Mutual Fund Investors: Watch Your Style

How to know what a fund's style really is.

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Scott Holsopple

You say you’ve done all the big-picture stuff to create your 401(k) investing strategy, and you want to get your hands dirty with some details?

Well then, it’s time to choose some mutual funds.

If your 401(k) plan offers a few options from each asset class, there are several things to consider during your mutual fund selection process. The last piece I wrote about fund selection covered the basics, but I also want to address the importance of choosing funds that will stay true to your asset class allocation.

If you’ve worked hard to analyze yourself, your goals and the market, it would be a real shame to waste that work by selecting funds that venture too far from their box.

Let me explain.

Each mutual fund has an investing strategy and a stated purpose. Every fund has a written obligation that defines the percentage of its assets that must fit within specific investment types. That means funds generally invest in companies that are similar to those held in whatever market index the fund is trying to beat, with fund managers using discretion to differ from an index in an effort to outperform it. Based on that information, fund research companies like Morningstar evaluate the fund’s characteristics and assign each fund to a style box. Common style box categories are based on the size (large cap, mid cap, small cap) of the companies the fund invests in, and the type of stocks the fund invests in, like those showing growth and value characteristics.

Here’s the problem: funds are allowed leeway. Within its fund mandate, managers are given a level of discretion. Funds that specify by name they will invest in certain types of investments or regions are required by law to invest at least 80 percent of their net assets in the types of investments suggested by the fund name. This will leave the fund manager with room on the remaining 20 percent. For example, a fund with "Large-Cap Value" in its name will have to invest 80 percent in large-cap value investments, but the other 20 percent could be anything.

So your fund might be called an international bond fund, but the reality is that it could easily hold other types of investments based on the fund manager’s discretion.

This means that fund managers could cause your intended asset class allocation to be quite different from what you actually want.

Your 401(k) allocation should be designed to spread risk by spreading your investments into several asset classes. Simultaneously, a well-designed allocation places you at a risk level that’s appropriate for you.

You can see why it’s very important to find funds that don’t deviate too far from their style box. If you want to be in a domestic bond fund, but the fund manager is investing heavily overseas to increase returns, your portfolio is taking a different amount of risk than you originally intended.

In the current economic climate there are a few thoughts to keep in mind when it comes to reviewing a fund’s style and your asset allocation.

First, because we’re in a slow recovery with slowed economic growth, everyone is searching for returns and yield. Some fund managers may be looking for opportunistic ways to gain growth. In the process, they may push the limits of their mandates.

Second, there are funds commonly called “go anywhere” funds or “broad mandate” funds. Managers have the capability to take the underlying holdings in any direction. Because of the level of market volatility we’ve seen during the past few years, there’s demand for funds that feature high levels of manager autonomy. The issue for you is that these funds are still placed in specific boxes even though they can’t be easily categorized. You’ll need to do more research to find out what you can about risk associated with these funds.

Individuals who’ve worked to create a personalized investment plan want to ensure the funds they choose are fairly true to their asset class in order to maximize the benefits of asset allocation.

Scott Holsopple is the president and CEO of Smart401k, offering easy-to-use, cost-effective 401(k) advice and solutions for the everyday investor. His advice has been featured on various news outlets, including FOX Business, USA Today and The Wall Street Journal.