Fagan Associates Archive for February, 2008

There is an old saying in the investment community that the average investor spends more time researching what toaster to buy than what mutual fund to invest in. With this in mind, we thought that it would be a good idea to identify some issues that should affect your investment decision regarding a specific mutual fund. Please keep in mind that by no means is this a complete list of considerations, but just some that an investor should be aware of.

Whether investing in mutual funds or individual securities, an investor must first identify their investment objectives, including the intended time horizon until reaching those objectives as well as the risk and volatility they are willing to assume along the way. Furthermore, an investor must decide whether they are going to require help when selecting specific investments. However, please keep in mind that even if you are going to require advice, that does not eliminate the responsibility of the investor in determining how their advisor is compensated and what charges, if any, will be levied by the mutual fund. An additional piece of investigatory work that an investor must do prior to putting their hard earned money to work is to review the prior returns of the specific mutual fund, keeping in mind the risk that the fund has taken in order to achieve those returns and then applying an appropriate benchmark to determine the relative returns; always keeping in mind that historical investment returns are not indicative of future investment results. Finally, prior to investing an individual should have enough cash on the sidelines for emergencies such as home repairs, short-term unemployment or health issues.

The answers to all of the questions noted above can be found on the internet either at the website of the family in which the mutual fund you are considering is a member, on a financial website such as Yahoo! Finance or at Morningstar.com. However, let’s take a couple of paragraphs and determine that you will be looking for after arriving at one of these or a similar site.

The first consideration we noted was to make certain that the investment objective of the mutual fund matched that of the investor’s. Prior to investing, it is imperative to determine the percentage of the fund that can, by prospectus, be invested in stocks, bonds, cash or other instruments. Generally speaking, the higher the percentage in stocks, the more volatile the fund. An investor who invests into a fund with more than 75% of its assets in the stock market is implying that he has a time horizon or ten or more years and is willing to accept the volatility along the way. An investor who chooses a fund with 50%-75% in the stock market is implying that he has a time horizon or five to ten years and is somewhat concerned with volatility and preservation of capital. Finally, an investor who chooses a fund with less than 50% is implying that preservation of the majority of their capital is a primary concern and that capital appreciation is secondary.

Volatility of a fund can be measured in several different ways, with the two most common being beta and standard deviation, both of which can be found on the internet or in the prospectus of the mutual fund. Simply put, the beta of the fund tells an investor how sensitive a fund is, in response to the movement of the stock market. The stock market always has a beta of 1.00 so if the beta of the mutual fund you are researching has a beta of 1.25 it means that the fund is 25% more volatile than the overall stock market. Therefore, it is safe to assume that if the stock market goes up 10%, you can expect 25% more gains from your fund. However, the opposite also holds true. Should the stock market fall 10%, one could expect a decline 25% greater than that. Standard deviation also measures the volatility of the fund in that it helps determine how often the fund has wild swings. According to Morningstar, a leading researcher of mutual funds, “approximately 68% of the time, the total returns of any given fund are expected to differ from its mean total return by more than plus or minus the standard deviation figure.” In plain English, referring to standard deviation, the higher the number, the rockier the ride will be.

Regarding the cost of entering or exiting a fund, an investor must always remember that nobody works for free. So there is a cost. Ask your investment advisor the explicit or internal costs of investing in a particular fund. If he or she balks at your question, ask specifically how much the advisor is compensated as a result of a potential investment. If they are unwilling to answer, look for another advisor.

Finally, when reviewing past returns, as mentioned above, it pays to keep in mind the risk the fund has historically assumed to achieve their returns. It is important to look at the absolute total returns, but more important to look at the returns relative to an appropriate benchmark such as the S&P 500 or Morgan-Stanley Composite Index for the European, Australian and Far-East (MSCI/EAFE) markets. This number will tell you how the fund fared against its peers.

In conclusion, if you take the time to know what you are getting involved in prior to making an investment than you will be much more capable of making intelligent, rational decisions on perhaps when to make changes. This will ultimately help you reach your goals. Good luck!

In addition to meeting with our clients, and as part of a continuous effort to communicate with our clients, is included an annual year-ending letter detailing where we believe both the stock and bond markets are headed. Furthermore, we provide some details as to where we believe the opportunities lie. Due to the length of the letter, it is impossible to reprint it in its entirety so we have taken pertinent excerpts for this column. Please note that this letter was written on January 16, 2008 and begins in the following manner.

