We don’t care how much regulation there is, the publicly available mutual fund will always be the Wild West of finance. Why?
The reason is simple: these funds are targeted at laypeople, who may never have invested before. And they are fantastic at using buzzwords to keep you invested, even when they’re on the verge of imploding. Forget their marketing spin, and look for these signs:
1. Your mutual fund is a closet indexer
Take a peek inside your mutual fund. What are the stocks in it? If you see something like the 30 blue chip companies on the Straits Times Index and nothing else, we have news for you: you’re dealing with a closet indexer.
A closet indexer buys stocks that mimic an index as closely as possible. This is a very reasonable way to make money, except you know what? That’s called an index fund. There’s no point paying higher fees for a mutual fund – especially if you have an actively managed mutual fund – if all it does is behave like an index fund. You may as well sell it off and go buy an actual index fund; it would be the same thing, but probably cheaper.
This isn’t a condemnation of index funds, mind you. We’re just pointing out that index funds tend to have expense ratios of under one per cent, whereas mutual funds tend to charge in the one to two per cent range. That higher fee might be justified if they are doing something besides just indexing.
One easy way to spot closet indexers is a high R-square. R-Square reflects how much of an asset’s movement can be explained by movements in a benchmark index. It’s one component of the Capital Asset Pri…and now you’re asleep.
Okay, forget it. If the R-Square is really high, like 80 to 90 per cent, look inside the fund. It may be a closet indexer. This is usually indicated somewhere on the fund’s literature (if you can’t find it, contact them and ask).
2. The fund manager keeps changing
A fund manager leaving (or a change of algorithm / software if it’s a computer) isn’t in itself a problem. That happens all the time. But if there are repeated changes in a short time, such as five different fund managers in three years, that often suggests two things: (1) something is about to go wrong, or (2) there are better prospects elsewhere.
Fund managers have a very good sense of self-preservation. We would rank their survival skills somewhere above a camel in the Sahara. They know when something is wrong, and they won’t ruin their reputation by being around when it does.
This is the same principle you would apply to companies when picking stocks: if the CEO keeps changing, you should keep your distance.
Fund managers may also leave when they sense few prospects (read: really bad bonuses) for what they’re managing. Take that as a cue to “up periscope”, and see if there are better funds to be involved with.
3. The fund has broken your limit on underperformance
Set a limit on how much, and how often, you will allow the fund to underperform. If you are new to investing and aren’t sure how to do this, check out some of the methods on The Fifth Person. Or like us and drop us a message on Facebook.
Don’t subscribe to sunk cost fallacy, where you hang on to an underperforming fund because you’re hoping to “make back” year of underperformance. Gambling and hope go hand in hand, and neither are good strategies for your retirement.
Have a clear line. And when it’s crossed, get rid of the fund. Don’t even waste time worrying about how much it’s already cost you. While you’re busy moping, everybody else in the market is already moving on to the next dollar.
4. The fund consists of too many assets you already own
If you’re in the habit of buying many different mutual funds, you should know that’s not what diversification means.
Well, it is a kind of diversification, but you’re not grasping the whole concept. Yes, you should never sink everything into just one mutual fund. But remember that mutual funds are not individual stocks – they may be grab bags composed of different assets, including stocks, bonds, derivatives, and poor work-life balance (fund management is a tough job).
Some mutual funds will overlap with others. For example, you may have three separate mutual funds, each of which includes shares in DBS. You may notice this defeats the purpose of diversification – you think you’re diversified, but you’re still buying too much of the same assets.
It would pay to sort through your mutual funds and get rid of the ones with too many overlaps. Or if that sounds annoying and tedious, maybe it’s time to build your own portfolio.
5. The fund changes direction two or three times within a single year
Funds change their strategy all the time. It’s not unusual for a fund that once focused on, say, South East Asian markets to switch focus to China, or for a fund that once focused on small cap stocks to start adding mid-cap stocks.
There’s usually an explanation of this in the reports.
But you should worry when a fund starts to change direction repeatedly, within a short time period. There are usually costs involved in this sort of constant shuffling, and they may be eating into your returns. On top of that, it’s always worrying when a fund manager can’t seem to pick a direction (although they will attempt to play it off as “adaptability” in their explanations).
If may also be time to leave if the fund takes you past your “sleeping point”. For example, if you keep hearing the fund manager talk about “evolving hypotheses” and how they are going to buy more of a stock that went down even though they were expecting it to rise, perhaps the fund no longer suits your risk appetite.
One of the main appeals of a managed fund is that you can sleep at night (hence the term sleeping point). It is supposed to be a less tumultuous way to invest. If that isn’t happening for you, then perhaps it’s time to rethink the fees you’re paying.