Narrowing your focus

One of the benefits of mutual funds is the diversification they offer. However, some are more diversified than others. Rather than taking a broad-based approach, some funds specialize. For example, a fund might invest in a subset of a general asset class, such as stocks or bonds. Or it might specialize in a particular way of investing, basing its investment objectives and securities selection on a clearly defined methodology. As with any mutual fund, information about a specialized fund’s investment approach, objectives, risks, fees, and expenses are contained in its prospectus, which is available from the fund and which you should carefully review and consider before investing.

Though they are not necessarily appropriate for everyone, specialized funds can be particularly useful in helping to round out an already diversified portfolio. However, all investing involves risk, including the potential loss of principal, and there can be no guarantee that any investing strategy will be successful.

Sector or niche fund

A sector fund invests primarily in the securities of companies that (1) are principally engaged in one segment of business activity, (2) belong to a group of industries, or (3) belong to a single industry. Areas that often are covered by sector funds include agriculture, health care, financial services, communications, technology, real estate, natural resources, and utilities, among others. These funds usually aim for capital growth, allowing investors to invest in a targeted industry or sector they think will do well in the future. They also may be referred to as “specialty funds” or “single-industry funds.”

A sector fund’s concentrated investment in a narrow slice of the market means that it can have strong returns when that sector experiences overall positive business trends over a relatively short time period. However, this narrow focus also can make a sector fund extremely volatile, which may result in sizable losses even when the broader market is performing well. For this reason, sector funds are not for everyone.

Benefits

• Potential for high returns–Many industries are highly cyclical in nature. If the industry in which a fund invests is in a strong part of its economic cycle, a sector fund may outperform the stock market as a whole.
• Less risky than investing in an individual company–Though diversification alone cannot guarantee a profit or ensure against a loss, there is less risk of losing your entire investment because of the fortunes of a single organization.
• Potential for capitalizing on or counteracting specific economic conditions or other market segments–Some industries tend to move in the opposite direction of others; for example, a natural disaster might create problems for insurance companies but spur new construction. Some funds specialize in investments that have traditionally been viewed as a hedge against inflation.

Tradeoffs

• Greater risk than a broadly diversified fund–Even though a fund may be diversified within its own industry grouping, its performance is still entirely dependent on that one industry. If the industry suddenly takes a sharp downturn or moves into a slow part of its business cycle, significant losses may result.
• Potential for double jeopardy–If your livelihood depends on a particular industry, you may be tempted to apply your knowledge of that industry by investing in a sector fund. However, you should remember that if your industry experiences difficulty, you could experience a double blow if both your income and your sector investment suffer.

Socially conscious/ethical investing funds

Socially conscious funds, sometimes known as socially responsible or ethical investing funds, are distinguished not by investing in a specific industry but by selecting investments according to a set of social, ethical, or religious priorities and guidelines. For example, a fund might avoid investing in particular companies, industries, or countries whose products, services, policies, or practices are at odds with the fund’s social priorities. Examples of companies that often are excluded from socially conscious funds include those in the tobacco and gambling industries, those with significant interests in countries with repressive or racist governments, or those that contribute to environmental pollution. A fund also might actively seek as investment targets companies or industries that are perceived as supporting certain beliefs about religion, social justice, or ethical business practices.

If you feel strongly about the societal benefit or harm your investment might help support, a socially conscious fund can be both personally and financially rewarding. However, each fund has a unique set of investment guidelines, and anyone considering an investment in one should understand that specific fund’s priorities and investing strategy to ensure that its goals match their own. Also, recognize that the fund may rule out many companies that have strong upside potential but whose activities don’t fit the fund’s agenda. That might or might not limit potential returns compared to funds with fewer restrictions. Though past performance is no guarantee of future results, reviewing data on the fund’s track record can help you understand whether your principles may affect the return you can expect.

Like all investments, socially responsible investments (SRIs) entail risk, could lose money, and may underperform similar investments not constrained by social policies. There is no guarantee that an SRI will achieve its investment objectives. As with many investment strategies, SRIs may limit the total universe of available investments, and investors who want to diversify their portfolios among a variety of sub-asset classes may not find a SRI to fill each sub-asset class. Different companies offering SRIs may use different definitions of socially responsible. investing.

