The criteria that mutual fund managers use to select their assets vary widely according to the individual manager. So when choosing a fund, you should look closely at the manager's investment style to make sure it fits your risk-reward profile.
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"Investment style is incredibly important because of the way that investing works," says Chris Geczy, director of The Wharton School's wealth management program at the University of Pennsylvania.
"Both risk and return are connected to style. According to current practice portfolio theory, you can optimize a blend of styles for diversification, balancing reward and risk."
Here's a look at a half-dozen common investment strategies among fund managers.
Top-down or bottom-up investing
Top-down investing strategies involve choosing assets based on a big theme. For example, if a fund manager anticipates that the economy will grow sharply, he or she might buy stocks across the board. Or the manager might just buy stocks in particular economic sectors, such as industrial and high technology, which tend to outperform when the economy is strong.
If the manager expects the economy to slump, it may spur him or her to sell stocks or purchase shares in defensive industries such as health care and consumer staples.
Bottom-up managers choose stocks based on the strength of an individual company, regardless of what's happening in the economy as a whole or the sector in which that company lies.
"The great advantage of top-down is that you're looking at the forest rather than the trees," says Mick Heyman, an independent financial adviser in San Diego. That makes screening for stocks or other investments easier.
And, "When you're right, you're really right," says Tim Ghriskey, chief investment officer at Solaris Asset Management in Bedford Hills, N.Y.
Of course, managers might be wrong on their big idea. And even if they're right, that doesn't guarantee they'll choose the right investments.
"A good example is gold," says James Holtzman, a shareholder at Legend Financial Advisors in Pittsburgh. "That would make sense for a top-down investor. But what if you're looking at a gold mining stock and the company is being run into the ground? The particular stock could be ready to collapse, even though investing in gold makes sense."
A bottom-up manager benefits from thorough research on an individual company, but a market plunge often pulls even the strongest investments down.
Fundamental or technical analysis
Fundamental analysis involves evaluating all the factors that affect an investment's performance. For a stock, it would mean looking at all of the company's financial information, and it may also entail meeting with company executives, employees, suppliers, customers and competitors. "You want to analyze management, really understand what's driving the company and where growth is coming from," Heyman says.
Technical analysis involves choosing assets based on prior trading patterns. You're looking at the trends of an investment's price.
Most managers emphasize fundamental analysis, because they want to understand what will drive growth. Investors expect the stock to rise if a company is growing profits, for example.
But fundamentals don't always carry the day. "In this market environment, fundamental analysis doesn't do as well, because the market is so emotional," Holtzman says. "We haven't changed our philosophy away from focusing on fundamentals, but you can have a period of time where the market moves on technicals."
Heyman sees power in technical analysis, because he believes an asset's price at any single moment reflects all the information available about it.
The best managers use both fundamentals and technicals, he says. "If a stock has good fundamentals, it should be stable to rising. If it's not rising, the market is telling you you're wrong or you should be focusing on something else."
Contrarian managers choose assets that are out of favor. They determine the market's consensus about a company or sector and then bet against it.
The contrarian style is generally aligned with a value-investing strategy, which means buying assets that are undervalued by some statistical measure, says Wharton's Geczy.
"In the long run, value has beaten growth in assets around the world, though during certain periods that's not true," he says. "The contrarian style generally rewards investors, but you have to choose the right assets at the right time."
The risk, of course, is that the consensus is right, which results in wrong bets and losses for a contrarian manager.
As the name suggests, dividend funds buy stocks with a strong record of earnings and dividends. Because of the stock market volatility of the past several years, many investors like the idea of a fund that offers them a regular payout.
"Even if the price goes down, at least you're getting some income," says Russ Kinnel, director of mutual fund research at Morningstar. "It's a nice way to supplement income if you're retired."
However, the recent popularity of dividend stocks cause some market pundits to wonder if they’re currently overvalued. Also, beware of funds with extremely high yields. That could be a sign that companies are taking outsized risk and are headed for declines.
Most experts advise diversifying among investment styles. "In the end, a balanced way of looking at things tends to create fewer errors," Heyman says.