Investing in Growth Mutual Funds

Growth mutual funds, as the name implies, invest in “growth stocks”. A growth stock is typically a younger, burgeoning company with earnings or revenue that’s growing faster than the average firm. Instead of paying out dividends to investors, growth firms usually choose to reinvest their earnings to support rapidly expanding operations or develop new products and services.

As opposed to more mature dividend-paying stocks, which aim to provide regular income to stockholders, gains from growth stocks come from an increase in the stock price over time. So the objective of the fund manager is to pick stocks with the potential for continued earnings and sales growth which will hopefully drive the stock price ever higher.

The reason to own a growth mutual fund is to capitalize on bullish momentum across most of the stocks in the fund’s portfolio. Some stocks within the growth fund may exhibit bearish tendencies at any given time, but you want the overall basket of stocks to demonstrate an upward trend.

Many growth funds concentrate on companies with a similar market capitalization, such as small-cap, mid-cap or large-cap firms. Others will hold stocks from firms of varying size. You may be bullish on a particular sector or industry because it is in favor with investors or it is undergoing widespread growth. Be certain to choose a growth mutual fund that best matches your individual requirements. Regardless of intention, the market can always behave counter to your analysis. Owning a growth fund can result in losses if the mutual fund declines in value. The steeper the decline, the greater the loss will be.

Instant diversification

Because growth mutual funds are usually made up of many different stocks, your investment, in essence, is instantly diversified. In general, price movement for a growth mutual fund may be less volatile than an individual stock. But diversification doesn’t mean safety. Look at a chart for any given index and you will invariably see certain periods of significant decline. Don’t buy a growth mutual fund during uncertain times and naively expect safe haven from the next financial storm. Diversification doesn’t guarantee a profit or ensure against a loss.

Active management

Growth mutual funds are actively managed, meaning the mix of stocks held by the fund are continually re-evaluated and possibly changed by the fund manager. As a result, costs are incurred while researching companies or trading in or out of stocks when the fund manager adjusts the holdings of the growth fund’s portfolio. As a result, the expense ratio (ongoing fees associated with owning a mutual fund) tends to be higher for growth funds than for passively managed investments like index mutual funds. This is because passively managed funds hold mostly the same mix of stocks over the long-term.

Lower maintenance over the long-term

Some investors choose mutual funds as a long-term, lower-maintenance trade than choosing individual stocks. If you don’t have the time or inclination for picking growth stocks, then buying a growth mutual fund may be a strategy to consider. In that case it may be worth paying the higher fees associated with actively managed mutual funds in exchange for the fund manager’s expertise. Keep in mind however, higher fees are not an indicator of better performance. You’ll need to weather the storms of increased volatility of a more actively managed investment. Bottom line: Don’t put your money in a mutual fund, go to a faraway island and forget about it. You need to be as vigilant as you can and keep an eye on your investments.

Dollar-cost averaging or lump-sum investing?

There are two common methods for investing in mutual funds. Lump-sum investing is when you plunk down a boat-load of cash all at once, or over a short period of time, such as a few weeks. At the other end of the spectrum, some investors choose to employ dollar-cost averaging. This approach entails investing a fixed amount of money according to a pre-set schedule over many years, such as monthly or quarterly, irrespective of how the mutual fund is performing. You can think of it as tiptoeing into the fund, as opposed to shooting off all your bullets at once.

In general, lump-sum investing is suitable for investors who feel they can time their investments well, buying in when the mutual fund is low in price. If correct, the lump-sum investment is likely to outperform similar investments made with a dollar-cost averaging strategy. If instead the lump-sum investment is ill-timed and coincides with a peak followed by a decline, the investment will likely underperform. Ideally speaking, lump-sum investors like their investments to increase at the beginning of the time horizon, and remain at least relatively stable towards the end of the investing period.

Dollar-cost averaging is preferred among investors who choose to invest periodically with smaller amounts. That way, you avoid buying in all at once when the mutual fund is at an anomalous peak, but you’ll also miss investing a lump sum at the lows. If it declines, you continue buying in. Because you buy more shares as the market declines and fewer shares as the market rises, you lower your average cost per share. Dollar-cost averaging fares better than lump-sum investing if the investment increases in value more towards the end of the investor’s time horizon.

Although we all want the value of our investments to increase over time, lump-sum investors have more of an edge if their timing is well-chosen. However, many investors may not have adequate capital resources for lump-sum investing and prefer to invest over time using dollar-cost averaging.

Please note: If you use a growth mutual fund in a market timing strategy, this may involve frequent trading, higher transaction costs, and the possibility of increased capital gains that will generally be taxable to you as ordinary income. Market timing is an inexact science and a complex investment strategy.

Time Horizon

Investing in growth mutual funds tends to be a longer-term play (one year or preferably more). The goal here is relatively consistent growth over time, rather than spectacular short-term gains. Remember to check which fees for different share classes will apply given your time horizon.

