Mutual fund investment styles
Key Points
- Active vs. Passive
- Mutual Fund Investment Styles
- Growth vs. Value
- Size
- Bottom-Up vs. Top-Down
- Technical vs. Fundamental Analysis
- Don't Judge a Fund by Its Cover
- Points to remember
The growth in the number of mutual funds is, in part, a reflection of the variety of investment styles employed by fund managers. The following is an overview of some of the key style categories.
Active vs. Passive
Active investors believe in their ability to outperform the overall market by picking stocks they think will perform well. Passive investors, on the other hand, feel that simply investing in a market index fund will produce higher long-term results. Passive investors believe this is due to market efficiency. In other words, they feel that all information available about a company is reflected in that company's current stock price, and it's impossible to predict and profit on future stock prices. Rather than trying to second-guess the market, passive investors buy the entire market via index funds.
Active investors counter that the market is not always efficient and that through research, active fund managers may be able to uncover information not already reflected in a security's price and potentially profit by it. For example, some active investors feel that the small-cap market is less efficient than the large-cap market since smaller companies are not followed as closely as larger blue-chip firms. A less efficient market could potentially favor active stock selection, they reason.
Growth vs. Value
Some stock fund managers can be divided into growth and value seekers. Proponents of growth seek companies they expect (on average) to increase earnings by 15% to 25%. Stocks in these companies tend to have high price to earnings ratios (P/E) since investors pay a premium for higher potential returns. They also usually pay little or no dividends. The result is that growth stocks tend to be more volatile, and therefore more risky.
Value investors look for bargains — stocks perceived to be undervalued that are often out of favor, such as cyclical stocks that are at the low end of their business cycle. A value investor is primarily attracted by asset-oriented stocks with low prices compared to underlying book, replacement, or liquidation values. Value stocks also tend to have lower P/E ratios and higher dividend yields. These higher yields tend to cushion value stocks in down markets while certain cyclical stocks will lead the market following a recession.
Other investors choose not to lock themselves into any one investment style. Returns on growth stocks and value stocks are not highly correlated. This means that an increase or decrease in one type usually has little effect on the other. By diversifying between growth and value, investors can reduce some risk and still enjoy long-term return potential.1
Mutual Fund Investment Styles
Active — Strives to outperform the market by actively picking out the stocks.
Passive — Believes that investing in a market index will produce better long-term results.
Growth — Seeks out growth stocks with high P/E ratios.
Value — Picks asset-oriented "cheap" stocks with lower P/E ratios.
Technical Analysis — Advocates analyzing charts of stock prices and economic trends.
Fundamental Analysis — Believes in analyzing annual reports and other data, as well as visiting companies.
Bottom-Up — Searches for strong individual companies.
Top-Down — Examines macroeconomic trends, picks the industry, and then looks for companies within the industry.
Small Cap — Prefers small-cap stocks for their higher potential for growth.
Large Cap — Believes that large-cap stocks provide less volatility and can still outperform small-cap funds.
Size
Some investors use the size of a company as the basis for investing. At times, the highest returns — on average — have come from stocks with the lowest market capitalization (common shares outstanding multiplied by share price). But since returns tend to run in cycles, there have also been periods when large-cap stocks have outperformed smaller stocks. Small-cap stocks also tend to have higher price volatility, which translates into higher risk. Some investors choose the middle ground and invest in midcap stocks — seeking a trade-off between volatility and return.
Bottom-Up vs. Top-Down
A top-down investor looks first at economic factors and then selects industries accordingly. For example, during periods of low inflation, consumer spending increases, which might be a good time to buy automobile stocks or retail stocks. The top-down investor would then search for the best values in these industries. A bottom-up investor is more concerned with the fundamentals of individual companies. They reason that even if its industry is doing poorly, a strong company will still outperform the market. Both emphasize fundamentals but place different emphasis on the economic environment.
Technical vs. Fundamental Analysis
Another difference is that some equity investors look at the fundamentals of individual stocks, while others invest based on technical analysis. Fundamentalists, who represent the majority, spend time poring over annual reports and visiting companies attempting to uncover investment opportunities and maximize return over the long run. Technical analysts pore over charts of stock prices and economic data in an attempt to divine patterns indicative of future trends, and they are more concerned with short-term market timing than individual stock picking. Although technical analysts fell out of favor as studies questioned their predictive powers, increased access to information and the rise of computers have led to a resurgent interest.
Don't Judge a Fund by Its Cover
With such a wide variety of investment styles, individual fund investors may be confused as to which is the best. In order to reduce volatility, many experts encourage diversifying or spreading money around among different investment styles. Fund investors need to ask questions, carefully read the fund prospectus, and consult fund rating services to make sure they are buying a style that is right for them.
Points to Remember
- There are several investment styles, and each plays a dominant role in overall fund returns.
- Active vs. Passive: While active investors believe in their ability to outperform the market by actively selecting securities, passive investors believe in investing in a market index for long-term results.
- Growth vs. Value: Proponents of growth-style seek companies with growth potential — typically with a high P/E ratio — while value-style investors look for stocks perceived to be undervalued at the low end of their business cycle.
- The bottom-up approach believes in first finding good stocks and then looking at macro factors such as the economy and specific industries. Top-down adherents believe in first zeroing in on the industry and then selecting a stock within that industry.
- Find out the fund manager's style of investing before investing in a fund.
1 Diversification helps you spread risk throughout your portfolio, so that investments that do poorly may be balanced by others that do relatively better. Diversification does not ensure a profit or protect against loss.
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