Part 3 Practical Mutual Funds: Finding Equity Value

Over first and second articles discussing how to implement Mutual Funds, we’ve gone into detail about the obvious rewards, and lesser-known risks associated with fund investment. With these valuable tools under control, I’m now going to share with you some professional tips on how to implement the broad categories of Mutual Funds in a portfolio. By the end of the next two sections, you’ll know exactly what you’re looking for when fund-hunting with your advisor.

When dealing with Equity-Based Mutual Funds, there are three broad styles that a personal investor has access to:

Value Funds

A value fund is one that focuses on the pursuit of deep discounts on tangible cash flows and assets. The late Ben Graham (mentor of Warren Buffet) described this strategy as the pursuit of buying dollars for cents, and unlocking hidden value. While this strategy contains little financial risk (true value investments will even earn a profit upon liquidation), there is a great deal of patience required, as it can take an extremely long time for value-based assets to appreciate to their true worth. This means that a value fund requires an investment horizon of several years, but will also perform extremely well during aggressive bull-markets, as investors are more actively searching to buy up opportunities.

That being said, a good Value Manager is an expert of building a portfolio that contains at least one stock that will double every year, regardless of conditions. One thing to be wary of with this kind of security is the risk of sudden capital gains. Value stocks are prone to acquisition and liquidation, resulting in sudden gains in value that could stick you with the good kind of unexpected tax obligation.

Growth Funds

Growth funds are similar to value funds, in that they focus on companies with the potential for capital appreciation. The difference, however, is that a growth fund will focus more on earnings potential than asset value, and may even measure levels of technical ‘momentum’ to evaluate buying and selling opportunities. Growth funds will tend to favour companies that have moved beyond the stage of being a value opportunity, and have begun demonstrating an ability to access the capital markets to fund rapid expansion and scaling. However, these are the funds that get hit the hardest during periods of economic decline.

The sensitivity of the fund to the earnings growth of the companies themselves requires either a particularly robust company, or particularly robust competitive advantage. This is the sort of fund you want to try to pocket away in a corner of your portfolio for when the world pulls itself together. You don’t need to hold a bunch of it, just enough to make an impact when it finally pops. As with value funds, be aware of sudden capital gains, and the risk of a market collapse. Because of this kind of fund’s inadvertent exposure to overall market risks, there is a risk of Contango should the earnings power of the companies inside the fund begin to decline due to a slowing market.

Special Equity Funds

‘Special Equity’ is a particularly vague phrase used to indicate that a fund is composed of a selection of very niche-specific securities. The niche itself could be anywhere as specific as Asian producers of components for services vehicles, to an industry specific focus. Alternatively, special equity funds may give smaller investors access to high-performance hedge-funds, venture capital, or private equity offers. Regardless of the specific focal point of the fund, the purpose is almost always to facilitate the transfer of capital between opportunities that require a high level of understanding, and capital sources (investors), through a knowledgeable intermediary (the fund manager).

As remarkable as it may sound, the ‘special’ qualities of many of these funds tends to generally remove the companies within these funds (and therefore the funds themselves) from the fundamental systemic risks that impact the greater market. The end result is that a special equity fund has the capacity to perform without direct correlation to the market itself (ie. It has no real Beta). As exciting as that may sound, small time investors may find themselves overwhelmed by the complexity that some of these products can offer.

This can result in investors being at the mercy of the Fund Managers themselves, and the high fees they may choose to collect. Because of the complexity involved with some of these products, its best to let your advisor handle this category at their own discretion.

That’s it. Although I could go on forever about all the exotic classes of equity funds out there (and in future articles, I likely will), the fundamentals above are all you really need to get going on discussing a solid equity fund portfolio with your advisor. With that aspect under control, be sure to make some time to get through the final section of this series, which will discuss one of the easiest fixed-income strategies on the street.