Peeking Under the Hood
With a countless number of mutual funds in existence, each with their own unique name that tries to grab an investors’ attention, it can be dangerous for an investor to assume they know what type of assets that fund is holding. A fund may have a name that denotes its focus on a specific geographic location or a particular strategy but could also have the ability within its mandate to ‘drift’ into other areas that are not overtly reflected in the name of the fund. The only way to get an idea of what is ‘under the hood’ of a fund is by looking deeper into the asset allocation. For those who hold mutual funds, understanding the composition of the funds is a necessary step in determining an investors’ true asset allocation.
While there are various sources that can be used to obtain the information that will be discussed below, we will be using the Morningstar website as the primary reference simply because it is accessible to anyone with internet and it is what I am personally most familiar with. Upon arriving at the site, a simple search will bring up a desired fund. An investor will likely see various classes of the same fund, some of which require a membership to view. Regardless of the class, any differences in holdings should (hopefully) not be material. The first and likely most important tool that is offered when determining the make-up of a fund is the asset allocation table.
Asset Allocation:
A breakdown of the funds asset allocation can be found along the right hand side of the Morningstar quote page. This outlines how assets are allocated geographically between fixed income and equities as well as how much cash is being held. To some individuals’ surprise, they may find that what they thought would be a 99% allocation to one area is not the case. There is nothing ‘sinister’ going on with this discovery as a funds ability to do something like this should be outlined in their mandate but it is important an investor is aware of this as it does have implications on their broad asset allocation. A portfolio may be significantly over or underweight an asset class due to the allocations of one or many mutual funds. The allocations of balanced funds are the most likely to surprise an investor once they are looked at closely.
One area to watch in the asset allocation table is that of cash. One may often come across funds that are holding more than 10% of the portfolio in cash. In my opinion, this should be viewed very critically as an investor is not paying a manager to hold their funds in cash (and charge fees on it). They are being entrusted with assets and paid to invest a certain way. It should be left to the individual investor to decide how much cash they want to be holding or if they want to make a ‘go to cash’ type of timing decision. The one caveat with this is that there is obviously a need for mutual funds to hold some percentage of cash to allow for further purchases and there are times that cash may be higher if a fund is exiting one position and preparing to enter another. Nevertheless, funds holding cash in the 10% range should be an issue that is scrutinized closely by an investor.
Top Sectors:
Seeing a breakdown of the sectors a fund holds can help show where many of the returns are coming from as well as if the fund is making a ‘bet’ on a particular sector. If an investor is holding a technology fund, it should be expected that a large proportion of holdings would be in the technology sector but if a general fund is holding a high amount of technology exposure it may create an unnecessary overweight position relative to the investors’ total portfolio. Again, this is not necessarily a bad thing but is something the investor should be aware of.
Top Holdings:
Going even more granular into a funds allocation, as the heading explains, this section outlines the largest holdings in a fund. These holdings can and will change but it is helpful to get an idea of how the fund is accumulating positions. Do they have heavy weights in the top ten? Depending on preferences, an investor may prefer larger positions being taken versus smaller ones that are more likely to perform similar to an index/ETF.
After breaking down a funds’ general composition through the above three tools, an investor can gain a grasp of their asset allocation. Understanding the asset allocation can help to inform an individual of whether they are over/underweighted towards particular asset classes and how this positioning affects their risk/reward scenario and long term goals. It is easy for investors to end up holding a very different allocation than expected when the portfolio consists of primarily mutual funds. While it is reasonable to allow a fund to drift into other allocations; if a portfolio of 6-12 funds are all drifting 10% to 20% toward other assets it becomes easy to imagine that at the end of the day an investor could be holding a material position in an asset class that they were unaware of. For an investor who wishes to hold mutual funds, they should look at them similar to how they would buy a used car. The name on the car may sound good but you would always take a look under the hood to make sure that all the right parts are there and in some cases to ensure that at least the engine is there so that you can get to where you want to go.
Ryan Modesto
No comments