The Expanding Universe of Mutual Funds

After record sales of mutual funds this past year, and with more than 6000 varieties available to Canadian investors, it’s timely to discuss the role that mutual funds play in portfolios today.

Franklin Templeton introduced the first mutual fund to Canadian investors in 1954 with their Templeton Growth Fund, still in existence today.  Until the 1980’s monitoring the mutual fund universe was less complicated.  Since then the retail investor has been bombarded with an exponential increase in mutual fund products and their ever-changing mandates.

The original purpose of a mutual fund was to allow investors to pool money to obtain diversification through one investment company that invested in stocks or bonds.  The pooling of the investor’s funds provided some efficiency along with having experienced management.

The mutual fund universe is a bit of a minefield.  Paying attention to the following points should assist you in avoiding common pitfalls.

Past Performance May Not Be Repeated

Quite often, investors are attracted to mutual funds based on performance alone.  Purchasing last year’s star performer is often a mistake.  Although it is important to look at past track records, investors need to be very skeptical about short-term returns, such as three, six or twelve months.  How has the fund done over three years or over five years?  Have there been any changes in the management of the fund?  How is the fund performing against its peer group?

Avoid Chasing the Flavour of the Month

It seems that many fund companies provide to the market exactly what investors are wanting.  In the late nineties investors wanted technology funds.  Some investors abandoned their plans and purchased funds whose mandate was to hold technology stocks.  These same investors, often over-weighted in the latest flavour, saw their fund values decline significantly when the tech bubble burst.  A key point to highlight here is that a sector fund should reflect the investor’s investment objectives and risk tolerance.

Selling Based on Poor Performance

It may sound counter-intuitive to think that a well-constructed portfolio should generally have some investments that are not performing as well as others.  Different types of investments will have different returns in different markets.  Before selling that under-performing fund we recommend that you first compare its performance next to its peers and its relative benchmark.  It is quite possible that the fund is complementing your portfolio but will only show its true colors in a different market.  If a fund has under-performed its benchmark and its peers then by all means it may be time to look at a change.

The Merits of Disciplined Management

Investing in a mutual fund means you are pooling your money with other investors and having a manager do a certain job investing it on your behalf.  In doing so, they can make hundreds of transactions and changes a year.  Buying a fund because it has some large weighting in a company you like isn’t a well-thought out idea.  If it hasn’t changed by the time you bought the fund, it could change very shortly thereafter.

Prior to purchasing any investment it is important that the investment is suitable for your overall portfolio strategy.  Your investment advisor should be equipped with the necessary programs to evaluate your mutual fund holdings.  Our next column will provide some tips on items you should look at when selecting mutual funds.