Stock Funds Stumble, But Don't Fail

The third quarter was not kind to stock-oriented mutual funds. Out of the approximate 800 stock funds covered by our Quarterly Low-Load Mutual Fund Update newsletter, relatively few showed gains. Worse, among the winners, just one uses the traditional strategy of buying stocks; the rest invest in both stocks and bonds, are designed to move inversely to stock prices, or use other hedging strategies.

Despite the performance, stock funds did not fail their shareholders. Rather stock funds were victims of the securities that investors pay them to invest in. Stock prices fell globally last quarter. For a fund whose objective is to invest in stocks, losses were unavoidable.

The only options for investors were to buy contra funds or strategically shift to holding bond funds, particularly long-term government bond funds. Doing either would have required successfully timing the market. Unwinding these trades and moving back into stock funds require successfully timing the market a second time–a feat that is much easier said than done.

If you held a mix of stock and bond funds (or just stocks and bonds), your portfolio's decline was cushioned. Diversification did not prevent you from losing money last quarter, but it did lessen the blow as it is designed to do.

If you own stock mutual funds, particularly actively managed funds, look at the returns relative to those of their category peers. Though mutual funds like to tout their performance in advertisements, a fund's absolute return is not the first thing you should look at. Rather, figure out what asset classes and subclasses your portfolio needs (e.g., U.S. small-cap stocks, emerging market stocks, bonds, etc.) and then find the best funds that fulfill those needs. Tax efficiency, expense ratios, yield and risk all should be considered when evaluating a fund.

Once you buy a fund, have patience with it and understand the factors that impact its performance. A good manager can have a bad quarter for reasons beyond his control. Such was the case for many funds over the past three months when narrowing correlations reduced the potential advantages of active management. This said, don't stick with a poorly performing fund if the manager consistently underperforms his peers.

Hedge Funds Struggled Too

I realize that this is not much in the way of consolation, but hedge funds also fared poorly last quarter. Industry consultant Henessee Group calculated that hedge funds suffered their worst quarter since the fourth quarter of 2008. Henessee Group's hedge fund index fell 3.78% in September and is down 5.53% year-to-date.

Excerpted from my weekly AAII Investor Update newsletter.

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