What Is In A (Mutual Fund's) Name?
Investors Need to Look Beyond a Mutual Fund’s Name When Evaluating Its Suitability
I recently performed a Portfolio X-Ray[1] for a new client. While analyzing the detailed report of the portfolio’s holdings, I noticed something unusual. A small-cap mutual fund made up about 20% of the client’s portfolio, but on the X-Ray report only about 5% of the individual holdings were classified as “small-cap.” How could that be? If 20% of the portfolio is in a small-cap fund, shouldn’t 20% of the individual positions be small-cap companies? As it turned out, not necessarily.
I decided to review the fund’s prospectus. A mutual fund’s prospectus is the brochure that provides more of the nitty-gritty disclosures regarding the fund including objectives, practices, fees, managers, managers’ tenure, etc. It’s very similar to the “terms of service” agreement most online tools and social media platforms have users click “OK” on prior to utilizing the service; it lists all of the legalese in excruciating detail, and no one actually reads it. Prospectuses can be found on the respective fund sponsor’s website or through a simple web search, and the information it contains is invaluable.
Upon perusing the prospectus, the reasons for the discrepancy in the percentage of assets became clear:
First, this particular mutual fund defined “small-cap” as a company that has a market capitalization[2] of less than $6B. A quick search will show that the general rule of thumb for a small-cap stock is a maximum market capitalization of $2B. However, this fund took it upon itself to redefine this type of asset class. Is this allowed? Apparently. And now that you know this, caveat emptor!
Second, the fund prospectus indicated that the manager is allowed to continue to hold shares of a company that subsequently appreciates above the fund’s small-cap threshold. Meaning, if the portfolio manager picks a great small-cap stock, and the stock is so successful that it grows into a mid-cap or even large-cap stock, the fund is allowed to continue to hold this position even though it is technically no longer a small-cap stock.
Finally, the prospectus indicated (paraphrasing) that the fund will normally invest X% in small-cap stocks. However, the fund may be allowed to go below that X% because of the 2 reasons noted above. While it sounds like a fund’s target is X%, the fund is absolutely allowed to go below it. So that begs the question, “By how much?” The prospectus is silent to that question. It would seem that setting a hard floor would be a better way to establish the parameter, i.e. fund is not allowed to go below a 70% allocation to small-cap stocks. Unfortunately, the fund’s mandate allows for much greater flexibility and less transparency.
This begs the question, “Is that small-cap fund really a small-cap fund?” It may be harder to tell than one might think. The good news is the information to make that determination is available. The bad news is that it requires a bit more effort than just looking at the fund’s name.
[1] A Portfolio X-Ray is a program used to evaluate an investor’s portfolio consisting of mutual funds and exchange-traded funds. A mutual fund or ETF can be made up of hundreds, if not thousands, of securities. The portfolio X-Ray will look through the mutual funds and provide an analysis based upon each fund’s individual holdings.
[2] Market Capitalization is the total value of a company given its current share price. For example, if a company has 500 shares issued and outstanding, and the share price is $10 per share, the market capitalization is $5,000.
About the author:
JP Geisbauer is a Certified Public Accountant and a Certified Financial Planner ®. He is the founder of Centerpoint Financial Management, LLC, a retirement planning, investment management, and tax planning firm located in Newport Beach, CA. If you have specific questions regarding your situation, please schedule a complimentary 30-minute call here.
Disclaimer:
This article is for general information and educational purposes only. Nothing contained in this article constitutes financial, investment, tax, or legal advice. Before taking any action on any topic discussed in this article, please consult with your financial planner, investment advisor, tax professional, and/or attorney for advice on your specific situation.