Few issues generate more heated discussion in investment management cir- cles than do approaches to investment decision making. In a sense, this topic resembles religion—men and women of good faith can (and do) consider the same reality and come to diametrically opposed conclusions. In 1995, Bill
Source: Lipper, 2004 Table 4.3 (continued)
General Domestic Taxable Fixed-
Income Funds General Municipal Debt Funds
43. Adjustable-Rate Mortgage Funds 44. Corporate Debt Funds A Rated 45. Corporate Debt Funds BBB Rated 46. Flexible Income Funds 47. General Bond Funds
48. General U.S. Government Funds 49. General U.S. Treasury Funds 50. GNMA Funds
51. High Current Yield Funds 52. Multi-Sector Income Funds 53. Target Maturity Funds 54. U.S. Mortgage Funds
62. General Municipal Debt Funds 63. High-Yield Municipal Debt Funds 64. Insured Municipal Debt Funds
65. Other States Intermediate Municipal Debt Funds
66. Other States Short/Intermediate Municipal Debt Funds
67. Single-State Municipal Debt Funds 68. California Short/Intermediate Municipal Debt
Funds
69. Florida Intermediate Municipal Debt Funds 70. Florida Insured Municipal Funds
71. Massachusetts Intermediate Municipal Debt Funds
72. New York Intermediate Municipal Debt Funds 73. New York Insured Municipal Debt Funds 74. Pennsylvania Intermediate Municipal Debt
Funds
75. Virginia Intermediate Municipal Debt Funds World Taxable Fixed-Income Funds Money Market Funds (Taxable) 55. Emerging Markets Debt Funds
56. Global Income Funds 57. International Income Funds
58. Short World Multi-Market Income Funds
76. Institutional U.S. Government Money Market Funds
77. Institutional U.S. Treasury Money Market Funds
78. Institutional Money Market Funds 79. Money Market Instrument Funds 80. U.S. Government Money Market Funds 81. U.S. Treasury Money Market Funds Short/Intermediate Municipal Debt
Funds Money Market Funds (Municipal)
59. Intermediate Municipal Debt Funds 60. Short/Intermediate Municipal Debt Funds 61. Short Municipal Debt Funds
82. California, Connecticut, Massachusetts, Michigan, New Jersey, New York, Ohio, Pennsylvania, and Other States Tax-Exempt Money Market Funds
83. Institutional Tax-Exempt Money Market Funds 84. Tax-Exempt Money Market Funds
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Griffeth published a book—Mutual Fund Masters—containing interviews with 18 well-known and eminently successful investment managers.17 Read- ing this book, one is struck by the number of times that one of the masters fl atly contradicts a prescription made by one of the other masters. One says you should start analyses of emerging markets with the government econo- metric reports, another says to ignore those reports. One says to pick com- mon stocks by understanding the fundamentals of the companies themselves, another says to look at the patterns in the prices of companies’ stocks. The list of examples goes on and on.
An exhaustive discussion of investment decision making alternatives, if indeed it is even possible, would itself fi ll a book. This section merely high- lights a few of the major, commonly encountered approaches, to illustrate the range of possibilities.
Active versus Passive Management
Can any individual or group of individuals, even professional portfolio manag- ers, consistently pick securities that are winners? That is the crux of the ques- tion that divides the proponents of active management from those of passive management. The passive management school’s argument, made most visibly in Burton Malkiel’s A Random Walk Down Wall Street, contends that fi nancial markets are so effi cient* that they make it impossible for active managers to consistently outperform market averages.18 Passive managers therefore do not attempt to select individual securities, but rather match the composition of a segment of the market. Typically, they attempt to match a major benchmark index such as the S&P 500 or the Lehman Intermediate Term Government Bond Index. A passively managed fund (or index fund) can usually operate at a lower expense ratio than an actively managed one, because it requires no expenditures on portfolio manager expertise or research, and it minimizes trading costs.
Active managers attempt to outperform market averages using various investment techniques, succeeding sometimes and failing sometimes. The allure for the investor, of course, is the potential of fi nding a fund whose man- ager will succeed in outperforming the market during the period the investor holds the fund. At least one researcher analyzing mutual fund performance has found evidence that (1) some funds consistently outperform the market;
* Effi cient in this context means that at any point the market has assimilated all the available information about a security and refl ected this information in its price. An investor or portfolio manager cannot possibly pick under- valued stocks, since the market has already taken into account any information the investor or manager possesses (except for insider information, which could only be used illegally).
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The Mutual Fund—Product Defi nition 79 and (2) sophisticated investors direct assets to these funds.19 (Most academic research, however, tends to support the passive management argument.)20 Actively managed funds typically have higher expense ratios than index funds, for the reasons cited earlier.
