There are several types of bond funds that are particularly popular with risk-averse investors. Funds made up of U.S. Treasury bonds lead the pack, as they are considered to be one of the safest. Investors face no credit risk, as the government's ability to levy taxes and print money eliminates the risk of default and provides principal protection.
Bond funds that invest in mortgages securitized by the Government National Mortgage Association (Ginnie Mae) are also backed by the full faith and credit of the U.S. government. Most of the mortgages (typically mortgages for first-time home buyers and low-income borrowers) securitized as Ginnie Mae mortgage-backed securities (MBS) are those guaranteed by the Federal Housing Administration (FHA), Veterans Affairs, or other federal housing agencies.
Next on the list are municipal bond funds. Issued by state and local governments, these investments leverage local taxing authority to provide a high degree of safety and security to investors. They carry a greater risk than funds that invest in securities backed by the federal government, but are still considered to be relatively safe.
Taxable bond funds issued by corporations are also a consideration. They offer higher yields than government-backed issues, but carry significantly more risk. Choosing a fund that invests in high-quality bond issues will help lower your risk. (Corporate Bonds: An Introduction To Credit Risk provides information about how to evaluate the risks or investing in corporate bonds.)
While corporate bond funds are riskier than funds that only hold government issued bonds, they are still less risky than stock funds. (Evaluating Bond Funds: Keeping It Simple provides an overview of some of the key factors for determining a fund's risk-return profile and Bond Funds Boost Income, Reduce Risk highlights the stable returns these investments can provide.)
Beyond Bonds
When it comes to avoiding recessions, bonds are certainly popular, but they aren't the only game in town. Ultra-conservative investors and unsophisticated investors often stash their cash in money market funds. While these funds do provide a high degree of safety, they should only be used only for short-term investments. (To learn more, read Introduction To Money Market Mutual Funds and Are Money Market Fund Risks Worth It?)
Contrary to popular belief, seeking shelter during tough times doesn't necessarily mean abandoning the stock market altogether. While investors stereotypically think of the stock market as a vehicle for growth, share price appreciation isn't the only game in town when it comes to making money in the stock market. For example, mutual funds that focus on dividends can provide strong returns with less volatility than funds that focus strictly on growth. (To learn more about dividends, see Dividends Still Look Good After All These Years.)
Utilities-based mutual funds and funds that invest in consumer staples are less aggressive stock fund strategies that tend to focus on investing in companies that pay predictable dividends.
Traditionally, funds that invest in large-cap stocks tend to be less vulnerable than those that invest in small-cap stocks, as larger companies are generally better positioned to endure tough times. Shifting assets from funds that invest in smaller, more aggressive companies to those that bet on blue chips provides a way to cushion your portfolio against market declines without fleeing the stock market altogether.
More Aggressive Strategies
For wealthier individuals, investing a portion of your portfolio in hedge funds is one idea. Hedge funds are designed to make money regardless of market conditions. Investing in a foul weather fund is another idea, as these funds are specifically designed to make money when the markets are in decline.
In both cases, these funds should only represent a small percentage of your total holdings. In the case of hedge funds, "hedging" is actually the practice of attempting to reduce risk, but the actual goal of most hedge funds today is to maximize return on investment. The name is mostly historical, as the first hedge funds tried to hedge against the downside risk of a bear market by shorting the market (mutual funds generally can't enter into short positions as one of their primary goals). Hedge funds typically use dozens of different strategies, so it isn't accurate to say that hedge funds just "hedge risk." In fact, because hedge fund managers make speculative investments, these funds can carry more risk than the overall market. In the case of foul weather funds, your portfolio may not fare well when times are good.
Diversification: A Strategy for Any Market
While bond funds and similarly conservative investments have shown their value as safe havens during tough times, investing like a lemming isn't the right strategy for investors seeking long-term growth. Trying to time the market by selling your stock funds before they lose money and using the proceeds to buy bonds funds or other conservative investments and then doing the reverse just in time to capture the profits when the stock market rises is a risky game to play. The odds of making the right move are stacked against you. Even if you achieve success once, the odds of repeating that win over and over again throughout a lifetime of investing simply aren't in your favor.
