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Educational Programming Video

The Value Line Mutual Fund Survey
Program 23: Picking a Fund - Part 2

The Value Line Mutual Fund Survey
Program 23: Picking a Fund - Part 2

In the last session, we started to discuss the fund selection process. We'll continue that discussion focusing on management style.

Although our hypothetical investor wants a moderate risk and has a medium time frame, there is still a great deal of latitude when it comes to selecting individual funds. Granted, on the domestic equity front, we are only trying to fill four asset categories, namely large-cap growth, large-cap value, small-cap growth, and small-cap value, but each one of these asset categories can be filled with stock funds that focus on sectors ranging from technology to utilities.

As we discussed in the previous session, we will assume that our moderate investor is looking within Value Line's Growth and Growth and Income objective groups. The list of funds that passed our first screens is now broken out by the four broad asset categories, which we are attempting to fill. The question is, "Which fund or funds should be chosen?"

We start with each fund's management style. Essentially, management style tells how the fund manager does his or her job, what makes these professionals buy or sell a stock. To get you started, we're going to highlight two important terms you should be aware of when reading a Value Line report or a fund prospectus.

"Top-down" and Bottom-up". These two terms refer to the way in which fund managers view the stock selection process. A pure top-down manager looks at the large picture, such as the economy or the health of a particular sector, and then invests in the areas that the manager believes have the best growth prospects. Note that stock selection wasn't even mentioned here. A pure top-down manager doesn't particularly care what stocks he or she buys, just that they are in the right sector or sub-sector. A pure bottom-up investor, meanwhile, doesn't look at the larger picture and only focuses on a company's financial strength and potential growth. Each stock is selected individually and no larger trends are followed. This type of manager doesn't care if any particular sector is hot, all he or she cares about is that a particular company meets a buy criteria.

In truth, there are very few pure top-down fund managers. Most mix a top-down approach with bottom-up selection, first finding hot sectors and then picking the stocks they like from that particular sector or sub-sector. There are, however, managers who are exclusively bottom-up. These managers often have eclectic portfolios.

Very often fund companies will not come right out and tell you which style they follow, but if you read between the lines it will quickly become apparent. Managers who focus on economic issues are highlighting top-down factors, while those that look at company growth rates and financial strength are taking a bottom-up view.

What you need to decide is which type of management style you feel most comfortable with. Do you believe that looking first for the hottest sector or the most undervalued sector makes sense? Or should each company be evaluated on its own merits and growth prospects? Once you make this choice, you can focus more on those funds that fit your broad investment beliefs.

From here, you need to figure out what you think constitutes growth and value. Is "growth" purely earnings growth? Some managers think sales growth is more important than earnings growth because they believe that, even if earnings growth is slow, sales growth will eventually drive earnings. On the value side, some managers look at value relative to the entire stock market, while others consider value only relative to a sector. The latter would likely lead to investments in more growth-oriented sectors, while the former might keep investments in out-of-favor areas.

We've only touched on a couple of different management issues, but there are plenty more for you to digest when examining a fund. The point you should take away from this is that you must understand and believe in the way your funds are managed. But, why?

As an investor, you should focus on maintaining your asset allocation model, letting investment professionals do the individual stock picking. That said, however, you want to make sure that the person you hire to pick stocks for you is doing so in a way that suits your investment preferences. This is important because investment styles go in and out of favor. You don't want to be changing funds every time a fund's investment style goes out of favor. You want to stick with a fund so long as there aren't any fundamental changes in management's investment approach. But it's really hard to stay with a poorly performing fund if you don't believe in or even understand how management invests.

In our next session we will discuss foreign stock funds.

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