Mutual Fund Investment Strategies

There are many different mutual fund investment strategies. In fact they’re only limited by regulatory issues, the ability of money managers and investor demand. But in choosing a fund, the investor must be vigilant that the fund is actually doing what its name implies.

The Importance Mutual Fund Investment Strategies

Mutual fund investment strategies, or any other kind of investment, should incorporate an understanding of the market conditions and ultimate objective of the fund.

Since mutual funds are essentially pools of money managed by a professional money manager, there are many different mutual fund investment strategies. Potential strategies are only limited by regulatory issues, the ability of money managers, the desire of a sponsor to establish such a fund and the demand from investors for that type of fund.

Outline of Mutual Fund Investment Strategies

Categorization

Mutual funds are classified by mutual fund surveys into categories based on their investment policy statement and the predominant type of assets held. This categorization influences the mutual fund investment strategies that are applicable. The broad categories are:

Equity Funds, which hold mainly common stocks, or “equities;” Bond or Fixed Income Funds, which hold bonds and fixed income securities; Balanced Funds, which hold stocks, bonds and short-term securities and allow the investment manager to alter the proportion of these investments; Income or Dividend Funds, which hold preferred and common stocks that generate high dividend income; and Money Market or Short-Term Funds, which hold treasury bills, money market securities and other income generating investments which are less than one year in term.

At first, there would seem to be little constraint on the type of fund that could be created. In reality, most funds are established by marketing imperative. A fund sponsor will only establish a type of fund if there is the sufficient prospect of assembling enough assets to provide a profitable return. This means that new types of funds usually gurgle up from the well of “investor fashion.”

What’s in a Name?

Funds specify their “investment policies” in their trust indentures and public prospectuses, which in turn affect their investment strategies. These can allow the manager a wide range of latitude in investing a fund’s assets. While this in itself isn’t bad, it has led to many funds bearing little resemblance to their name.

This had led to increased concern by regulators in Canada and the U.S. that the performance of some funds has been quite different than their name would suggest.

For example, a well-known “Mortgage and Income Fund” in Canada held mostly equities and very few bonds or mortgages. While this led to good long-term performance, it led to the fund being classified in the Income Fund section of several mutual fund performance surveys. Investment professionals acquainted with this fund considered it to be a Balanced or Equity Fund.

In the U.S., some money market funds in the United States held “derivatives” of longer-term mortgage-backed securities (MBS). Money market funds usually restrict their holdings to fixed income securities less than one year in term to assure that their holdings can be redeemed quickly and at a price close to their quoted value. The structure and valuation of the MBS derivatives was based on expected cash flows from the underlying mortgages. Where most money market securities offer good protection against rising interest rates, the MBS derivatives lengthened in term and fell substantially in value. This led to capital losses in money market funds holding these securities, something that investors in these funds didn’t expect. In some cases, the mutual fund sponsors contributed to the funds to compensate for the losses, although they were not legally obligated to do so.

Sector and Theme Funds

Sector funds are based on specific areas or “sectors” within a broader asset class or mutual fund grouping. “High yield” or “junk bond” funds are bond funds that invest in lower quality “junk” or “less than investment grade” bonds. “Resource” equity funds invest in the equities of companies in the resource industry.

Theme funds invest according to a particular investment philosophy or “theme.” Traditional “growth” and “value” equity funds are based on interpretations of these investment philosophies. More recently, funds have been created that reflect a particular “investment theme.” Environmental funds invest in companies that have “environmentally-friendly” policies. “Emerging market” funds reflect the investment theme that emerging country economies will grow faster than the more established economies.

Mutual Fund Investment Strategies: Effects

Mutual fund investment strategies affect the way these funds are organized and the kinds of assets they can be invested in. While categorization can be fairly loose, it is important when considering the classification and marketing of funds. As we have seen, loosely defined categorization can cause conflict between the actual investments of a fund, its market category, and the internal understanding of the fund.

4 years ago