Nondiversified funds

Some funds focus their investing efforts by limiting the number of stocks the fund holds, investing a large percentage of assets in a single security. To meet the definition of a diversified fund, the SEC requires that at least 75 percent of a fund’s portfolio must be diversified, meaning it can invest no more than 5 percent of that portion of the fund in a single company. Also, it cannot hold more than 10 percent of a company’s outstanding stock. By contrast, half of a nondiversified fund–also known as a concentrated, compact, select, or focused fund–may be invested in as few as two securities (25 percent in each one). Generally, a nondiversified fund will hold fewer than 40 stocks; some hold fewer than 20.

The premise underlying a nondiversified fund is that most of any fund’s returns are produced by a relatively few holdings. Nondiversified fund managers believe that to surpass average stock returns, the manager’s attention and the fund’s assets should be concentrated on his or her best investing ideas. According to this way of thinking, diversification is a double-edged sword. Just as it may help cushion the blow of poorly performing securities, diversification also can act as a drag on returns by reducing the impact of a portfolio’s winners.

The potential downside to a nondiversified fund? Successful stock selection becomes even more essential than with a diversified fund. Also, the smaller the number of holdings, the greater the impact of gains or losses on a single stock; as a result, a nondiversified fund may experience relatively high volatility. Finally, because the number of holdings is so limited, a manager must be especially careful about choosing and monitoring each one. With a nondiversified fund, the manager’s abilities become especially critical.

A nondiversified fund may be better suited to an aggressive investor, or one who also has other, more diversified holdings, than to a conservative investor with a lower risk tolerance.

Tax-efficient funds

Taxes are one of the most significant costs of investing, and tax planning can be a great concern for investors in mid to high tax brackets. A tax-efficient mutual fund (also known as a tax-managed fund) is designed and managed specifically to minimize its shareholders’ income tax liability and maximize after-tax returns. Regardless of what specific investments a fund holds, its manager can employ a variety of strategies to avoid taxable distributions.

How taxes take a bite out of returns

When a fund sells securities in its portfolio, any net capital gains realized from sales are distributed to the fund’s investors. As a shareholder, you generally must pay capital gains tax each year on your portion of the total capital gain distributions the fund pays out (unless the fund is in a tax-advantaged account). In addition, you may have current income from fund dividends, which include dividends and/or interest paid by the fund’s individual securities. Some types of dividends and all interest payments are taxable at your ordinary income tax rate, whether received in cash or reinvested (again, except in the case of tax-sheltered retirement accounts). Dividends paid on stock mutual funds may be taxed at the same lower tax rates as long-term capital gains through 2013.

What are some common tax-efficient strategies employed by these funds?

• Selling winners and losers together to offset capital gains–A tax-efficient fund may postpone selling appreciated securities until the sale of other securities in the portfolio produces capital losses that can offset those capital gains.
• Selling securities that have the highest cost basis–By taking cost basis into account when deciding which securities to sell, a manager may reduce the capital gain generated by the sale.
• Buying and holding–A portfolio manager who holds stocks for a long time rather than trading frequently avoids realizing capital gains that must be distributed annually to the fund’s shareholders.

When is a tax-efficient fund useful?

Tax-efficient funds may be especially valuable for investors who are in a mid-level (25 percent) to high tax bracket, have reasonably large capital gains from mutual funds each year, or have other tax concerns. They are generally less helpful to short-term investors, or those whose money is in 401(k) plans or other tax-deferred vehicles.

How can I determine a fund’s tax efficiency?

A fund’s turnover ratio–the frequency with which the manager sells stocks in the portfolio during a calendar year–can indicate how tax efficient a fund might be. A turnover ratio of 100 percent means that the total value of all the fund manager’s purchases of individual securities for the year equals the fund’s total value. Generally, a fund with a low turnover ratio has lower realized gains.

A mutual fund must include its turnover ratio in its prospectus, which also must include its after-tax returns for 1-, 5-, and 10-year periods.

Inverse/bear market funds

An inverse fund is designed to mimic the performance of a particular market benchmark–except in reverse. It is inversely correlated to that benchmark (typically an index), and is designed to fall when its index rises, and rise when the index falls. In order to perform as a mirror image of an index, an inverse fund typically sells short futures contracts that are based on the chosen index. Not all funds geared toward bear markets are inverse index funds; some actively managed bear market funds may short individual stocks or invest part of the fund in defensive asset classes that are highly uncorrelated with the bulk of the portfolio.

