How stocks are chosen for funds: Three tactics

October 1, 2006

Is there really much of a difference in how mutual fund managers determine which stocks to include in their portfolios?

Q. Is there really much of a difference in how mutual fund managers determine which stocks to include in their portfolios?

Fundamental analysis examines the relationship between a company's intrinsic value and its stock price. The intrinsic value quantifies what the company would be worth if it were sold tomorrow, and then determines its corresponding stock price. Research activities surrounding fundamental analysis include examining factors such as dividends, cash flow, outstanding debt, and earnings growth rates. Fundamental research is focused on finding the companies whose current stock price doesn't fully reflect the potential or growth opportunities of that specific company. The goal of the researchers is to find stocks of companies that, based on their fundamental analysis, appear to be undervalued by the market.

In contrast to fundamental analysis, quantitative analysis removes the emotion and any personal biases toward a company from the stock-picking process. This may, however, also prove to be a disadvantage because it often fails to take into account the human skills utilized primarily in fundamental types of analysis.

Mathematical analysis essentially eliminates the need to use portfolio managers or research analysts to select stocks by relying on a carefully constructed mathematical formula to seek performance that exceeds a market index or other specific benchmark. One of the potential advantages of mathematically based portfolio management is the opportunity for disciplined risk management. Unlike the fundamental and quantitative management approaches, which generally rely on portfolio managers to determine when to sell a stock, mathematical models have predetermined risk levels that ensure that market volatility is effectively managed by knowing exactly when a stock will be sold, regardless of a gain or a loss.

As most investors know, diversification is a key determinant of portfolio returns and potential overall risk reduction. While most investors think of diversification as investing in various asset classes such as stocks (domestic and international and small, medium, and large, companies), bonds (domestic and international), and cash equivalents, it may also make sense to diversify the methods used to select the specific securities.

Mutual fund companies, in general, make this task relatively easy and straightforward by promoting their stock selection process within their own sales and marketing literature. Fund managers may even use a combination of these three approaches or other less well-known methods in selecting stocks to include in their fund.

Q. My father, age 79, is considering buying a tax-deferred annuity and naming me as his beneficiary. He doesn't need any additional income and doesn't want to pay any income taxes while he is alive. My broker suggested as an alternative that he take that money and invest it in growth stocks so at the time of his death, I would receive a step-up in basis, which he said would be preferable from a tax standpoint to inheriting the annuity. Is this correct?