.
A small-cap fund, like T. Rowe Price Small-Cap Stock, will focus on companies with a market value below $1 billion. The volatility of the fund often depends on the aggressiveness of the manager. Aggressive small-cap managers will buy hot growth and technology companies, taking high risks in hopes of high rewards. More conservative „value“ managers will look for companies that have been beaten down temporarily by the stock market. Value funds aren't as risky as growth funds, but they can still be volatile.
Because of their volatility, small-cap funds require that you have enough time to make up for short-term losses. There are times when the market turns away from small-cap companies altogether for extended periods, as we witnessed most recently in 1998. Since then, however, small-cap managers have had more reasons to smile, as small-cap blend funds excelled in 1999 and small-cap value funds have held their ground in a tough market over the past three years.
After periods of slow growth, small companies typically will regain favour, growing more quickly than their larger cousins. This can provide a good kicker for aggressive investors who need to build as much wealth as possible while they're young.
There are some companies with market values below $250 million. These funds tend to look for either start-ups, takeover candidates or companies about to exploit new markets. With stocks this small, the volatility (read: risk) is always extremely high, but the growth potential is exceptional.
If client has the time and inclination to pay attention to a fund like this, he or she might be willing to put some money in.: Micro-cap funds can rear up and bite the client.
EVERY MANAGER is different, but there are three broad archetypes when it comes to investment strategy: value, growth and blend. The issue here is whether the manager is,
These funds like to invest in companies that the market has overlooked or lost faith in. Managers like Bill Nygren of the Oakmark Funds search for stocks that have become „undervalued“ – or priced low relative to their earnings potential.
Sometimes a stock has run into a short-term problem that will eventually be fixed and forgotten. Or maybe the company is too small or obscure to attract much notice. And then there's what can happen during times of economic uncertainty, when large groups of stocks get broadly punished, as occured during the weeks that followed the Sept. 11 attacks, even though a specific company's fundamentals haven't necessarily changed. In any event, the manager makes a judgment that there's more potential there than the market has recognized. His bet is that the price will rise as others come around to the same conclusion.
These funds tend to look for the fastest-growing companies on the market. Growth managers are willing to take more risk and pay a premium for their stocks in an effort to build a portfolio of companies with above-average earnings momentum or price appreciation.
If the client held growth funds during this bear market, then he or she is probably aware that they have a dark side as well. This group is the most volatile of the three investment styles. And unfortunately, when growth slows, watch out – the more momentum a stock has, the further it's likely to fall when the news turns bad. That's why only aggressive investors – or those with enough time to make up for short-term market losses – should buy these funds.
These can go across the board, investing in both growth and value stocks. They might, for instance, hold some high-growth biotech stocks as well as some cheaply priced industrial cyclical stocks. That means they're tough to classify in terms of risk. The Vanguard 500 Index fund invests in every company in the S&P 500 and could therefore qualify as a blend. But because it's also a large-cap fund, it tends to be steady. The Legg Mason Special Investment fund is more aggressive, with nearly double the weightings in technology and telecom stocks at the end of 2002. In order to determine if a particular blend fund is right for clients needs, he or she'll probably have to look at the fund's holdings and make a judgment call.
It doesn't mean that a good international fund shouldn't be in every client’s portfolio. Although the gap is closing, the economies of the world's different regions still tend to boom and bust in cycles that offset each other. International stocks can provide excellent diversification for a portfolio heavy on U.S. equities. And when investing in the far corners of the world, finding a good manager is often the best way to go, since research is scarce and foreign companies are notoriously hard for individual investors to track on their own.
International funds give client exposure to overseas markets at varying levels of risk. Some are fairly tame. Others can make your hair stand on end. Consider the disappointing returns Latin American funds posted in 2002, when they shed about 20% on average. Argentina's economic crisis, concerns about Brazil's national election as well as its ability to repay its debt and political unrest in Venezuela weighed on the region's returns. And even when foreign economies are doing reasonably well, currency fluctuations can have a negative effect on stock prices.
Economic and currency risk can also swing very strongly in a positive direction. So, as always, diversification is the key to managing risk. Funds investing overseas fall into four basic categories: world, international, emerging market and country specific. The wider the reach of the fund, the less risky it is likely to be.
World funds are the most diverse of the four categories. But don't be fooled by their cosmopolitan-sounding name. They're able to invest in any region of the world, including the U.S., so they don't actually offer as much diversification as a good international fund. stocks.
These funds invest most of their assets outside the U.S. Depending on the countries selected for investment; foreign funds can range from relatively safe to more risky. Fidelity Diversified International, for instance, has its assets spread over more than 30 different countries, many of which are in Europe. Templeton Foreign, on the other hand, has significant exposure to some of the most traditionally volatile regions in the world, with a 23% weighting in Pacific Rim countries such as Thailand, South Korea and Hong Kong. The average foreign fund has just a 6.6% stake in these regions. The best thing to do is to choose a fund with the best balance, or make damn sure the manager has done a good job of moving in and out of regions profitably.
These funds invest in one country or region of the world. That kind of concentration makes them especially volatile – particularly if client pick a fund that invests in a country that's viewed as an emerging market (see below). Granted, if you pick the right country at the right time – Russia or Korea in 2001 and 2002. Only the most sophisticated investors should venture into this territory.
