Mutual funds: Stock picks vary by type of analysis

February 2, 2013

Mutual funds can be a fairly stable investment. Find out how mutual fund managers pick stocks.

Q How do mutual fund managers decide which stocks to buy for their fund?

A While investors themselves may use some pretty unconventional methods to identify attractive stocks, the experts toe a more scientific line. There are three main approaches that active portfolio managers-as opposed to passive or index fund managers-use to pick individual stocks: fundamental analysis, quantitative analysis, and mathematical analysis. The key for the individual investor attempting to beat the return of a certain market index is to gain a general understanding of the different approaches used in the stock selection process.
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 to be 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 for 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.
Quantitative analysis is similar to fundamental analysis from the standpoint that both are attempting to find undervalued stocks. The difference is that quantitative analysts and researchers measure and make predictions utilizing data relating to company performance, analyst estimates, earnings ratios, and economic events in an effort to select the most attractive stocks. They take their research even further by frequently using what is known in the industry as the “black box” method that measures such probabilities as how a stock might perform during a particular interest rate climate or an estimated economic growth rate environment.
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, since 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 fundamental and quantitative management, which generally rely on portfolio managers to determine when to sell a stock, mathematical models have predetermined risk levels to 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 small, medium, large companies), bonds (domestic and international), and cash equivalents, others continually try to “beat the market.

” For those investors, the actively managed mutual fund industry, in general, makes this task relatively 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 w

ell-known methods in selecting stocks to include in their fund.
Understanding how a mutual fund portfolio manager chooses stocks within the fund is yet another tool for those investors striving to outperform a specific market index. While some may outperform in certain short-term market periods, the difficulty lies in their ability to deliver long-term, above-market returns on a consistent basis.

Q We are considering a move out of state to save taxes. Does that make sense?

A The starting point is to look at the state’s income tax rate relative to your current state’s rate. Seven states-Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming-have no state income tax. Two states-New Hampshire and Tennessee-tax only dividends and interest income that exceeds certain limits. On the other end of the tax spectrum, the five states with the highest marginal tax rates are Hawaii, Oregon, California, New Jersey, and Vermont. There are also other tax-based considerations, such as the state’s allowance for itemized deductions, personal exemption amounts, and how Social Security and retirement income are taxed.
If a move is being contemplated, be sure to meet with your accountant to weigh all the various tax implications prior to making a decision.UT


Joel M. Blau, CFP,
Ronald J. Paprocki, JD, CFP, CHBC

Joel M. Blau, CFP,  is president and Ronald J. Paprocki, JD, CFP, CHBC, is chief executive officer of MEDIQUS Asset Advisors, Inc. in Chicago. They can be reached at 800-883-8555 or or