Mutual fund shares are easy to buy and sell. But it is not so easy to determine if a mutual fund portfolio is just right for an investor. Part of the problem is we are inundated with so much controversial material that it is difficult even for a sophisticated investor to sort out the wheat from the chaff. However, it does not have to be this way. Here are seven rules to build a mutual fund portfolio that is right for an investor.
Rule 1: Conduct an Annual Review. Frequently, we hear the celebrated phrase, the past record does not guarantee future performance. That is the truth. So, one must ensure that the selected mutual fund’s performance does not drastically lag the performance of the category.
For instance, in 2002, the equity market represented by the S&P 500 registered a significant decline. If during that year an equity mutual fund lagged this rate of decline, one note it. However, a word of caution. Recognize that one year does not establish a track record. The performance of every successful money manager occasionally lags the market or a relevant index. It is inadvisable to fire a portfolio manager on the basis of just one year’s poor performance. However, it makes sense to get more information from each under-performing fund man- ager. Then decide if switching the manager is advisable. One should have a rule on when to dump a manager.
Rule 2: Check the Risk Profile of the Fund. Risk is one of the most misunderstood words in the investment world. Academicians measure it with beta, standard deviation, and variance. The average investor classifies risk profiles as conserva- tive, average, and aggressive. A leading mutual fund classifies investor risk pref- erences as cautious control, balanced medium, and assertive dynamic.
Instead of getting mixed up with the perennial problem of defining risk, it is desir- able to adopt the following approach. First, one should recount the performance of the selected mutual fund relative to the following bear markets: February
1994–April 1994, 2000–2002, and 2007–2009. If the fund did poorly during one or more of these market declines, the investor is likely to be exposed to serious risk in future down markets. If that is the case, then the investor may want to reduce fund holdings to reduce the potential loss in a weak market.
Rule 3: Determine Who is the Boss. Most investors recognize their funds’ names but rarely are familiar with the respective portfolio managers. This can be a costly for two reasons. First, if the performance of the mutual fund is tied to a specific manager. If that manager leaves the fund, the investor may be surprised with the new manager’s record. Second, if in the past a portfolio manager has been successful in following a certain investment policy, but chooses to change that policy, that change may not even be recognized. This can hurt performance in the long run.
It is important for investors to become familiar with the names of their portfolio managers, their basic philosophies, and track records. Fortunately, a growing number of mutual funds recognize the importance of exposing their fund man- agers directly to investors. Unfortunately, most shareholder representatives have limited training, and strict limitations are imposed on what they are allowed to say to callers. Therefore, to fill that information gap, some fund com- panies have inaugurated hot lines. Here managers discuss holdings and market outlook.
Rule 4: Tighten the Portfolio. People are usually attracted to what is hot. They fre- quently buy multiple funds with similar concentrations. For instance, many investors bought US stock funds with large exposure to technology companies prior to the dot-com bubble in 2000. An investor holding several top-perform- ing funds could have ended up with several funds with similar holdings. So one should tighten the portfolio by weeding out funds that duplicate the invest- ment philosophies the investor wishes. Investors investigate fund similarities at overlap.com.
Rule 5: Eliminate Unnecessary Funds. Investors frequently make the mistake of owning several similar mutual funds for their goals such as retirement, financing college education, or making large purchases. This is not only unnecessary but can be counterproductive. It is both expensive and difficult to track a large number of mutual funds. Investors should streamline portfolios and have a lim- ited number of funds for each goal.
Rule 6: Beware of Emerging Markets. Financial magazines are replete with exciting stories about emerging markets. These markets, generally associated with
developing countries, are growing rapidly. They are often generating annual returns in excess of 30 to 40 percent, and sometimes even higher. It is wise to allocate at least a portion of the portfolio to mutual funds specifically dealing with emerging markets. However, risk-averse investors, or those close to retirement, should invest no more than five to 10 percent of the portfolio in emerging markets.