Emerging-markets funds are the most volatile. They invest in undeveloped regions of the world, which have enormous growth potential, but also pose significant risks – political upheaval, corruption and currency collapse, to name just a few. Of course, as the current bear market has taught us, domestic stocks can be extremely volatile as well. So adding a small slice of emerging-markets exposure to your portfolio could be one way to reduce the overall risk of your portfolio. In 2002, for example, emerging-markets funds shed 5.9% while the average domestic portfolio lost 20.5%. Better is to recommend this group to a short-term investor, but long-term investors will find that the best way to cut risk is to have one's fingers in many pies
Sector funds do what their name implies: They restrict investments to a particular segment – or sector – of the economy. Vanguard Health Care, for instance, only buys only health-care companies for its portfolio. No matter which sector client is interested in investing in, chances are there's a fund that tracks it. Fidelity, for example, has a whole stable of sector funds from Fidelity Select Insurance to Fidelity Select Automotive. The idea is to allow investors to place bets on specific industries or sectors whenever they think that industry might heat up.
While such a strategy might appear to throw diversification to the wind, it doesn't entirely. It's true that investing in a sector fund definitely focuses exposure on a certain industry. But it can give client diversification within that industry that would be hard to achieve on your own.
Both open- and closed-end funds are pools of investor money managed by professionals to maximize diversification within a set strategy. The difference is in how the fund is structured in terms of ownership.
An open-end fund issues and redeems shares on demand, whenever investors put money into the fund or take it out. This happens routinely every day, and the total assets of the fund grow and shrink as money flows in and out. This means the more investors buy the Vanguard 500 Index fund, for instance, the more shares there will be. There's no limit to the number of shares the fund can issue. Nor is the value of each individual share affected by the number outstanding, since net asset value (NAV) is determined solely by the change in prices of the stocks or bonds the fund owns, not the size of the fund itself.
A closed-end fund is a different animal. Like a company, it issues a set number of shares in an initial public offering, and they trade on an exchange. A fund like the Nuveen Muni Value fund trades on the New York Stock Exchange just like any other stock. Its share price is determined not by the total value of the assets it holds, but by investor demand for the fund.
Investing in closed-end funds can be very confusing for the novice investor, and we don't recommend it. But for those who fully understand the market, closed-end funds can be appealing, since they often trade at a discount to their underlying asset value. Savvy investors search for closed-end funds with solid returns that are trading at large discounts and then bet that the spread between the discount and the underlying asset value will close. If client don't understand the mechanics of evaluating the discount spread, however, he or she is better off sticking to open-end funds.
Bond funds are designed to give client’s portfolio its recommended dose of fixed-income investments so he or she doesn’t have to go through the hassle of buying bonds their self. Thesecome in various types.
All bonds are structured so client gets paid his or her principal after a set amount of time. They're either short, intermediate or long term, depending on the number of years until they mature. Bond funds are the same way. A fund like Dreyfus Premier Short Term Income is typical of its class, buying a mixture of corporate and government bonds with durations of less than three years. Intermediate funds like Liberty Intermediate range between three and 10 years, while Vanguard Long-Term Corporate typically only buys bonds with maturities greater than six years.
Generally speaking, the longer the duration, the higher the risk and reward. It isbecause the longer client hold a bond before it matures, the greater the chance its value could be adversely affected by inflation. As a result, whatever company or government issued the bond has to promise a higher yield upfront.
Muni-bond funds invest in bonds issued by state municipalities. Some funds, like Eaton Vance National Municipal, invest in bonds offered throughout the country. Others, like the Pimco New York Municipal Bond fund, invest in one state only. Tax breaks are the big draw of muni-bond funds. If client own a national fund, he or she is exempt from federal income taxes on any income he or she receive from the fund. If client live in the state specified in a state-specific fund, he or she is exempt from state and federal taxes. However, client lower taxes generally come with lower returns. Only investors in high tax brackets should buy these funds.
Bond funds invest in different grades of corporate bonds. High-yield, or „junk-bond,“ funds are the most well-known of the bunch, because they offer the highest rates. Since these funds invest in low-grade corporate issues, they also entail the greatest risk. Companies with credit ratings of BBB or less are the most likely to default on their coupon payments. Although the income may be high on a fund like Fidelity High Income, it's not guaranteed. Only the most risk-tolerant investors need apply.
Money-market funds are often touted as the safest kind of mutual fund, but that depends on client perspective. On the one hand, it's almost impossible to lose client principal in one of these things. On the other, their returns are so low – especially these days when they are offering on average just 1% – that they can't beat inflation over time. In the long term, client money loses its buying power and so actually becomes less valuable. Consequently, money-market funds are most useful for parking cash client need in the short term – a car or house down payment, for instance, or next year's tuition.
The reason money funds are so stable is because they invest in ultra short-term securities like those issued by banks, the federal government or big companies with Grade A credit ratings. Client return comes in the form of a dividend. In these respects, money-market funds are very similar to a bank certificate of deposit. The advantage of a money fund is that it is completely liquid. Unlike a CD, which will lock up client money for at least three months, client can sell his or her shares in a money fund at any time. They also often offer perks like the ability to write checks against the principal.
There are various types of money-market funds based on the type of securities they buy, but the most important distinction is whether client dividends are taxable or tax-free. The yields on tax-free funds are somewhat lower than those on the taxable funds, but if client is in the 30% tax bracket or higher, this could be the way to go.