The argument between proponents of active and passive management has continued unabated for over 20 years. It has prompted both scholarly research and emotional name-calling. Any discussion here will certainly fail to resolve it. An interested reader can easily fi nd numerous books and articles weighing in on either side of the argument.
Active equity fund managers employ a variety of investment strategies and styles to select the securities that they believe will outperform the market.
They may base their investment decisions on analysis of the issuing compa- nies, on the state of the fi nancial markets, on economic trends, on patterns in stock prices, or on combinations of these factors. Active bond fund manag- ers make their selections according to such factors as interest rate forecasts, the impact of securities on the maturity time span of the portfolio, and the credit quality of the issuer. The next few paragraphs describe some of the more prominent methods active managers take to select securities and con- struct their portfolios.
Top-Down versus Bottom-Up Portfolio Construction
The top-down manager starts the selection process by identifying general eco- nomic trends and incorporating them into specifi c market and economic fore- casts. He or she then selects industries and companies that should benefi t from those trends. The bottom-up investment manager considers individual stocks before industry, sector, country, and economic factors. This approach assumes that individual companies can prosper, even when the industry or economy is not performing well.
Growth versus Value Stock Selection
Growth and value managers represent two fundamentally different approaches to selecting common stocks. Growth investing attempts to identify companies that promise dramatic revenue or earnings increases. These companies are typically smaller to medium-sized fi rms that are expanding into new or exist- ing markets or developing new products. For the most part, growth managers don’t mind paying higher prices to get the right stocks and taking more risk to achieve greater return. Growth managers tend to do very well during the advanced stages of a bull market when investors become more aggressive, pushing the markets to new highs.
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Value investing attempts to identify out-of-favor companies, whose stock has a good potential to increase in price. Value managers usually have a lower turnover of securities in their portfolios and assume less risk than growth-oriented managers. They tend to hold large cash positions at market peaks, when bargains are presumably rarer. In general, value managers do best when the economy is coming out of a slump and undervalued companies begin to recover.
Fundamental versus Technical Analysis
Fundamental analysis involves study of the issuing company itself—its fi nan- cial statements and other quantitative data, plus qualitative assessments of factors such as the company’s management, physical plant, and market pres- ence. Based on the analysis of these fundamentals (and different managers have many different ways of going about these analyses), the manager esti- mates a value for the company’s stock that can be compared to the current market price. If the manager fi nds that the current market price is lower than the computed value, then the stock is considered underpriced and a candidate for buying.
Technical analysts, sometimes called “chartists,” focus on the details of quantitatively measurable data—on changes in the price of particular stocks or of short interest in the market, for example. They attempt to fi nd patterns in past behavior that they can use to match to current patterns and thereby pre- dict future price behavior. In recent years, some researchers have attempted to employ computer artifi cial intelligence (most often, neural nets) to perform these technical analyses, detect patterns, and predict price movement.
Stock Market Timing
Stock market timers (not to be confused with the more controversial “market timers” of mutual fund shares) attempt to predict how the prices will trend for individual stocks, stock groups, or the market as a whole. They attempt to determine the right times to buy and sell by analyzing technical factors behind the supply and demand for stocks, such as volume and price, often using charts or computer programs.
Asset Allocation
Asset allocators focus on the anticipated risks and returns of the various asset classes—stocks, bonds, and cash—given certain assumptions about economic growth, interest rates, market valuations and other fundamental indicators. They continually adjust their portfolio composition among the
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The Mutual Fund—Product Defi nition 81 classes, and individual security selection is accorded secondary importance.
The C/Funds, for example, employ an asset allocation strategy, moving hold- ings between equity and fi xed-income securities according to forecasts of economic conditions.
Group Rotation
These managers try to fi nd stock groups that will outperform others at a par- ticular time. They analyze macroeconomic trends and how a particular eco- nomic cycle may unfold and affect various industrial sectors. (For example, they might examine economic forecasts involving unemployment and dis- posable income to make judgments on how companies producing consumer durable items might fare.) They then concentrate their investments in those sectors that the trend should benefi t.
Momentum Investing
These investors attempt to fi nd and exploit factors that are currently pushing or about to push a stock’s price upward. Some momentum investors focus on the issuing companies—their earnings, cash fl ow and other statistics, and especially any surprises about these. Other momentum investors look at the stock prices themselves, emphasizing the degree to which a stock is outper- forming (or underperforming) the market index or other stocks in its group.
Every mutual fund is free to select a style that its managers believe will best meet the investment objectives. The fund is obligated, however, to dis- close this choice in the prospectus and SAI, and to adhere to its stated princi- pal investment strategies as it operates.