Mutual Fund Investment Styles

The growth in the number of mutual funds is, in part, a reflection of the variety of investment styles employed by fund managers. The following is an overview of some of the key spectrums of investment style.

Active vs. Passive

Active investors believe in their ability to outperform the overall market by picking stocks they think will perform well. Passive investors, on the other hand, feel that simply investing in a market index fund will produce higher long-term results. Passive investors believe this is due to market efficiency. In other words, they feel that all information available about a company is reflected in that company's current stock price, and it's impossible to predict and profit on future stock prices. Rather than trying to second-guess the market, passive investors buy the entire market via index funds.

Active investors counter that the market is not always efficient and that through research, active fund managers may be able to uncover information not already reflected in a security's price and potentially profit by it. For example, some active investors feel that the small-cap market is less efficient than the large-cap market since smaller companies are not followed as closely as larger blue-chip firms. A less efficient market could potentially favor active stock selection, they reason.

Growth vs. Value

Some stock fund managers can be divided into growth and value seekers. Proponents of growth seek companies they expect (on average) to increase earnings by 15% to 25%. Stocks in these companies tend to have high price to earnings ratios (P/E) since investors pay a premium for higher potential returns. They also usually pay little or no dividends. The result is that growth stocks tend to be more volatile, and therefore more risky.

Value investors look for bargains -- stocks perceived to be undervalued that are often out of favor, such as cyclical stocks that are at the low end of their business cycle. A value investor is primarily attracted by asset-oriented stocks with low prices compared to underlying book, replacement, or liquidation values. Value stocks also tend to have lower P/E ratios and higher dividend yields. These higher yields tend to cushion value stocks in down markets while certain cyclical stocks will lead the market following a recession.

Other investors choose not to lock themselves into either investment style. Returns on growth stocks and value stocks may not be correlated. This means that an increase or decrease in one style's returns may occur independently of the other. By diversifying between growth and value, investors can reduce some risk and still enjoy long-term return potential.¹

Size

Some investors use the size of a company as the basis for investing. At times, the highest returns -- on average -- have come from stocks with the lowest market capitalization (common shares outstanding multiplied by share price). But since returns tend to run in cycles, there have also been periods when large-cap stocks have outperformed smaller stocks. Small-cap stocks also tend to have higher price volatility, which translates into higher risk. Some investors choose the middle ground and invest in midcap stocks -- seeking a trade-off between volatility and return.

Target Date

With target-date funds, your portfolio's asset allocation is automatically rebalanced on your behalf over the years by the fund's managers, typically growing more conservative as the identified target date approaches. Generally speaking, the name of each target-date fund includes a specific year. All you need to do is choose a fund named for the year closest to the year of your goal. From that point on, professional investment managers make all the investment decisions.

Sector

Sector funds are mutual funds that invest in sectors such as utilities, financial services, technology, or health care, to name a few. They target specific industries and economic niches to seek above-average returns. Although these funds may reduce individual security risk, some may fluctuate in value more than diversified, multi-sector funds. These funds may also include a greater percentage of small-cap stocks, which may offer greater opportunity for growth but at the expense of potentially greater risk.

Don't Judge a Fund by Its Cover

With such a wide variety of investment styles, individual fund investors may be confused as to which is the best. In order to reduce volatility, many experts encourage diversifying or spreading money around among different investment styles. Fund investors need to ask questions, carefully read the fund prospectus, and consult fund rating services to make sure they are buying a style that is right for them.