Diversify -- that should be the watchword for investors in mutual funds as well as stocks, says Philip Edwards, managing director of funds research for Standard & Poor's. He recommends a mixture of growth and value funds across small-, mid-, and large-cap categories, as well as some fixed-income portfolios and perhaps an index fund or two for good measure.
Edwards is cautiously optimistic about the outlook for the market and for funds, and he stresses quality stocks with "a visible track record of earnings and dividend growth." He mentions large-cap growth fund ABN Amro/Montag & Caldwell Growth (MCGFX ) and large-cap value fund Eaton Vance Large-Cap Value (EHSTX ). Among the fund families that S&P analysts rate high, he names American Funds, Vanguard, Dodge & Cox, Payden, and American AAdvantage.
However, Edwards warns that the investigations of mutual-fund scandals may not be over, and suggests that the spotlight may turn to fund distribution. These were a few of the points Edwards made in an investing chat presented Oct. 26 by BusinessWeek Online and Standard & Poor's on America Online, in response to questions from the audience and from Jack Dierdorff of BW Online. Both BW and S&P are units of The McGraw-Hill Companies. Following are edited excerpts from this chat. A full transcript is available from BusinessWeek Online AOL at keyword: BW Talk.
Q: Before we get into mutual funds, Phil, the S&P 500 and the other indexes staged a nice recovery today. Can we be optimistic?
A:Yes, I think there's room for optimism. However, I think it's cautious optimism. We're entering the third year of a bull market, and market returns in this period are typically in the single digits.
Q: Do you feel the same cautious optimism about mutual funds?
A:Absolutely. I think that, for now, there's room to be optimistic with mutual funds, but I think investors need to be cautious at the same time.
Q: Many people identify S&P with stocks and bonds -- tell us a little about your work with mutual funds.
A:S&P has a staff of 45 analysts dedicated to nothing but the in-depth research of mutual funds. These analysts are located in nine offices around the world and currently cover about 2,000 funds.
Q: From your research, what kinds of mutual funds look best now?
A:Based on what we're hearing, the mutual funds that focus on quality stocks may be most appropriate in this environment. By quality, we mean those stocks that have a visible track record of earnings and dividend growth.
Q: And what might some of those funds be?
A:Well, in the large-cap growth area, one fund is ABN Amro/Montag & Caldwell Growth Fund (MCGFX ). On the large-cap value side, the Eaton Vance Large-Cap Value Fund (EHSTX ), which also focuses on quality stocks.
Q: So both growth and value look good, depending on the fund?
A:As a matter of fact, we suggest a diversified portfolio of both growth and value funds, as well as large-, mid-, and small-cap funds. In addition, fixed-income funds are important for a diversified portfolio.
Q: It seems that index funds always appear to beat most of the funds. Doesn't it make sense to just go with an index fund?
A:Our own research on this shows that the majority of actively managed funds do not beat benchmarks. So that would tend to suggest that index funds -- which are based on benchmarks -- are an attractive alternative. However, you do need to be careful when selecting an index fund. Index funds should have low expenses and low tracking errors to the benchmark. Not all index funds are created equal. On average, index funds beat the majority of actively managed funds. But from year to year, they can flip back and forth. So in some years, actively managed funds do better, and in other years index funds do better. As a result, a portfolio including both is an attractive option.
Q: So what index funds would you recommend?
A:Vanguard, in terms of index funds, has about two-thirds of the market. So it has a definite leadership position in this arena. This allows it to keep its costs low and tracking error low. However, you should know that Vanguard relies primarily on indexes from MSCI, a fairly new provider of U.S. indexes.
Q: Am I better off using iShares instead of index funds?
A:It depends on how often you intend to add to the account or take away from your account. If you're going to make frequent deposits or withdrawals, an index fund may be better since you'll avoid the trading costs associated with an exchange-traded fund.
Q: How have the sector funds been doing? Any recommendations -- or cautions -- there?
A:We don't see a whole lot of leadership in the market right now. Our equity analysts do not have strong feelings to overweight or underweight, to any significant extent, any of the sectors. The only exception may be energy, where we see prices remaining relatively high for an extended period.
Q: Have we seen the worst of the mutual-fund trading scandals? How have the fund families most involved, such as Putnam, been performing?
A:Many of the fund families that have received the majority of the headlines are seeing some stabilization in the outflow of their assets. Others, such as Strong Funds, are being acquired or merged into other fund groups. I don't think we've seen the end of the investigations into mutual funds yet. I think there may be more to come, involving the distribution rather than the manufacturing of mutual funds.