A far better strategy is to build a diversified mutual fund portfolio. A properly constructed portfolio, including a mix of both stock and bonds funds, provides an opportunity to participate in stock market growth and cushions your portfolio when the stock market is in decline. Such a portfolio can be constructed by purchasing individual funds in proportions that match your desired asset allocation or you can do the entire job with a single fund by purchasing a mutual fund that has "growth and income" or "balanced" in its name. (To learn more, read Managing A Portfolio Of Mutual Funds.)
Conclusion
Regardless of where you put your money, if you have a long-term time frame, look at a down market as an opportunity to buy. Instead of selling when the price is low, look at is an opportunity to build your portfolio at a discount. When retirement becomes a near-term possibility, make a permanent move in a conservative direction. Do it because you have enough money to meet your needs and want to remove some of the risk from your portfolio for good, not because you plan to jump back in when you think the markets will rise again.
by Lisa Smith, (Contact Author | Biography)
Saturday, January 24, 2009
8 Reasons To Dump A Mutual Fund
1. Portfolio Rebalancing
Over time, trends in financial markets might cause asset allocations to diverge from desired settings. In other words, some mutual funds can grow to a large proportion of the portfolio while others shrink to a smaller proportion, exposing you to a different level of risk. To avoid this outcome, the portfolio can be rebalanced periodically by selling units in funds that have relatively large weights and transferring the proceeds to funds that have relatively small weights. Under this rule, the time to sell equity mutual funds is when they have enjoyed good gains over an extended bull market and the percentage allocated to them has drifted up too high
2. Mutual Fund Changes or Mismanagement
Mutual funds might change in a number of ways that can be at odds with your original reasons for buying. For example, a star portfolio manager could jump ship and be replaced by someone lacking the same capabilities. Or there may be style drift, which arises when a manager gradually alters his or her investing approach over time. (For more insight, check out Focus Pocus May Not Lead To Magical Returns and Should You Follow Your Fund Manager?)Other signals to move on include an upward trend in annual management expense ratios (MERs) or a fund that has grown large relative to the market. If the fund has grown large compared to the market, managers could have difficulty differentiating their portfolios from the market in order to earn above-market returns.
3. Investor Growth
As you gain experience and acquire more wealth, you may outgrow mutual funds. With greater wealth comes the ability to buy enough individual stocks to achieve adequate diversification and avoid MERs. And with greater knowledge comes the confidence to do it yourself, whether it is actively picking stocks or buying and holding market indexes through exchange-traded funds (ETFs).
4. Life Cycle Changes
Although stocks historically have been the best investments to own over the long run, their volatility makes them unreliable vehicles in the short term. When retirement, children's post-secondary educations, or some other funding requirements approach, a good idea is to shift out of stock-market funds into assets that have more certain returns, such as bonds or term deposits, whose maturities coincide with the time that the funds will be needed. (To learn more, read The Seasons Of An Investor's Life.)
5. Mistakes
Sometimes, investors' due diligence is incomplete and they end up owning funds they otherwise would have not purchased. For example, the investor might discover that the fund is too volatile for their tastes, a closet-index fund with a high MER, or invested in undesirable securities.Portfolio errors might also have been committed by the investor. A common mistake is over-diversifying with too many funds, which can be difficult to keep tabs on and can tend to average out to market performance (less fund fees). Another common misstep is to confuse owning a large number of funds with diversification. A large number of funds will not smooth out fluctuations if they tend to move in the same direction. What's needed is a collection of funds, of which some can be expected to be up when others are down.
6. Valuation
Shift out of mutual funds to rebalance your fixed portfolio allocations by using a flexible or opportunistic approach. A common valuation yardstick is the price-earnings ratio (P/E ratio); for U.S. stocks, it has averaged 14 to 15 over time, so if it rises to 24 to 26, valuations are overextended and the risk of a downturn is elevated. (See P/E Ratio: Introduction, for more.)
7. Something Better Comes Along
Investing legend Sir John Templeton advised selling whenever something better came along. In the mutual fund realm, some funds can come onto the market with innovations that are better at doing what your fund is doing. Or, over time, it may become apparent other portfolio managers are performing better against the same benchmarks.
