5 Questions to Ask About Each Fund You Own

Ariel Skelley/Blend Images/Getty Images

Years ago buying mutual funds was expensive and you needed a broker to make the purchase. Not today. Today it’s cheap and you can do it from your computer with the click of a mouse.

That makes it all too easy to invest without having any idea what it is you are investing in. C’mon. Admit it… you’ve been guilty of this, haven’t you?

As you get closer to retirement, you’ll want to pay more attention. After all, you’ll need to live off these investments the rest of your life. Here are five questions to ask about your mutual funds so that you know what they own.

1. What does it own?

Many people buy mutual funds without knowing what types of investments the fund owns. This is like buying a house without knowing how many bedrooms and bathrooms it has. You must get a handle on the basics before you buy.

With a mutual fund, first you need to know if it owns stocks, bonds, or both. Then you need to have a basic understanding of what type of stocks or bonds it owns.

With stocks, find out if it invests overseas, or in the U.S. Does the fund own large company stocks or small companies? Does it focus on growth stocks or value stocks? Or is it an ‘all cap stock’ fund which means it can move around between different types of stocks?

With bonds, does the fund focus on corporate, government, municipal, or high yield bonds? Shorter maturity bonds or longer maturity bonds? Or is it a ‘total return’ or ‘absolute return’ fund which means it can move around between different types of bonds as the fund management team sees appropriate?

If the fund owns both stocks and bonds, does the fund objective require it to maintain a steady allocation such as 60% stocks/40% bonds (which is called a balanced fund ), or can the fund management team vary the allocation as it sees fit?

Make sure you know what the fund owns before you buy.

2. How does it generate its return?

Some funds actively trade in and out of stocks in an attempt to earn solid returns. Other funds identify a type of stock, such as large cap value stocks, and own all stocks that fit the criteria they’ve outlined. Some funds write options against the assets of the portfolio to generate additional income (most closed end funds do this). Each strategy has its own risks and potential returns.

If you are choosing passive or index funds (which is highly recommended) then the goal of the fund will be to capture returns of the overall market it invests in. For example, if you own a large cap international index fund, the fund should generate about the same returns as the MSCI EAFE index. (MSCI EAFE stands for Morgan Stanley Capital International Europe Asia Far East).

If you have chosen actively managed funds, the goal of the fund may be to beat a particular index return, or it may have a goal of managing risk, which means the fund is attempting to generate respectable returns but with less volatility in the share price.

Be sure to understand the strategy the fund is using before you invest.

3. How volatile has it been?

You can check on the price and income volatility of a fund or stock by going to Yahoo Finance. Type the ticker symbol in the search bar at the top. Then under “Charts” on the left hand side of the screen, click “Interactive”. At the bottom choose “Max” to get a graph of the share price since the fund started. This allows you to visually see how much volatility to expect.

On the left if you click “Historical Prices”, you’ll get a list of past pricing. In this screen you can click “dividends only” to see a list of when past dividends were paid and how much they were. This is important as many people buy a fund today expecting it to pay a certain amount going forward. Dividend payouts can change. By looking up past dividend history you’ll see how consistent past dividend payouts have been.

It’s important to understand the degree to which your shares may go up and down in value so you are not caught off guard by large market movements.

4. What are its primary risks?

You ought to know what market conditions may cause a fund to do poorly. If it owns long term bonds or preferred stocks you can expect it to be interest rate sensitive – meaning the share price will go down as interest rate go up.

If it is a concentrated stock portfolio, your primary risk is that management makes decisions that don’t pan out, and your fund tanks while the market goes up. There are many historical references to funds that had great track records and then suddenly went through a period of horrible performance. (See my Investment Pornography article for examples of this.)

If it is a sector fund, such as technology, transportation, health care, or biotech, business conditions that affect that sector could cause the fund to do quite well, or perform poorly.

Smart investors understand the risks before they buy.

5. How and why does it fit into your portfolio?

Investments are not stand alone entities. The different investments you own should be chosen to work as a team to accomplish a desired outcome over time. Perhaps you are adding international or emerging markets funds because you have realized your current portfolio has only U.S. holdings.

Or maybe you are shifting to short term bonds funds because you are concerned that your long term bond fund holdings will go down if interest rates go up .

Or maybe you are adding a small cap value fund because you have a long term time horizon (over 15 years) and research has shown that small cap value has the potential for higher returns than other asset classes when owned over longer time horizons.

Whatever your reason – the important thing is to make sure you have one. It’s your money. Make sure you know what it is invested in, and why.