“Unlikely as it may seem and perhaps unbelievably as it may sound, after this rough start to 2008, we believe that the major stock indices, including dividends, will conform to longer term historical returns of between nine and twelve percent.”

“In response to the recession affecting the housing market and the resulting weakness in the consumer sector, the Fed began cutting interest rates and has promised ‘substantive’ measures in the future. Given these facts, we expect that the year will be back-end loaded with the best two quarters for equities being the third and fourth as the economy picks up steam in response to lower interest rates and perhaps some fiscal stimulus coming from Congress. If anything, we believe that these estimations are too optimistic and perhaps the market may not perform quite as well as we anticipate. That said, we nonetheless think stocks and stock-based mutual funds will outperform their fixed income brethren, given the fact that the 10-year U.S. Treasury Note is currently yielding only 4.00%.” Currently, the 10-year U.S. Treasury Note is yielding 3.61%.

“Two sectors drove the stock market during 2007, namely Oil & Gas and Basic Materials. Oil & Gas has benefitted over the past several years from a rapidly expanding global economy causing more demand for petroleum based products than supply. Basic Materials also benefited from the above referenced global economic growth and from the fact that much of this growth emanated from the ‘BRIC’ countries, Brazil, Russia, India and China. Other than these two sectors, 2007 proved an uninspiring year for stock investors. Furthermore, the problems with housing referenced several times above resulted in a twenty-percent decline in financial service companies. This will most likely linger into the first half of 2008.”

“We believe that 2008 will result in solid over-performance in Health Care including large biotechnology companies, medical instrumentation and equipment as well as health maintenance organizations. We like those health care companies that help contain cost. As the Presidential Election draws near and the “rebuild America” theme grows louder, your large cap industrial stocks should benefit. However, because general economic weakness will trump this theme early in 2008, we urge you to be patient. Another theme that we like going into 2008 is ‘feed the world.’ Once again, we are going to exhibit patience in this sector given the run-up during 2007, it is due for a breather. Other second half industries that we think will benefit from a reaccelerating domestic and global economies include technology, basic materials and, dare we say, financial service companies. Digging a little deeper, we believe the dollar remains relatively weak which should benefit those companies that export a relatively large percent of their overall revenue. We also continue to believe in investing in companies domiciled in other countries, specifically in Latin and South America, the Far East and Central Europe.”

“On the interest rate front, we believe that the Fed will continue to lower interest rates, therefore choosing an emphasis of economic growth rather than one of inflation-fighting, at least for the foreseeable future. Should the Fed assume this posture, and we have no reason to believe that they won’t, short-term rates will continue lower as will longer-term rates. Then, once the cuts take hold and economic growth accelerates, we would expect to see a normalized yield curve (one in which long-term rates are higher than short-term rates) as well as higher interest rates along the entire curve. We project that the yield spread (difference between the two and ten year treasury notes) to be between .75% and 1.50% by the end of 2008. It is for these reasons that we believe short-term bonds best suit our clients. The time will come when we can extend those maturities, just not now.”

“We are NOT concerned about rampant inflation, noting that productivity growth in high-end industries such as technology and biotechnology in the United States remains strong and global competition for the commoditized industries is keen. This global competition quite often results in production overseas for many basic industries therefore keeping ‘wage push’ inflation in check.”

“The risks to the assumptions noted above are many, not the least of which include the ever-present threat of terrorism. Other risks include unanticipated actions by Iran, an unanticipated spike in energy prices, and the potential that the Fed will not be aggressive enough in cutting interest rates. Also, if the consumer shuts down their habits of consumption, it could further lengthen the recovery process. The question remains as to what Chairman Bernanke was referring to when he stated that the Fed was ready to take “substantive” action when fighting this economic slowdown. Time will tell. However, should Chairman Bernanke prove either unwilling or ineffective in fighting this economic slowdown, it may be a long year for the economy and the stock market.”

“In conclusion, we have much greater confidence in the stock market providing solid returns through the end of calendar year 2008 relatively to the just concluded 2007. We also firmly believe that Chairman Bernanke will make the right decisions pertaining to interest rates. We also have a high degree of confidence in our enthusiasm regarding overseas markets and our estimate for interest rates. That said, we continue to be wary of geo-political events as well as the impact on the economy of the malaise in the housing market.”