8. Tax Reduction
Mutual funds held in taxable accounts might be down substantially from their purchase price. They can be sold to realize capital losses that are used to offset taxable capital gains and thus lower taxes. If the sale was solely to realize a capital loss for taxation purposes, the investor will want to re-establish the position after the 30-day period required to avoid the superficial-loss rule. The investor might take a chance that the price will be the same, lower or might choose to hold a proxy for the fund's price movement. Tax-loss selling tends to occur during August to late December. That's also the period when many funds have estimated the capital gains and income they will be distributing to investors at year end. These amounts are taxable in the hands of the investor, so an additional reason to sell a losing fund from the tax point of view may be to avoid a large year-end distribution that would require paying additional taxes. (Read A Long-Term Mindset Meets Dreaded Capital-Gains Tax, for more insight.)
Conclusion
Although these eight reasons should compel you to consider getting rid of your fund, remember to keep the impact of deferred sales charges, short-term trading fees and taxes in mind whenever you sell. If these other factors don't fall in your favor, it may not be the best time to get out.
Over time, trends in financial markets might cause asset allocations to diverge from desired settings. In other words, some mutual funds can grow to a large proportion of the portfolio while others shrink to a smaller proportion, exposing you to a different level of risk. To avoid this outcome, the portfolio can be rebalanced periodically by selling units in funds that have relatively large weights and transferring the proceeds to funds that have relatively small weights. Under this rule, the time to sell equity mutual funds is when they have enjoyed good gains over an extended bull market and the percentage allocated to them has drifted up too high
2. Mutual Fund Changes or Mismanagement
Mutual funds might change in a number of ways that can be at odds with your original reasons for buying. For example, a star portfolio manager could jump ship and be replaced by someone lacking the same capabilities. Or there may be style drift, which arises when a manager gradually alters his or her investing approach over time. (For more insight, check out Focus Pocus May Not Lead To Magical Returns and Should You Follow Your Fund Manager?)Other signals to move on include an upward trend in annual management expense ratios (MERs) or a fund that has grown large relative to the market. If the fund has grown large compared to the market, managers could have difficulty differentiating their portfolios from the market in order to earn above-market returns.
3. Investor Growth
As you gain experience and acquire more wealth, you may outgrow mutual funds. With greater wealth comes the ability to buy enough individual stocks to achieve adequate diversification and avoid MERs. And with greater knowledge comes the confidence to do it yourself, whether it is actively picking stocks or buying and holding market indexes through exchange-traded funds (ETFs).
4. Life Cycle Changes
Although stocks historically have been the best investments to own over the long run, their volatility makes them unreliable vehicles in the short term. When retirement, children's post-secondary educations, or some other funding requirements approach, a good idea is to shift out of stock-market funds into assets that have more certain returns, such as bonds or term deposits, whose maturities coincide with the time that the funds will be needed. (To learn more, read The Seasons Of An Investor's Life.)
5. Mistakes
Sometimes, investors' due diligence is incomplete and they end up owning funds they otherwise would have not purchased. For example, the investor might discover that the fund is too volatile for their tastes, a closet-index fund with a high MER, or invested in undesirable securities.Portfolio errors might also have been committed by the investor. A common mistake is over-diversifying with too many funds, which can be difficult to keep tabs on and can tend to average out to market performance (less fund fees). Another common misstep is to confuse owning a large number of funds with diversification. A large number of funds will not smooth out fluctuations if they tend to move in the same direction. What's needed is a collection of funds, of which some can be expected to be up when others are down.
6. Valuation
Shift out of mutual funds to rebalance your fixed portfolio allocations by using a flexible or opportunistic approach. A common valuation yardstick is the price-earnings ratio (P/E ratio); for U.S. stocks, it has averaged 14 to 15 over time, so if it rises to 24 to 26, valuations are overextended and the risk of a downturn is elevated. (See P/E Ratio: Introduction, for more.)
7. Something Better Comes Along
Investing legend Sir John Templeton advised selling whenever something better came along. In the mutual fund realm, some funds can come onto the market with innovations that are better at doing what your fund is doing. Or, over time, it may become apparent other portfolio managers are performing better against the same benchmarks.