In some cases, an inverse fund tries not only to move in the opposite direction from its index, but to move even more dramatically. It may use leverage to magnify its gains and losses–for example, to attempt to go up by twice as much as any drop in its benchmark. Of course, because leverage affects both gains and losses, a fund leveraged in that way also would likely go down by twice as much as any gain in the benchmark.

Inverse and bear market funds are one way to, in effect, short a particular market or sector rather than just individual stocks. As a result, they are sometimes used to hedge against the possibility that a long-only investment in a similar asset will lose value. They can be used to try to offset the risk of an individual sector, or to implement a market timing strategy. Inverse funds also can be used to try to profit from a declining market while restricting your potential loss; unlike shorting a stock or index, which does not limit your potential losses, the most you can lose with an inverse fund is your original investment plus any earnings (though a 100 percent loss may not seem like a great advantage).

Jim has invested $50,000 in a mutual fund based on the S&P 500 index, and does not want to sell his shares because he would owe substantial capital gains taxes. However, he feels the stock market may be about to move down. He decides to buy $25,000 worth of shares of an inverse fund that also is based on the S&P 500. Shortly thereafter, the market takes a 10 percent drop, which means Jim’s index fund investment is now worth $45,000. At the same time, Jim’s inverse fund rises by 10 percent, so Jim’s net loss on these two investments is now $2,500 instead of the full $5,000. If the S&P 500 had not dropped but had risen by 15 percent instead, Jim’s $7,500 profit ($50,000 x 0.15 = $7,500) would have been cut in half, to $3,750, because the value of his inverse fund would have dropped ($25,000 x 0.15 = $3,750).

Using inverse funds must be done with caution. The overall direction of the stock market over time has been up, so sustained use of an inverse fund might reduce long-term returns, and timing the market is notoriously challenging. Also, expense ratios, especially for funds that use leverage, might be relatively high. Finally, leveraged bear market funds that try to magnify an index’s gains also mean correspondingly greater risk of loss.

Some exchange-traded funds also have similar inverse strategies.

An inverse fund may be designed to achieve its objective on a daily basis. However, any daily differences between the fund’s performance and that of the benchmark index would compound over time; this is particularly true of a fund that employs leverage. Those differences can be magnified in volatile markets, and would tend to grow over time. If you’re considering investing in such a fund, you should carefully assess the potential implications of holding it for an extended period of time.

Absolute return/market neutral funds

The typical mutual fund’s performance is affected not only by a manager’s skill in selecting securities but by the performance of the overall market. If the Standard & Poor’s 500 Index is down, a fund that invests in similar stocks will likely move down as well. The measurement of how much of the variation in a fund’s return is correlated to the behavior of the overall market is called its beta.

Some mutual funds attempt to achieve returns that neutralize market movements, so that the fund performs well regardless of whether a given market is up or down–at least in theory. Funds whose strategies try to neutralize the impact of market fluctuations are known as market neutral funds (sometimes called absolute return funds). Their managers aim not for relative return (performance relative to an appropriate benchmark) but for absolute return that can be generated regardless of market conditions. Typically, that number is over and above what can be earned in a cash equivalent such as a Treasury bill, though there’s no assurance that goal will be achieved, or that such a fund won’t suffer losses.

Most traditional mutual funds are long-only; they try to avoid investing in securities that are likely to drop in value. For a market neutral fund, such investments may be part of its game plan. There are many ways to pursue a market neutral strategy, but generally a manager tries to balance long investments with others that are likely to benefit from very different market conditions, and whose performance is not correlated with that of any long investments. For example, in addition to purchasing securities that are expected to increase in value, a market neutral fund might attempt to profit by selling short securities whose prices are likely to fall. Another manager might invest in two stocks or indexes whose prices generally move in tandem but currently diverge; the manager might sell one of them short while investing in the other on the theory that their prices will eventually converge again.

Typically, an equity market neutral fund will have roughly equal long and short positions; the idea is that the market exposure of each will cancel out the other. In theory, that would make a fund’s performance independent of overall market movements. Because balancing long and short positions attempts to remove market performance as a contributing factor, in theory any return from a market neutral fund should be based purely on selecting the right securities (plus interest on any cash collateral resulting from the short sales). In a way, market neutral funds are the mirror image of index mutual funds, whose performance depends almost exclusively on market performance.

