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Don’t Get Fancy, Just Use Funds

December 2, 2017

Strategies for Mutual Fund Investing

Assembling a mutual fund portfolio isn’t just a matter of looking at performance figures. Each fund in your portfolio should be designed to fill a specific role. Strategies for mutual funds fall into three basic areas: (1) strategies for the timing of your investment(s), (2) strategies for selecting specific mutual funds, and (3) strategies for ensuring that taxes don’t cut into your returns any more than necessary.

Remember that any investment approach involves some type of risk, including the loss of principal, and there’s no guarantee any strategy or technique will be successful.

Timing strategies

Dollar cost averaging/periodic investing

Also known as a constant dollar plan or systematic investment plan, dollar cost averaging involves putting a fixed amount of money in one or more funds at set intervals, regardless of market conditions. Because the amount you invest is always the same, you end up buying more shares when the price is low and fewer shares when the price is high. This strategy allows you to average out the market’s highs and lows. Consequently, the average cost per share should be lower than the share price. Further, dollar cost averaging lowers the risk of investing a lump sum at an inopportune time. Keep in mind, though, that dollar cost averaging does not guarantee a profit or protect against potential loss, and you must be able to continue to invest during periods of falling prices.

However, be aware that the benefits of dollar cost averaging tend to diminish over time as the short-term price swings of a given investment begin to be less important than the overall direction of its price movements.

Investing a lump sum

If you have the option of investing a large sum of money all at once and plan to stay invested for a long time, some experts contend that your returns are better if that sum is invested immediately. Putting your money to work as soon as possible means you have a longer time period for the benefits of compounding to have an impact.

The challenge, of course, is that you run the risk of investing just before the markets take a downward turn. Though nothing can protect you completely from this possibility, you may be able to help minimize this risk by spreading the money over multiple asset classes. Also, be sure that you understand a given investment’s potential for both short-term and long-term losses as well as gains. Though past performance is no guarantee of future results, check on how a fund has behaved in both bull and bear markets, and how volatile it has been.

Periodic rebalancing

If you have chosen a selection of funds based on an appropriate asset allocation, it’s likely you’ll need to adjust the amount of money in each one from time to time to maintain that asset allocation. If one type of fund has done well, it might represent a higher share of your assets than you intended. To maintain the desired percentage, you would sell shares of that fund and invest the money in a fund that represents a different asset class to bring it back to the appropriate level for your allocation. Or you could direct new assets into that asset class.

Buy and hold

If your goal is to try to benefit from long-term upward price trends, you might adopt a buy-and-hold strategy, in which you identify what seem to be appropriate high-quality funds and hold them for a long time, trying not to be too concerned with day-to-day ups and downs. A buy-and-hold strategy is an excellent way to avoid the expense and effort involved in frequent trading. All too often, investors buy a fund that has outperformed recently, become disillusioned with it if it fails to match that performance, and sell only to move to the next hot fund. This is known as chasing performance, and has the potential to seriously hamper long-term returns. Investors who chase performance often find themselves investing in a certain hot fund just as the conditions that produced that outperformance are about to change.

Buy and hold isn’t the same as holding on to a position after it’s outlived its original role in your portfolio, or just because you may have suffered a loss and cling to the idea of recouping that investment. Even funds you plan to hold for a long time should be reexamined periodically to make sure they’re still appropriate in the context of your overall portfolio and any changes in your circumstances.

Another benefit of a buy-and-hold strategy is that it takes advantage of the compounding effect of reinvesting any dividends you may receive. Dividends can be automatically reinvested in additional full and fractional shares instead of in cash. Virtually all mutual funds allow you to reinvest dividends and capital gains distributions. However, remember that unless your fund shares are held in a tax-deferred retirement plan, the dividends you reinvest will be taxable just as if you received them in cash. You also need to keep records of the market price at which each additional share is purchased because when you eventually sell your shares or pass them along to another, you will need a record of what you paid for them to determine your cost basis. That cost basis affects the amount of taxable capital gain (or tax-deductible capital loss) you realize.