8. Tax Reduction
Mutual funds held in taxable accounts might be down substantially from their purchase price. They can be sold to realize capital losses that are used to offset taxable capital gains and thus lower taxes. If the sale was solely to realize a capital loss for taxation purposes, the investor will want to re-establish the position after the 30-day period required to avoid the superficial-loss rule. The investor might take a chance that the price will be the same, lower or might choose to hold a proxy for the fund's price movement. Tax-loss selling tends to occur during August to late December. That's also the period when many funds have estimated the capital gains and income they will be distributing to investors at year end. These amounts are taxable in the hands of the investor, so an additional reason to sell a losing fund from the tax point of view may be to avoid a large year-end distribution that would require paying additional taxes. (Read A Long-Term Mindset Meets Dreaded Capital-Gains Tax, for more insight.)
Conclusion
Although these eight reasons should compel you to consider getting rid of your fund, remember to keep the impact of deferred sales charges, short-term trading fees and taxes in mind whenever you sell. If these other factors don't fall in your favor, it may not be the best time to get out.
Friday, January 23, 2009
WARRANTS ????Whats that??
A warrant, like an option, gives the holder the right but not the obligation to buy an underlying security at a certain price, quantity and future time. However, unlike an option, an instrument of the stock exchange, a warrant is issued by a company. The security represented in the warrant (usually share equity) is delivered by the issuing company instead of an investor holding the shares. Companies will often include warrants as part of a new-issue offering to entice investors into buying the new security. A warrant can also increase a shareholder's confidence in a stock, if the underlying value of the security actually does increase overtime. There are two different types of warrants: a call warrant and a put warrant. A call warrant represents a specific number of shares that can be purchased from the issuer at a specific price, on or before a certain date. A put warrant represents a certain amount of equity that can be sold back to the issuer at a specified price, on or before a stated date. Characteristics of a Warrant Warrant certificates have stated particulars regarding the investment tool they represent. All warrants have a specified expiry date, the last day the rights of a warrant can be executed. Warrants are classified by their exercise style: an American warrant, for instance, can be exercised anytime before or on the stated expiry date, and a European warrant, on the other hand, can be carried out only on the day of expiration. The underlying instrument the warrant represents is also stated on warrant certificates. A warrant typically corresponds to a specific number of shares, but it can also represent a commodity, index or a currency. The exercise or strike price is the amount that must be paid in order to either buy the call warrant or sell the put warrant. The payment of the strike price results in a transfer of the specified amount of the underlying instrument. The conversion ratio is the number of warrants needed in order to buy (or sell) one investment tool. Therefore, if the conversion ratio to buy stock XYZ is 3:1, this means that the holder needs three warrants in order to purchase one share. Usually, if the conversion ratio is high, the price of the share will be low, and vice versa. (In the case of an index warrant, an index multiplier would be stated instead. This figure would be used to determine the amount payable to the holder upon the exercise date.) Investing In Warrants Warrants are transferable, quoted certificates, and they tend to be more attractive for medium-term to long-term investment schemes. Tending to be high risk, high return investment tools that remain largely unexploited in investment strategies, warrants are also an attractive option for speculators and hedgers. Transparency is high and warrants offer a viable option for private investors as well. This is because the cost of a warrant is commonly low, and the initial investment needed to command a large amount of equity is actually quite small. Advantages Let us look at an example that illustrates one of the potential benefits of warrants. Say that XYZ shares are currently priced on the market for $1.50 per share. In order to purchase 1,000 shares, an investor would need $1,500. However, if the investor opted to buy a warrant (representing one share) that was going for $0.50 per warrant, with the same $1,500, he or she would be in possession of 3,000 shares instead! Because the prices of warrants are low, the leverage and gearing they offer is high. This means that there is a potential for larger capital gains and losses. While it is common for both a share price and a warrant price to move in parallel (in absolute terms) the percentage gain (or loss), will be significantly varied because of the initial difference in price. Warrants generally exaggerate share price movements in terms of percentage change. Let us look at another example to illustrate these points. Say that share XYZ gains $0.30 per share from $1.50, to close at $1.80. The percentage gain would be 20%. However, with a $0.30 gain in the warrant, from $0.50 to $0.80, the percentage gain would be 60%. In this example, the gearing factor is calculated by dividing the original share price by the original warrant price: $1.50 / $0.50 = 3. The '3' is the gearing factor, and the higher the number, the larger the potential for capital gains (or losses). Warrants can offer significant gains to an investor during a bull market. They can also offer some protection to an investor during a bear market. This is