If you are investing in an actively managed fund, you need to judge whether the plan makes sense.
Unfortunately, the least visible aspect of a mutual fund is the person responsible for making the decisions. Although the Securities and Exchange Commission requires disclosure of a considerable amount of important material in a mutual fund's prospectus, informative discussions of a fund investment manager's approach are often lacking.
However, there is material available to individuals—fund marketing literature, manager interviews by the AAII Journal (which has published over 130 interviews) and other publications, and even some fund prospectuses—that can help you understand a fund manager's approach, if you know what to look for.
Here we focus on the questions you need to ask about a portfolio manager's approach. Excerpts from past AAII Journal interviews of fund managers, most of whom have above-average long-term track records, are used to illustrate what these questions can reveal.
What is the overall investment philosophy?
Good portfolio managers have philosophies that go beyond a simple statement that they are "value" or "growth" investors. For example, a portfolio manager who really understands and applies a value approach points out that it is one that is going against the market, and that's what creates the "value." In addition, philosophies can sound similar if only a one-word description is provided; big differences emerge when descriptions are more complete.
For example, consider these descriptions by two fund managers, both with good track records and both of whom describe their approaches as value investing.
Manager #1:
"We go through a comprehensive fundamental analysis on individual companies and then compare our forecasts for the prospects of the company against the current pricing. We are trying to find a significant difference between our forecast of future profitability for a company and the profit expectations indicated by the current stock price of that company."
Manager #2:
"We focus on companies that are undergoing some kind of fundamental change, because we think the market does not know how to price "change." If people decided that a company's growth rate is going from 15% to 16%, all the valuation models in the world will tell you what that would do to the stock's price. But when a firm gets a new chairman, how do you analyze that? It requires a lot more creativity, and that's where we think we can get an edge."
Needless to say, the stock selections of the two funds are quite different.
What is the stock universe that you select from—for instance, do you focus on dividend-paying stocks, small-cap stocks, mid-cap stocks?
This question zeroes in on the segment of the market in which the portfolio manager is concentrating, which is not always obvious.
The answer to this question should also be tied in with the portfolio manager's investment philosophy. For example, the universe of stocks from which one growth fund makes its selection is the service sector of the S&P 500, which is defined very broadly as non-manufacturing stocks, and consists of close to half of the S&P 500 by market capitalization. The portfolio manager explains the rationale for this particular universe as follows:
"The underlying investment thesis is that the service sector of the economy has been the primary engine of growth in the overall economy since World War II, and that this sector of the economy will continue to grow faster than the rest of the economy."
Understanding the fund's universe will also clue you in on the appropriate index by which to compare the portfolio manager's performance. Conversely, an index by which the portfolio manager measures himself may clue you in on the kinds of stocks in which he is invested.
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