Market neutral investing strategies have been widely used by hedge funds, but some mutual funds also have adopted the approach, though there are more constraints on how a mutual fund may implement it. Managers often use sophisticated computer models to determine which investments might be highly uncorrelated, and therefore good candidates for a market neutral strategy. Depending on a fund’s individual approach and objective, a market neutral strategy might involve not only stocks but debt derivatives, currencies, commodities and arbitrage.

Benefits

• Returns are designed to neutralize the systematic risk involved with a given asset class. As a result, a manager’s skill at securities selection may be less likely to be outweighed or hampered by factors unrelated to the specific portfolio.
• A market neutral portfolio attempts to produce a positive return during both down and up market cycles. As a result, it can be used to try to balance other investments whose returns are more tightly linked to overall market performance.

Tradeoffs

• Because the portfolio’s return relies so heavily on the manager’s correctly identifying both overvalued and undervalued securities, poor investment decisions may have greater impact on the portfolio than they might on a fund that also could benefit from a broad-based market rally.
• Unless the long and short portfolios are extremely well-matched and perform as expected, the fund may not be truly independent of market movements.
• Because such funds may have higher turnover, they may incur higher trading costs and therefore have higher expenses. Also, that higher turnover may mean higher capital gains that are passed through to investors, which in turn could mean higher capital gains taxes.
• Attempting to limit downside risk can also have the effect of limiting upside potential.

Long/short funds and 130/30 funds

As the name implies, a long/short strategy involves both long investments and short selling. In theory, a long/short fund manager attempts to profit from negative information about an investment that would otherwise be useless if the fund were long-only. By investing long in some securities and selling others short, a long/short strategy allows a fund manager to try to mitigate the impact of a market downturn, since the short sales would be intended to benefit from a drop in price. Many long/short funds are run according to quantitative models that identify candidates for investing, both long and short. However, some also screen potential investments by using fundamental analysis.

Though they may use similar techniques, long/short mutual funds are different from both market neutral funds and hedge funds. Long/short funds try to outperform a benchmark and reduce the impact of a down market; a long/short fund typically has a greater proportion of assets in long investments than it does in short sales. By contrast, a market neutral fund’s objective in investing both long and short is to actually decouple the fund’s performance from that of a given market, and it usually balances long and short investments almost equally. (However, different funds may have different levels of shorting.)

Compared to a hedge fund, a mutual fund is more tightly regulated in how extensively it can use hedging techniques. A mutual fund also provides greater liquidity than a typical hedge fund, though a long/short fund’s fees may be higher than those of other types of mutual funds.

An extension of a long/short fund is what has become widely known as a 130/30 fund; in fact, such funds sometimes are known as active-extension or short-extension funds. The name is derived from the relative proportions of a fund’s long and short investments; those proportions may vary from fund to fund. For that reason, they also are sometimes called 1X0/X0 funds. The X represents a variable number; for example, there also are 120/20 funds, 110/10 funds, and so on, though the 130/30 ratio has been the most widespread. Be sure to check a fund’s prospectus to see the ratio it uses and how much it is allowed to deviate from that ratio.

A 130/30 fund buys a basket of securities deemed by either a quantitative model or the manager’s judgment to be undervalued. It then sells short securities that are collectively valued at about 30 percent of the long position; these have been identified as overvalued. The fund then uses the proceeds from that short sale to purchase (go long on) additional undervalued securities that add up to 30 percent of the original investment. In effect, the fund has borrowed the value of the securities that are sold short, and used leverage to increase the fund’s long position to 130 percent of its assets.

Benefits

• Using leverage can magnify the fund’s gains. Using what is in effect borrowed money to increase market exposure can potentially lead to greater returns.
• A 130/30 fund allows the fund’s manager to replicate an index–for example, with the initial 100 percent long position–while simultaneously actively managing the additional 30 percent long investment(s).
• A 130/30 fund offers some of the same investing advantages enjoyed by hedge funds with fewer restrictions on participation and withdrawals.

Tradeoffs

• Just as leverage can increase potential returns, it also can increase potential losses. And even though long positions would presumably offset at least part of any losses from short-selling, short sales can mean unlimited exposure to potential loss.
• The manager could be forced to close out short positions and return the borrowed stock at an inconvenient time, which could reduce the fund’s overall return.
• Investing long and selling short require somewhat different perspectives and aptitudes, and a manager may not be equally skillful at both.
• The short component could involve higher trading costs and therefore higher fund expenses.