Q: So how has the fund industry been doing with inflow vs. outflow of investor money?
A:Last year was very healthy in terms of returns for the market. And cash flows tend to follow returns. So for the first part of this year, the mutual-fund industry benefited from ongoing cash inflows. However, as the market has slowed, so have the inflows of cash to mutual funds.
Q: Can you give us any insights as to what fund families are scoring best overall?
A:It's hard for one family to do everything well. However, the families that tend to come to the top of our list include American Funds, Vanguard, Dodge & Cox, Payden, and American AAdvantage.
Q: What about funds focusing on mid-cap stocks?
A:The Goldman Sachs Growth Opportunity Fund (GGOAX ) and the Janus Mid Cap Value Fund (JMCVX ) are two of our favorites. These are also examples of funds that focus on quality stocks.
Q: Speaking of Janus, people often ask if there's hope for the Janus Fund (JANSX ) and Janus Twenty (JAVLX ).
A:There has always been hope for the Janus Fund and Janus Twenty. It has never been much different. The Janus Fund has always been a fairly concentrated, high-risk fund that does well in markets similar to last year's. The Janus Fund is not doing well this year, down almost 5% year to date, as opposed to its peers, being down a little over 2%. And the Janus Twenty Fund is up 9.7% this year against the same peer group.
Q: What do you see for tech funds, or for including tech stocks in the broader funds?
A:Well, technology paid off handsomely last year. However, it has imploded again this year. Most growth funds have some exposure to technology. So if you own a growth fund, you probably have exposure to it already. So you would need to be careful about buying a tech fund in addition. I think tech will continue to be a volatile space, appropriate for long-term investors.
Q: What are some good bond funds?
A:Dodge & Cox Income Fund (DODIX ) is a very good general intermediate fund. For a shorter-duration fund, the Payden Short Bond Fund (PYSBX ) is also very good.
Q: Is there a balanced fund for income that fits the 55-and-over group?
A:Both Vanguard and T. Rowe Price offer some balanced funds that are targeted to a specific date. The closer the date, the greater the weight in fixed income. These are known as "lifestyle funds" and may be appropriate for your needs.
Q: I've been watching T Rowe Price New Era (PRNEX ) -- it did well this year. Will it continue, you think?
A:Well, it's tough to tell whether any fund is going to do well into the future. This fund has a strong long-term track record and management that has been in place since 1997, along with very low expenses. These features favor a continuation of the same trends. However, this fund is highly concentrated in energy and materials stocks. As a result, it's likely to be more volatile than a more diversified peer.
Q: What should a potential investor look for when shopping for mutual funds?
A:I think there are a few key features to look for. The first is the tenure of management. You want to ensure that the individual or team managing the fund has been in place for at least three years, if not longer. Second, you want to make sure that the expense ratio for the fund is competitive. Third, you want to make sure that the risk of the fund is suitable for your individual investing profile. And finally, you should focus on the consistency of performance. And I emphasize the word "consistency."
Q: Where does one find this information?
A:Well, one option is Standard & Poor's. Through its publication, The Outlook, investors can access reports on mutual funds. Obviously, Morningstar is a well-known provider of mutual-fund information. And, finally, the fund sponsors themselves also provide a wealth of information on their Web sites, and Businessweek.com has a lot of fund info.
Q: Is there any difference among the money-market funds for holding reserves?
A:With money-market funds, one of the big things I would look at is the expense ratio. I think that you want to make sure that you're getting an efficient vehicle to maintain your cash reserves. That's assuming that the providers that you've identified are all well-known and stable.
Q: Do you have any views on who are some of the best fund managers at work now?
A:Well, I gravitate more to teams than to individuals. I think the team at American Funds, as well as Dodge & Cox, is among the best in the business. However, you can't discount people like Bill Miller, John Rogers, and Bill Fries, who are all excellent individual managers.
Q: It seems more funds are becoming closed-end. What does this signal for the holders and for potential investors?
A:More small- and mid-cap funds are closing. For investors who are already in these funds, it's a good thing, since the weight of the extra assets will not hold down returns. However, it does make it difficult for investors looking for good mid-cap and small-cap funds that are still open. They're getting harder and harder to find.
Q: One arena we haven't touched yet is foreign and international funds -- any recommendations there?
A:Sure. On the international side, AllianceBernstein offers a very good international value fund (ABIAX ), and Dodge & Cox also offers an equally strong value-oriented international fund (DODFX ).