Firstly, the biggest reason why your Mutual Fund will ever lose value is because the securities inside of the portfolio are losing value…Fundamentals baby, you can’t fight’em.
A more frustrating risk associated with the holding of a Mutual Fund is an associated tax distribution. Depending on how your fund is structured and where it is located, it may be setup in a way which passes all tax merits onto its unit holders. While this is great for investors with income goals, or wanting to avoid double taxation, it can have some serious implications on the value of the fund itself. Tax distributions are generally most relevant at the end of the year, because that is when they will be distributing gains/losses to its investors.
If you buy a stock at the end of the year, just after it has adjusted its portfolio for gains in the previous year, you may wind up on the wrong end of a tax payout. You could find that your position has been diluted by a dividend payout that has just been cashed out. Additionally, the fund may place you in the awkward situation where you are liable for the taxes incurred by the fund over the course of the year even though you’ve only held your units for a very short period of time (ie. You owe a capital gain you never incurred).
Even if you don’t find yourself in either of these positions, the fund needs to re-balance itself at the end of the period, which means that the value of the fund will temporarily drop as distributions and tax-payments remove cash from the fund. Scared yet? Don’t be. Your investment advisor would almost assuredly make you wait until you are reasonably far away from the appropriate tax period before helping you buy in. Just to be sure though, remember to buy after the year end, not before.
Finally, a mathematical nightmare associated with Mutual Funds is the risk of Contango, or Backwardation, within a fund that is highly exposed to a specific external economic condition (ie. Commodities or interest rates). When describing Contango, I like to invoke a mental image of a terrible dance, in which the participants are incentivized to intentionally step on each others’ toes at the correct intervals. It is a confusing, frightening thing, and can be extremely frustrating for an individual who isn’t aware of what’s going on. However, it still follows a certain rhythm, and can be integrated into a sophisticated progression.
Here’s how it works:
A fund that is particularly tied to a commodity begins to lose value as the price of that specific commodity declines. The decline in the value of the commodity results in a periodic loss for the fund, and unit-holders (investors) are unhappy. This is where things begin to unravel quickly. Unit-holders begin redeeming their holdings to the point at which the fund is required to cash out of its own positions in order to meet the demands of the investors, even though the fund is not selling their at the opportune price by having to liquidate on such short order.
While this action is enough to magnify the loss being incurred by remaining investors, a double-whammy loss occurs if the fund is forced to sell these commodity assets at a capital gain, from holdings purchased in a previous period. Since the fund is likely passing all of its tax-implications onto the unit-holder, the remaining investors will be stuck with the loss in the value of their fund’s NAV, but still be required to pay out the capital gains costs associated with the assets that have been liquidated. The result? A small group of investors have gotten spooked, cashed out, and stepped on the toes of the remaining investors on their way out.
With that in mind, Contango can be easily monitored, and its effects negated. One way to avoid Contango is to stick with funds that maintain cash deposits to cover for unexpected spikes in redemption. Closed-End funds provide additional protection against this risk, because they can cycle their funds between cash and securities to accommodate their respective relevance. Lastly, and tragically, a very popular method of avoiding Contango is to simply escape from the fund before the other investors at the first signs that significant write-downs will need to be made. I’ll leave that decision up to you, but there’s never any shame in being the first person to leave a burning building.
Alright, that’s enough for now. No need to keep you up all night with spooky stories about Mutual Funds. Remember, these risks are all well within the combined abilities of yourself and your investment advisor to control. Being aware of the risks only helps you to better structure out the rewards. This sort of structuring is exactly what I’ll begin to describe in the next segment of this series.
Next: Part 3 Practical Mutual Funds: Finding Equity Value