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.