Rule 7: Diversify the Portfolio. Various types of investment can be included in a diversified portfolio. Generally, portfolio performance can be improved if it is broadly diversified between stocks, bonds, and money-market securities, as well as between domestic and international markets.
Rebalancing a Portfolio
From 2000–2007 there was a surge in stock prices. Subsequently, during 2008 and the beginning of 2009, all market indexes suffered big declines but they began to rise again in the latter half of 2009. Because of the market’s strong advance from 2000–2007, and subsequent declines and advances since 2008, it is likely that the equity portion of investors’ portfolios has significantly changed, throwing off the original asset allocation distribution.
One effective way of guarding against risk creep and maintaining a consistent investment strategy is to regularly rebalance the portfolio. This involves period- ically shifting funds among various asset classes to keep the portfolio diversifi- cation in line with the desired asset allocation strategy.
The strategy of rebalancing a portfolio can not only protect investors from grad- ually taking on more risk than desired, but it can also improve the portfolio’s performance. This is because occasional rebalancing forces investors to shift money from an asset that has performed well (sell high) into one that has lagged (buy low). For example, if stocks have been in a slump, an investor using a rebal- ancing approach would shift money from bonds and money-market securities into stocks. This takes advantage of lower stock prices. If this strategy is also followed after a period of rising stock prices, funds would be shifted from stocks to bonds or money markets.
However, let me be clear: asset rebalancing is not a market timing strategy, one in which an investor attempts to outguess the vagaries of the financial markets.
It is a systematic approach to maintaining a relatively consistent risk profile. The strategy is appropriate for tax-deferred retirement plans, since gains realized on the sale of securities are not subject to taxation until the funds are withdrawn.
This strategy could also be used for regular accounts, but frequent rebalancing could cause complicated tax reporting headaches.
Rebalancing in Practice
The following example demonstrates the use of periodic rebalancing strategy.
Consider the results of a $10,000 investment made in December 1969 in two tax-deferred plans with a diversified mix of 60 percent stocks, 30 percent bonds, and 10 percent cash. One portfolio is rebalanced each quarter so that the origi- nal investment mix is maintained. Here, if the percentage invested in stocks rise above the 60 percent guideline as a result of market appreciation, money is shifted from stocks to bonds and cash. This brings the portfolio back in line with the investor’s original strategy.
With the second portfolio, the investment mix is not rebalanced. It changes over time, reflecting the actual performance of stocks, bonds, and cash. The equity rose from 60 percent of assets at the beginning in December 1969 to 74 percent by September 1995, substantially raising the investor’s risk exposure.
Asset rebalancing, in this example, helped mitigate losses during stock market downturns in 1980–1982, 1987, 1990, and 1994. Furthermore, the investor took advantage of the lower equity prices by shifting money into stocks during these periods.
It is also interesting that over the entire period the rebalanced portfolio mod- estly outperformed the unbalanced one. That is even though the latter took on a higher risk profile as its equity position increased over time. By September 1995, the value of the more conservative, rebalanced portfolio was $145,000, compared with about $141,000 for the unbalanced one.
The results reflect the long-term impact of the 1973–1974 bear market on the performance of these two portfolios. The steep decline in equity prices reduced the equity allocation of the unbalanced portfolio to 49 percent. The rebalanced portfolio, at the same time, maintained its 60 percent equity position by buying stocks at bargain prices. The rebalanced account benefited from the market’s recovery after the bear market. I maintained its advantage every year after that.
While the unbalanced portfolio succeeded in closing the gap during strong bull markets, its gains were enough to overtake the rebalanced portfolio. In effect, the rebalanced portfolio reduced an investor’s loss during severe market down- turns, but over time provided a competitive return relative to a more aggressive portfolio.
Naturally, relative performance portfolio can vary, depending on the time period measured. There is also no guarantee that the story just presented will be repeated or that a rebalancing strategy will always be effective. Still, periodi- cally rebalancing a portfolio seems a conceptually sound strategy.