Timing the market

Timing the market can be challenging at best; even full-time professionals often have difficulty being successful at it. Several studies have shown that when investors try to time the market, they often underperform a buy-and-hold strategy because they tend to buy close to market tops and sell near the bottom. And even if you are able to get out of a market in time to protect yourself from a downturn, will you know when you should get back in? Also, because mutual funds are priced once daily, they aren’t as flexible as vehicles that can be traded throughout the day.

However, if you feel confident attempting to second-guess the markets, there are several approaches that may help. You could adopt a core-and-satellite approach (see below), so that you employ market timing with only a portion of your portfolio. Also, be prepared to devote sufficient time to monitoring your investments closely so you can minimize potential losses quickly. Finally, having an investment discipline and predetermined guidelines for buying and selling–and adhering to those guidelines–can help remove emotion from your decisions. For example, you might determine in advance that you will take profits when a given index has risen by a certain percentage, and buy when the market has fallen by a certain percentage. A variation of this would involve setting a mental stop-loss figure that represents the point at which you would sell a fund to prevent any further losses. Such a stop-loss target, which could be a percentage or an absolute number, would enable you to benefit from a rising market but prevent a loss from becoming catastrophic (though it also could keep you from profiting if the fund continues its upward movement after you’ve sold).

Before attempting to time the market, you should be aware that many mutual funds impose redemption fees or other measures designed to restrict short-term trading. It’s especially important with this strategy to determine if such fees and trading costs will outweigh the potential benefits. In some cases, closed-end funds, exchange-traded funds, or individual securities–all of which are traded throughout the day–could provide an equivalent vehicle.

Selection strategies

Before investing in any mutual fund, carefully consider its investment objectives, risks, charges, and expenses, which can be found in the prospectus available from the fund. Read it carefully before investing.

Core and satellite

A core-and-satellite strategy represents an attempt to blend strategic pursuit of long-term goals with more tactical portfolio management designed to try to take advantage of changing market conditions. A core-and-satellite portfolio starts with a selection of core funds that are designed to be held for a relatively long period regardless of changing market conditions. Satellite holdings are then added; these may be more narrowly focused and may change more frequently depending on the outlook for specific asset classes or market sectors. Because satellite holdings may be traded more often, a core-and-satellite portfolio strategy represents not only a strategy for selecting a specific fund based on whether it should be a core holding or not, but also a blend of the buy-and-hold approach with efforts at market timing. Again, be aware of any restrictions on frequent trading and the potential impact of any trading costs.

Active management vs. indexing

Index funds try to track the performance of an index by buying the securities in it. The index may be a stock index (such as the S&P 500 or the Dow Jones Industrial Average) or a bond index (such as Barclays Capital Aggregate Bond Index). The theory behind pursuing an indexing strategy is that because index funds’ expenses tend to be relatively low and because it can be difficult to beat market averages, net returns can be improved by simply using index funds to try to capture the vast majority of the return of a given market. Advocates argue that indexing makes sense because most of the variation between the performance of different portfolios is the result of their asset allocation rather than individual security selection.

By contrast, investing in actively managed funds puts the expertise of the fund manager at your disposal. With an actively managed fund, the manager attempts to outperform market averages through securities selection and smart timing of purchases and sales. An index fund is obligated to hold a security as long as it’s represented in the given index, even if that company is suffering (some indexes can be highly vulnerable to the performance of a specific market sector, such as technology or financials, or even a single large company). The manager of an actively managed fund, on the other hand, is free to sell an underperforming security, and put that money to work in something with greater potential.

Value/contrarian vs. growth/momentum

Investors have a mind-boggling variety of options when it comes to selecting a stock fund. In considering a strategy for selecting stock funds, approaching your decision in terms of whether a fund focuses on value investing or growth can help you narrow your choices.

