The following is the tenth of a series of weekly articles in which Sheryl will provide overviews of investment options that offer alternatives to bank accounts. Last week's article covered index funds. As with any investment that's not an insured deposit account, there are risks. Some may feel that these risks are worth it for the chance of higher yields. The focus of these articles will be on conservative investments that may appeal to some savers who want a chance of higher yields and minimal risk.
Some investors aren’t interested in being a homerun champion. They are perfectly content hitting a single, getting on base and just being in the game. For sure they want to win, but they are going to do so without theatrics.
These folks are ideally suited for conservative mutual funds. "There might be a few ways to define a conservative mutual fund, but in my mind, a conservative mutual fund is one that has a significant concentration in fixed income to possibly help minimize risk, and with low turnover that can help minimize trading costs,’ says Kenneth Kim, chief financial strategist at EQIS Capital.
There is typically more emphasis on capital preservation, risk reduction and reliable streams of income. Funds often include large, blue chip dividend paying companies, high credit quality bonds, interest bearing securities and cash equivalents, explains Charlie Smith, founder and manager of the Fort Pitt Capital Total Return Fund.
Here’s a look at some of the places you can go conservative.
Even when you go conservative there are many options. A bond fund for example, is a grouping of bonds and therefore it is assumed to have the same characteristics as a group of individual bonds would have. However, when interest rates eventually rise, bond prices will decline, as surely as a see-saw works when a greater weight is placed on one side, explains Selwyn Gerber, founding member of RVW Investing.
For individual bonds a rise in interest rates affects value temporarily, because value gets closer and closer to the face amount as the maturity date approaches, and upon maturity, the full par value is redeemed. However, bond funds do not have a maturity date per se, so there is no date by which they can recover to face value. Know too, he says, that in addition, the actual bonds held in the fund may not match the fund description of the bond fund or the expectation of the investor. "Managers have wide discretion about what they actually invest in, as was discovered in the 2008 crash by many bond fund investors," says Gerber.
If you’re interested in investing in bond funds, know the average maturity dates of bonds in the fund, the grades of bonds being purchased in terms of S&P rating, the annual costs of the fund and loads at the time of purchase, advises Gerber.
Growth and Income Funds
There are large company funds that hold many dividend paying stocks. Often these funds will invest in companies that are household names like Coke, Pepsi and Procter & Gamble. Dividend paying stocks tend to be not as volatile as their non-dividend paying growth stocks and may be perceived as being more conservative than stocks taken against the broader index, points out Leonard Wright, a CPA financial planner.
For example, he says, ExxonMobile currently has a dividend rate at over 3%. But it went from $105 down to $90 a share in about 105 days. "So there is risk. But when one looks over the long term, this is not a big deal. For instance about 15 years ago Exxon was about $20 per share. At nearly five times that value today, the dividend on that share price is about 15% -- not bad for a low yielding environment."
You can have your cake and eat it too. Balanced funds combine stocks and bonds usually with a 60/40 stock/bond split in the portfolio. "The theory is, and it is a pretty good theory, that stocks and bonds tend to balance each other out. When one category is up, the other is down and vice versa. Adding bonds also reduces the volatility of the funds," says Jeff Bogart, president of Sila Wealth Advisory.
Traditionally, these funds are invested in large domestic companies for both their stock and bond issues.
Low Volatility Funds
"This sounds like a free lunch, but there are no free lunches in life, or investments," says Bogart.
Low volatility funds can be invested in large, medium or small companies, domestically and or internationally. Though differing in name and construction, there is one common theme linking many of these strategies is a focus on stocks with low past volatility. In theory this type of investment should underperform the market.
What You Need to Know
For sure there’s something to be said for "safety. What are some other advantages of investing in conservative mutual funds? While much depends on your mix of investments, "You can expect returns of 3-6% before fees," says Kyle O’Dell.
Another advantage is that these funds can continue to generate streams of income, while preserving capital in volatile markets. "This is especially useful if you depend on periodic withdrawals from your portfolio in retirement and you are concerned about draining your funds sooner than anticipated if there is a bad year in the market," says Smith.
However, there can be some confusion about conservative mutual funds. "Most people buy these funds because they want a predictable rate of return without much risk, but at the end of the day, when the stock market drops, the stock market drops. If the fund has large cap stocks, the mutual fund will probably drop in value when we have our next market correction," says O’Dell.
Simply put, just because a fund has a capital preservation strategy doesn’t make it immune to capital loss. "There are situations when seemingly safe investments, such as investment grade bonds and large cap stocks, can lose value," says Smith.
If interest rates rise, investors in conservative mutual funds with a lot of fixed income might be surprised to see their value fall 10, 20 or even 30%, warns Kim.
Before you invest there’s a checklist of sorts, "What are the overall fees? How does the investment objective align with your particular financial goals? What are the underlying investments? What are the risk metrics of the funds?" points out Diane Bourdo, president of The Humphreys Group.
Evaluate how the fund performed against the benchmark and its peers over the prior 10 years, or whichever period is longest, if less than 10 years. "As boring as this may sound, read the prospectus and see what you’re buying. These have changed over the years and are quite useful. A summary prospectus is quite fascinating to read,’ says Wright.
Remember, points out Ed Vargo, founder of Burning River Advisory Group, "Conservative is in the eye of the beholder. Depending on the age and risk tolerance of the client, a conservative mutual fund might consist entirely of bonds (for older clients) or could be a 60-40 mix of stocks and bonds (for younger clients). There is no way to label a mutual fund ‘conservative’ without having some context."