When you buy a mutual fund, you usually have a pretty good idea of what sort of stocks you'd expect to find among its holdings. But recently, some fund shareholders have gotten a bit of a shock when they discovered exactly what fund managers were doing with their money.
Sticking with a style
Fund investors generally follow one of two strategies with the mutual funds they select. Some investors are content to let fund managers invest wherever they want, expecting them to make smart decisions about choosing the best stocks without having to worry about sticking to any particular sector, size, or geography in making those picks.
Other investors, on the other hand, want their mutual funds to follow strictly regimented practices when it comes to the stocks they choose. By picking funds that stick to specific parts of the market, you have complete control of how you divide your assets across different subclasses of stocks. For instance, if you want 20% of your money in international stocks, then it's easy: Just put 20% of your money in mutual funds that strictly invest in foreign companies, and the other 80% in domestic stock funds.
Sounds simple, doesn't it? But the problem is that if you don't look closely, you might not realize that your fund isn't limited to staying in its designated space -- and that can wreak havoc on your asset allocation.
Stepping on a landmine
Recently, the dangers of having a fund stray from what you'd expect it to invest in have become more apparent than ever. As a recent SmartMoney article noted, some mutual funds have taken a hit from owning Chinese small caps -- including a few funds that investors may not have realized would own international stocks at all.
For instance, the Rochdale Mid/Small Growth Fund (RIMQX) has a stated purpose of seeking capital appreciation by investing mostly in U.S. stocks. The prospectus mentions the U.S.-centered S&P 1000 Index as the relevant benchmark for measuring the appropriate size for portfolio holdings. Moreover, although it lists a number of investment risks, including the particular risks of small caps and growth-oriented stocks, it never points out the risks of foreign investing, such as currency fluctuation or the difficulty in getting information about certain types of small-cap foreign investments.
But technically, Rochdale only imposes a requirement that at least 80% of its assets go toward U.S. small and mid caps. Although many might interpret that as saying that the fund can keep cash on hand, the fund instead invested in overseas stocks -- including small Chinese companies Yongye International (Nasdaq: YONG ) , Puda Coal (AMEX: PUDA ) , and Zhongpin (Nasdaq: HOGS ) . Nor is the Rochdale fund the only one that has some foreign exposure. Jacob Small-Cap Growth (JSCGX) includes Home Inns (Nasdaq: HMIN ) among its investments.
None of this would have been a problem were it not for the behavior of certain Chinese small caps lately. For instance, several mutual funds turn out to have owned shares of Longtop Financial (NYSE: LFT ) , including some that are U.S.-centered.
In general, institutions have fled scandal-plagued Chinese small-cap companies. China-Biotics (Nasdaq: CHBT ) , for instance, reports just 18% of shares held by institutions. But with some, institutional investors still hold substantial stakes; for Advanced Battery Technologies (Nasdaq: ABAT ) , the corresponding figure is 40%.
Know what you own
The answer to the problem of mutual fund shenanigans is simple: Understand the fund you invest in, and know what latitude its managers have to go beyond the fund's regular investment objective. Although mutual funds don't have to disclose their holdings all that often, most do on a quarterly basis -- so take a quick look and see what changes your fund managers have made. That way, if you see something you don't expect, you can make a decision about it before one of your holdings blows up in your face.
Meanwhile, if you can't get comfort on what your funds own, remember that you have alternatives. Exchange-traded funds disclose their holdings every day, and they tend to follow much more rigid indexing strategies that leave little discretion in choosing stocks. For many, cheap ETFs are the best way to avoid mutual fund surprises.
If you're tired of mutual fund surprises, check out some ETFs that will open their portfolios to the light. The Motley Fool's special free report on ETFs will give you three great funds that won't hurt your wallet but will boost your returns.