because as the price of an underlying share begins to drop, the warrant may not realize as much loss because the price, in relation to the actual share, is already low. Disadvantages Like any other type of investment, warrants also have their drawbacks and risks. As mentioned above, the leverage and gearing warrants offer can be high. But these can also work to the disadvantage of the investor. If we reverse the outcome of the example from above and realize a drop in absolute price by $0.30, the percentage loss for the share price would be 20%, while the loss on the warrant would be 60%! Another disadvantage and risk to the warrant investor is that the value of the certificate can drop to zero. If that were to happen before it is exercised, the warrant would lose any redemption value. Finally, a holder of a warrant does not have any voting, shareholding or dividend rights. The investor can therefore have no say in the functioning of the company, even though he or she is affected by any decisions made. A Bittersweet Stock Jump One notable instance in which warrants made a big difference to the company and investors took place in the early 1980s when the Chrysler Corporation received governmentally guaranteed loans totaling approximately $1.2 billion. Chrysler used warrants, 14.4 million of them, to “sweeten” the deal for the government and solidify the loans. Because these loans would keep the auto giant from bankruptcy, management showed little hesitation issuing what they thought was a purely superficial bonus that would never be cashed in. At the time of issuance Chrysler stock was hovering around $5, so issuing warrants with an exercise price of $13 did not seem like a bad idea. However, the warrants ended up costing Chrysler approximately $311 million, as their stock shot up to nearly $30. For the federal government, this “cherry on top” turned quite profitable, but for Chrysler it was an expensive after thought. Conclusion Warrants can offer a smart addition to an investor's portfolio, but due to their risky nature, warrant investors need to be attentive to market movements. This largely unused investment alternative, however, can offer the small investor the opportunity for diversity without having to compete with large, market-influencing institutions
INVESTING IN COMMODITIES..
Commodities, whether they are related to food, energy or metals, are an important part of everyday life. Similarly, commodities can be an important way for investors to diversify beyond traditional stocks and bonds, or to profit from a conviction about price movements. Years ago, most people did not invest in commodities, because doing so required significant amounts of time, money and expertise. Today there are a number of different routes to the commodity markets, and some make it fairly easy for even the average investor to participate. Read on to learn which of the following tools will help you invest in commodities best: futures, options or funds. (For background reading on everyday commodities, read Commodities That Move The Markets and Commodities: The Portfolio Hedge.)Futures MarketA popular way to invest in commodities is through a futures contract, which is an agreement to buy or sell in the future a specific quantity of a commodity at a specific price.Futures are available on commodities such as crude oil, gold and natural gas, as well as agricultural products such as cattle or corn. (Read Become An Oil And Gas Futures Detective and Grow Your Finances In The Grain Markets for more on specific types of futures.) Most of the participants in the futures markets are commercial or institutional users of the commodities they trade. These hedgers may use the commodity markets to take a position that will reduce the risk of financial loss due to a change in price. Other participants, mainly individuals, are speculators who hope to profit from changes in the price of the futures contract. Speculators typically close out their positions before the contract is due and never take actual delivery of the commodity (grain, oil, etc.) itself. (Check out our Futures Fundamentals tutorial to learn all about these types of investments.)Investing in a futures contract will require you to open up a new brokerage account, if you do not have a broker that also trades futures, and to fill out a form acknowledging that you understand the risks associated with futures trading. Each commodity contract requires a different minimum deposit, depending on the broker, and the value of your account will increase or decrease with the value of the contract. If the value of the contract goes down, you will be subject to a margin call and will be required to place more money into your account to keep the position open. Due to the huge amounts of leverage, small price movements can mean huge returns or losses, and a futures account can be wiped out or doubled in a matter of minutes. Most futures contracts will also have options associated with them. Options on futures contracts still allow you to invest in the futures contract, but limit your loss to the cost of the option. Options are derivatives and usually do not move point-for-point with the futures contract. (Learn more about the pros and cons of options on futures in Leveraged Investment Showdown.)
Advantages:
It's a pure play on the underlying commodity.
Leverage allows for big profits if you are on the right side of the trade.
Minimum-deposit accounts control full-size contracts you would normally not be able to afford.
You can go long or short easily.
Disadvantages:
The futures markets can be very volatile and direct investment in these markets can be very risky, especially for inexperienced investors.
Leverage magnifies both gains and losses.
A trade can go against you quickly and you could lose your initial deposit and more before you are able to close your position.
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