Want Diversification? Don’t Overlook Mutual Funds, but Choose Carefully

Want Diversification? Don’t Overlook Mutual Funds, but Choose Carefully

Key Takeaways

    Mutual funds present investors with an efficient means of holding a large, diversified basket of assets

    The mutual fund universe offers a varying range of opportunities and risks; choose carefully

    Understanding your financial goals, engagement levels, and risk tolerance is key to selecting a suitable mix of mutual funds

So, you’ve decided your portfolio needs greater diversification, but you don’t have time to do all the legwork yourself. You may be “market smart,” but “market geek” status still hovers a few levels beyond your current capacity.

To complicate things further, you’re not only looking to drop a bit of diversification into your asset mix, but you also want some of those assets to hustle to the flow of market and sector opportunities, requiring a more active approach.

With that in mind, don’t overlook a solution that may sound too simple and old fashioned. Mutual funds have been around longer than Alan Greenspan or Warren Buffett. They’re not the sexiest way to invest when there’s a world full of flashier competitors, but that doesn’t mean they can’t be useful.

Besides providing a wide range of diversification potential, mutual funds can also be an efficient way to include stocks that, on an individual basis, may sit beyond the price range of most investors. This potentially gives you more flexibility and choice when deciding what to invest in.

When choosing mutual funds for diversification, consider thinking in terms of a wide palette, not panacea. In the end, you’ll have to choose one or a handful of funds from a much broader universe. If this makes you even slightly anxious or confused, no worries. We can help you get started.

What’s a Mutual Fund Again?

Look to the moniker to grasp the meaning—you’ve got “mutual” and “fund.” A mutual fund is an investment vehicle that pools the funds of many investors and invests those funds in stocks, bonds, or other assets, as specified by its prospectus—a document that describes the fund’s rules, objectives, limitations, and other information.

“A mutual fund gives you the potential benefit of pooling your assets under one umbrella with other investors under one manager,” said Viraj Desai, senior portfolio manager for TD Ameritrade.

And this umbrella, or pool, is potentially huge because a fund’s investors may range from individual investors’ personal holdings, 401(k) plans, and Individual Retirement Accounts, to institutions such as pensions and university endowments.

Why Invest in a Mutual Fund?

Investing in a fund lets you decide whether you want your exposure to go wide across multiple sectors and asset classes or concentrate with laser focus on just a few mutual funds can give you that flexibility. Investing in even a single mutual fund can also provide diversification.

How does this work? Suppose you’ve got $10,000 to invest and want to spread it across 100 or more big-name companies. If you were to invest in individual stocks, your money wouldn’t take you too far into variety, right?

But if you were to invest your $10,000 in a large cap stock fund, for example, you’d get exposure to all its securities, all wrapped up in one product. In this way, a mutual fund can be a diversified investment in and of itself.

Most investment professionals would agree that a diversified portfolio—spreading your financial eggs across multiple baskets—can reduce the risks of investing in a particular stock, industry, or even sector. But it’s important to note that equity mutual funds and other forms of stock diversification won’t protect a portfolio from the ebbs and flows of the broader market (aka “market risk” or “systemic risk”). In other words, diversification does not eliminate the risk of experiencing investment losses.

Another potential benefit of a mutual fund is expertise.

“Purchasing a fund means you’re hiring a pro to look at your assets every single day,” Desai explained. So, whether the value of your fund is shifting up or down, you have the assurance that a manager is watching it and trying his or her best to position it favorably over the long haul.

Still, there are thousands of funds in existence and too many ways to slice and dice them by category. It’s enough to induce a mental glitch for those trying to figure out what’s what in the mutual fund universe.

Let’s reboot our perspective. Here’s a simpler way to look at it.

Which mutual fund is right for you?

