Once in a while, the markets deliver a timely reminder that not all investments are created equal. We just got one — and right in time for the holidays.
Third Avenue Management’s Focused Credit Fund recently announced it would stop investors from cashing in their holdings. The reason was to facilitate the orderly liquidation of the fund’s holdings of speculative-grade fixed income securities, also known as junk bonds. To do otherwise would have meant a fire sale.
Should investors have been surprised that they couldn’t get their money when they wanted it? Maybe, maybe not. It is rather unusual for a mutual fund to do such a thing. That said, investors need to do their research before committing their hard-earned funds to any mutual fund.
“It’s dangerous out there and the more homework you do, the better off you’ll be,” says Art Hogan, chief market strategist and director of research at Wunderlich Securities.
Doing so will not eliminate losses, but it will help minimize them and will mean that you understand the risks involved. Here are nine tips from the experts:
Find out what the fund owns. In the case of the Third Avenue Management fund, investors could easily have seen that it owned junk bonds. “Someone getting involved with a high-yield fund should understand that there is greater volatility with such assets,” says Gary Schatsky, president of New York-based fee-only financial adviser ObjectiveAdvice.com. “It’s not that you shouldn’t buy such things, but you could easily know that they are traded in relatively illiquid markets.”
In illiquid markets, the prices for securities can easily get bounced around. He contrasts that with very liquid trading in mega-cap stocks like General Electric Co. (ticker: GE), which has a market capitalization of more than $300 billion. “Certainly you can buy or sell GE stock until the cows come home without affecting the price of General Electric,” he says.
Lack of liquidity isn’t just the realm of the junk bond market. Schatsky points to esoteric foreign stocks. It can also happen with small-cap stocks here in the United States, he says.
Those with specialized knowledge might also have been able to discern whether the securities the Third Ave Management fund owned were riskier than those owned by similar funds. If you don’t have the expertise, then find someone who does.
Yield has a cost. One of themes of the past few years has been investors seeking out income-producing securities while the Federal Reserve kept the cost of borrowing near zero. “Unfortunately, when you chase yield it doesn’t mean its bad investment, but you are giving something up for it,” Schatsky says. In this case, what was given up was the ability to get out of the investment quickly.
Is the fund diversified? Investors buy mutual funds to help remove the risk of holding single securities. Anything can happen to a single stock or bond. There is less likely to be a problem when a basket of them are owned. Unfortunately, some funds are riskier than others because of decisions the portfolio manager makes. “Investors should be aware if a fund is taking excessive risks by taking large positions in individual stocks,” says David Larrabee, director of continuing education at the CFA Institute in Charlottesville, Virginia. A mutual fund holding only a few stocks or bonds should be approached cautiously.
Follow the mandate. Investors need to see if the manager is staying true to the fund’s mandate. Sometimes, the mandate and what the manager does diverge. “You could end up with a fixed income fund manager investing in technology stocks,” Larrabee says. If portfolio managers don’t stick to the mandate, steer clear. Investors can find out what the firm says it aims to do by reading the prospectus and then compare that with what it owns. These documents can be dry, but they contain a lot of useful information.
Know the management tenure. An important question for any investor is to understand whether there is continuity and stability in fund management. You can see how long the portfolio manager has been in that job by looking at the fund prospectus. In general, frequent turnover of managers should be viewed as a red flag, Larrabee says. Unlike some professions, it is not unusual to find portfolio managers who remain with their firm for decades.
Check the annual expenses. Look to see what fees you’ll be paying, Hogan says. The annual expenses are disclosed in the fund prospectus and are also available on the Internet. In general, lower the fees, the better for investors.
Are there short-term trading fees? In addition to annual costs, there are sometimes redemption fees charged for cashing in holdings too quickly. It can be called a short-term trading fee. If you think you might want to bolt from the fund quickly, just be aware of how much it might cost you to do so.
Don’t make assumptions. It’s quite common for investors to buy a few different mutual funds. When they do, they think they’re are diversified, but often they aren’t. “If you buy a large-cap fund and growth fund you may actually own 80 percent of the same stuff in each,” Hogan says. Check by looking at the prospectus.
A fund’s performance may change. “Don’t make an assumption that someone who has had a good year will have another good one,” Hogan says. All fund prospectuses say that and most people ignore it. Don’t ignore it.
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9 Things to Know About Investing in a Mutual Fund originally appeared on usnews.com
