Just about every American worker invested in a 401(k) plan has money in at least one mutual fund. Ditto for employees with traditional pensions. Even standalone investors looking for low-risk opportunities appreciate mutual funds for the promise they offer. But how many really understand what drives the performance of their funds? Probably not many.
Stocks have a bad, but well-deserved, reputation for being extremely volatile. When Donald Trump won the 2016 presidential election, stock markets soared. When Congress failed to repeal Obamacare, they fell. They fell again when we dropped the mother of all bombs on Afghanistan. The thing to understand is that individual stocks and mutual funds react to such things differently.
As a financial advisor offering mutual funds to your clients, it is important that you explain to them what drives mutual fund performance. According to a number of advisors at Western International Securities, investor knowledge is key to investor success. The more your clients know about mutual funds, the better off they will be when it comes time to make decisions about the funds they are invested in.
How Mutual Funds Are Structured
The first thing clients need to understand is how mutual funds are actually structured. When a client invests in a mutual fund, he or she is not buying individual stocks and shares. Instead, he/she is invested in a portfolio put together by the mutual fund operator based on any number of criteria. One mutual fund might be industry-specific while another is linked to a specific index.
This structure is that which gives mutual funds the relative security. Because they are built on portfolios of securities rather than individual stocks, they are less volatile. Clients need to know this so that they do not panic when their mutual funds lose a little value a couple of quarters in a row. Mutual funds rarely nosedive for prolonged periods.
The Value of Holdings
The biggest factor driving mutual fund performance is the value of a fund’s holdings. Take a mutual fund that is linked to the S&P 500, for example. It might be comprised of 100 different stocks from companies listed on that index. As index value rises, the total value of fund holdings also increases. That drives up the value of the mutual fund.
The general rule of mutual funds says that they should outperform market averages over the long term. The reality is that most do not. They remain on par with average due to fund managers trying to earn a decent profit on behalf of investors without increasing the relative risk.
Mutual funds tied to specific sectors perform in line with sector performance. For example, a fund built around healthcare sector would expect to grow as the biggest players in that sector also grow. Should healthcare ever start showing signs of weakness, any related mutual funds would follow.
Sector performance is something you are very familiar with. However, your clients might not necessarily understand. For example, they may intuitively know that consumer stocks respond to the general state of the economy but fail to grasp that mutual funds tied to commodities perform better when commodity prices rise. Higher gas prices are bad news for drivers but good news for investors whose mutual funds are invested primarily in energy.
The final two factors driving mutual fund performance are fund expenses and cash flow. These two are less important to the individual investor, but still important enough to explain to your clients. They need to understand that mutual fund investing is a business subject to the same kinds of financial constraints as any other.