Breaking Mutual Funds into Three Simple Categories

Index funds are your run-of-the-mill mutual funds. The manager’s goal is to “track” the performance of a benchmark index—like the S&P 500 Index (SPX)—rather than attempting to “beat” it. Because index funds are about replicating benchmark performance, they tend to have lower fees than their actively managed peers. Of course, they go up and down with the indices, making you somewhat captive to the broader market. This can be good (consider the long bull market from 1982 through 2000) or bad (the broader market barely climbed from 1966 through 1982).

Actively managed funds are a little different. You’re essentially hiring someone to look at the market and build a portfolio that’s expected to beat or gain an edge over a given market benchmark or hurdle—what folks in finance call alpha. “It’s now a question of which hurdle you’re hoping to beat,” Desai commented, “and you might want to ask yourself if there’s a justification for seeking an active approach in that given space.”

In other words, you’ve decided the risk of generating alpha might be preferable to index performance in a given space, and you’re willing to pay a little extra for it. Actively managed funds, as you likely know, typically come with a higher fee than index funds because you’re paying an active manager to constantly monitor and reset the fund’s portfolio as the market changes. Before investing in an active fund, consider how much the fees will potentially subtract from your possible gains over the long haul, because the hit to your wallet can be substantial.

Multi-asset mutual funds are a smaller subset of the actively managed space. As you can guess from the term “multi-asset,” these fund managers can go almost anywhere on the map to seek assets that might best fulfill their risk-return goals. With a multi-asset strategy, they can concoct any flavor of global exposure, equity, or debt, and they can mix up the allocations of fixed income and equities, say 50/50, 30/70, or whatever might suit the fund’s goals. That can be an advantage or a disadvantage. A fund that decided to pull most of its large-cap stock market exposure in mid-2020 due to COVID-19, for instance, would have cost investors a ton.

So, where do you go from here for diversification? Should you stick with one type of mutual fund, or should you combine different funds with different goals and allocations?

Which Funds Might Best Suit Your Goals?

Clearly, you have quite a few important decisions to make. How involved do you want to be?

“If you’d rather let a manager handle most of your allocations and rebalancing, then a multi-asset fund might provide enough tactical flexibility to seek opportunities in both stocks and bonds, domestically and internationally,” Desai said.

But if you want to be more engaged in choosing your “active” exposures, you can find a mix of actively managed funds covering different parts of the market. How you layer your exposures is up to you. 

If you’re sensitive to fees or believe a conservative index approach might beat a more active approach, then Desai suggested a few passive index managers. You still have to decide what kind of benchmark exposures to hold, but once you’ve made your decision, you can rest assured your funds will more or less replicate your indices of choice.

Finally, if you want to be super engaged and get “granular” in the market, you can mix and match narrowly concentrated index funds (or even exchange-traded funds) to better suit your ideal risk-return profile.

You should also consider your risk tolerance. More aggressive investors might focus on actively managed funds that try to beat their benchmarks. However, these can be more volatile and sometimes fall dramatically if a sector or the market as a whole slides into a rough patch.

An index fund typically attracts investors who aren’t looking for quite as much risk, though these funds can also be risky endeavors in a bear market. The SPX fell more than 30% in one month during 2020 when the pandemic began. Being in an SPX index fund at that point wouldn’t have provided any protection.

The Bottom Line

Just because a mutual fund has a professional manager attached to it doesn’t mean it limits your choices or eliminates responsibilities when it comes to shaping your portfolio. The mutual fund universe presents an exceedingly wide and vibrant palette of opportunities and risks. Paint your portfolio as you may, but paint it nevertheless.

Carefully consider the investment objectives, risks, charges and expenses before investing. A prospectus, obtained by calling 800-669-3900, contains this and other important information about an investment company. Read carefully before investing.

Mutual funds funds are subject to market, exchange rate, political, credit, interest rate, and prepayment risks, which vary depending on the type of mutual fund. Fund purchases may be subject to investment minimums, eligibility, and other restrictions, as well as charges and expenses.

Karl Montevirgen is not a representative of TD Ameritrade, Inc. The material, views, and opinions expressed in this article are solely those of the author and may not be reflective of those held by TD Ameritrade, Inc.

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