Mutual fund investing should be less risky than buying individual stocks, but that's not always as true as it used to be.
When choosing a mutual fund, investors need to make sure they know not just the fund's objectives, but how far the fund manager will bend the rules to enhance the fund's performance.
For example, more and more fund managers – tempted by high-flying stocks like Apple Inc. (Nasdaq: AAPL) – have shown a willingness to overload their portfolios with riskier stocks in a gamble to beat the market averages.
Despite its volatility, Apple became the top holding among mutual fund managers earlier this year. According to Lipper, Apple stock makes up 10% or more of the assets of 117 mutual funds. Experts say any mutual fund position over 5% is considered too large a bet.
"Any time you get over 10 percent of the portfolio in one company it's a red flag," Michael Herbst, director of active fund research at Morningstar, told Reuters.
The increased position often goes unnoticed as long as the stock is doing well. When a popular-but-risky stock is going up, everyone is happy. The fund manager can bask in the success of outperforming his peers while investors enjoy outsized returns.
The result is a positive cycle that keeps pushing the stock ever higher. Mutual fund managers keep buying more, but so do index funds that by rule must keep pace with the stock's constantly rising weighting in major indexes.
But when such a stock reverses course, the strategy backfires.
When a Mutual Fund Investing Strategy Goes Haywire
A look at the fortunes of one mutual fund this year shows why you don't want to be invested in a fund that concentrates too heavily on one stock.
The Matthew 25 Fund has 17.4% of its assets in Apple stock. Its performance for the year closely mirrors Apple's. The Matthew 25 is up 27.24% year-to-date, while AAPL is up about 27%.
But most of that gain came early in the year, and anyone who bought into the Matthew 25 when AAPL was peaking in early April or September is underwater now.
A fund investor who bought Matthew 25 as long ago as mid-March is up only less than 5%. Any unfortunates who bought at Apple's peak in September are down 7%.
You see, when stock prices go down, fund managers start cutting their positions, driving the stock down even further. Index funds are forced to do the same.
This is exactly what has happened with Apple this year, and a major reason why the stock dropped so quickly and hasn't been able to sustain a recovery.
"Right now many people who did take huge overweight positions are right-sizing their portfolios to get it in line with their regular weightings," Sandy Villere, who has a 2.5% weighting of Apple in his $276 million Villere Balanced fund, told Reuters.
Apple isn't the only elevated-risk stock popular with mutual fund managers. Google Inc. (Nasdaq: GOOG) also turns up in a lot of portfolios. These are textbook examples of what happens when managers ignore the pitfalls of concentrated risk.
A Tempting Apple
So if this mutual fund investing strategy is so risky, why have so many fund managers persisted with it?
One reason has been Apple's extraordinary performance. Even with its recent fall, the stock is up more than 26% for the year, 58% over the past two years, and 162% over the past three years.
And until recently, selling on the drops has punished fund managers, as AAPL has consistently rebounded from declines to reach new highs.
But it turns out – and what is most frightening for mutual fund investing – is some of these funds shouldn't have been invested in Apple stock in the first place.
A Growing Danger in Mutual Fund Investing
It's bad enough when fund managers go overboard with a particular stock that falls within their fund's objectives.
But with Apple, some managers have shown a willingness to stray far outside their fund's parameters in their quest for higher returns.
Earlier this year, The Wall Street Journal found that 50 small-cap and mid-cap mutual funds owned Apple, which has the largest market capitalization of any company on the planet. And even before Apple started paying a dividend, 40 dividend funds owned the stock.
Needless to say, such flagrant disregard for a fund's objectives is critical information for potential fund investors.
"I have no idea how a fund manager even justifies that," Timothy Parker, an investment adviser in Midland Park, NJ, told The Wall Street Journal. "Is Apple a great company? Yes. Is it a good stock? Yes. But that is not what I'm hiring you to do."
The siren call of AAPL has persisted among some mutual fund managers regardless of their fund's objective even after the stock's 27% decline since September.
Some, like the Matthew 25 Fund's Mark Mulholland, are actually using Apple's drop to add to their positions.
"It's unbelievable," Mulholland told Fortune when the stock went under $550. "I am so psyched to be able to get shares of Apple at this level."
But however cheap AAPL gets, it doesn't change the fact that overweighting with a single volatile stock is a perilous mutual fund investing strategy.
"Yes, these funds may have performed well, but things could just as easily have gone the other way," Andrew Feldman, a Chicago-based registered investment adviser, told the Journal back in March – about a month before Apple's first 2012 stumble. "When you're holding things that you shouldn't be and they're doing great, there's no problem. But when it fails you're going to have a lot of very upset people."
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