A value-oriented fund focuses on stocks that appear to be bargains relative to the company’s intrinsic worth. A stock can have a low valuation for many reasons, such as management difficulties, tough competition, or legal problems. Or it may simply be in an industry that is currently out of favor with investors. It may have been overlooked by investors. A value fund manager believes that eventually the share price will rise to reflect the company’s true worth. A value fund is an example of contrarian investing. Contrarians believe that the greatest profit potential lies in buying when no one else wants to, or focusing on stocks or industries that are temporarily out of favor with the market.

A growth-oriented fund manager takes a different approach, looking for companies that are expanding rapidly. They are less concerned with finding a bargain than with investing in companies they feel have the greatest potential for rapid appreciation in share price. These often are newer companies in emerging industries with a bright future, which may also involve more uncertainty and greater risk. Some growth fund managers are what’s known as a momentum investor, preferring accelerating growth that is attracting a lot of investors and causing the share price to rise. Momentum investors believe you should buy a stock only when earnings growth is accelerating and the price is moving up. Unlike a value-oriented fund manager, they often buy even when a stock is richly valued, assuming the stock’s price will go even higher, and sell quickly to prevent further losses if a stock’s momentum reverses.

Some funds are sensitive to both growth and value considerations. These look for what’s called “growth at a reasonable price (GARP).”

Tax strategies

Harvesting losses

If you’ve experienced investment losses, you may be able to derive some tax benefit from selling those investments; this is known as harvesting losses. If you have realized capital gains and have no tax losses carried forward from previous years, you can sell losing positions to offset some or all of those gains. Any losses over and above the amount of your gains generally can be used to offset up to $3,000 of ordinary income ($1,500 for a married person filing separately) or carried forward to offset future gains. However, remember that tax considerations shouldn’t be the sole driver of your investing decisions.

Maximizing tax efficiency

If you decide to sell some mutual fund shares, there may be ways to minimize the tax burden. For example, you can figure your cost basis for the shares in whatever way is most advantageous from a tax perspective. Rather than using the average cost per share for your fund, you might decide to request that specific shares be sold–for example, those bought at a certain price. Your strategy for choosing those shares depends on whether you want to book capital losses to offset gains, or keep gains to a minimum to reduce your tax bite. (Obviously, this only applied to shares held in a taxable account.)

Another way to maximize the tax efficiency of your funds is to hold them in the appropriate account. For example, holding a municipal bond fund in a tax-advantaged account such as an IRA means that you may be forgoing higher returns for the tax-free feature of munis, even though the IRA shelters that interest from taxes anyway. A fund that invests in Treasury Inflation-Protected Securities (TIPS) is another example. Because TIPS investors owe taxes each year on any inflation-related adjustment to principal, holding a TIPS investment in a tax-deferred account can postpone payment of those taxes.

Before selling a fund, consider how long you’ve owned it. Assets held a year or less generate short-term capital gains and are taxed as ordinary income. That tax rate could be as high as 35 percent, not including state taxes. Long-term capital gains on the sale of assets held for more than a year generally are taxed at lower rates: 15 percent for most investors, 0 percent to the extent investors are in the 10 percent and 15 percent tax brackets through 2012.

You also can take tax efficiency into account when purchasing a mutual fund. If you’re considering buying a fund outside of a tax-advantaged account, find out when the fund will distribute dividends or capital gains, which it must do annually. Consider postponing action until after that date, which is often near year-end. If you buy just before the distribution is made, you’ll face potential taxes on that money, even if your own shares haven’t appreciated. If you plan to sell a fund, you may be able to minimize taxes by doing so before the distribution date.


Jake Rivas, CFP® is a financial advisor and CERTIFIED FINANCIAL PLANNER™ at i•financial located at 1901 NW Military Hwy Ste. 102, San Antonio, TX 78216. He offers securities and advisory services as an Investment Adviser Representative of Commonwealth Financial Network®, Member FINRA/SIPC, a Registered Investment Adviser. He can be reached at 210-342-4346 or by email at

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