When to Get In

Having time on your side is advantageous when investing, so in general getting in sooner rather than later is preferable. However there are some timing considerations for your initial investment. If you are using dollar-cost averaging, you would adhere to your periodic investment schedule.

Watch the overall market trends

When you begin your investment in a growth mutual fund, make sure you’re not trying to catch a falling knife. Don’t enter the order when the overall trend is still heading down and try to precisely nail the bottom. It’s best to have some sense that the bulls are loose before you buy a growth mutual fund. Ideally, you want to see a bullish trend underway or to dive in after a bear market or shorter-term correction has bottomed out and then has resumed upwards.

When to Get Out

When you buy a growth mutual fund, it’s usually a long-term investment. Typically, if you’ve reached your goals, if your investing strategy has fundamentally changed, or if you need the money for some long-term objective, you start to exit your position, either in phases, or all at once.

Ideally, you would like to get out during a bull market well before you really need the cash for its intended purpose. That way you can pick your spot and try to sell during economic high times. If you wait until the last second and you have mounting expenses you need to meet (such as when a child goes to college, you want to buy a home, or you’re about to retire) you could find yourself stuck in the midst of a recession, be forced to sell anyway, and be left with much less than estimated when you first initiated the investment.

Since timing the market is an inexact science and is easier said than done, it may be wise to lighten up your holdings in growth mutual funds over time as you get closer to the end of your time horizon. Dollar-cost averaging to exit is one method you could employ to do this. In other words, withdrawing a predetermined amount on a pre-set schedule as the date for completion of a financial goal approaches. Another method is based on asset allocation and is discussed in our series on bonds.

Bear in mind that you need to have realistic objectives. Investing in growth mutual funds may be a more aggressive approach than index funds, but you shouldn’t expect your money to double over the course of a few months. You are also unlikely to hit the high point of a rally. By trying to milk a trade for every last percentage point, time and again investors have given back too much of their gains. Don’t be one of them.

If your investment is a loser from the start, you have two options: hold tight and weather the storm, or stick to a predefined rule of acceptable losses and head for the exits. Although transaction costs are often minimal when compared to the total investment amount, they are not negligible. So be sure you understand how fees are incurred if you exit after a relatively short holding period. But don’t let them sway you to stay with a non-performing investment that is no longer in your comfort zone.

Investment Management

Because you have a professional fund manager managing your trades, this is a relatively low-maintenance strategy. You buy in through either a lump-sum or periodic investments, after reading the fund’s prospectus.

Since you’re investing in an actively managed fund, there are likely to be modifications in how the fund is managed over time. So review a current prospectus periodically to be aware of any noteworthy changes.

Any time you make an investment, you expect the results to be outstanding. As you know, that is not always the case. Even the most carefully chosen mutual fund can go south in a hurry, resulting in losses.

Remain aware of trends in the broader markets. If bearish times hit, growth mutual funds will tend to decline at a rate faster than the market at large. So be prepared for this increased volatility. If it’s more than you can stomach, evaluate your portfolio and make changes to fit with your overall financial picture.

It’s also a good idea to keep an eye on your fund’s performance relative to its peers. Of course past performance is not an indication of future results, but if your fund is underperforming, you may want to consider switching to one that’s been better managed on a historical basis. If you are scaling in or scaling out of this strategy with dollar-cost averaging, you need to be sure to stick to your investment schedule over the life of the investment. Deviate from your schedule only if there is a significant shift in your personal investment plan or financial picture.

Volatility Factor

Since some stocks can go up while others go down, a growth mutual fund’s price movement will tend to be less volatile than the average growth stock. Oftentimes growth funds hold investments in innovative, less-established companies frequently within new areas of the economy. So it’s important to recognize that growth mutual funds tend to be more volatile than other types of mutual funds, such as index funds, value funds or income funds. If you invest in a narrowly-focused growth fund which concentrates on a particular sector or industry, you are likely to experience even more volatility. While growth funds tend to perform better than other funds during bull markets, during bear markets they have the potential to decline much more rapidly than their more conservatively managed counterparts. So you should be comfortable with the increased risk and confident in a continuing bull market to run this strategy. Although it is possible that a growth mutual fund may have lesser volatility than another investment, it does not mean it is low risk.

Ally Invest Margin Requirements

After the trade is paid for, no additional margin is required. You cannot trade mutual funds on margin.

Tax Ramifications

There are several ways your mutual fund investment can impact your tax liability. Read our Mutual Funds Tax Guide and consult your tax advisor for the low-down on this important topic.

Tips for Mutual Fund Investors

Be wary of earnings season and news events. Just prior to and during quarterly “earnings seasons,” when corporate earnings are announced—January, April, July and October—major indices tend to be more volatile than usual. Furthermore, other types of announcements can cause increasing volatility as well.

If earnings are coming up, the Fed is about to hold a greatly anticipated meeting regarding interest rates, or you're generally unsettled by increased volatility, you may want to hold off with making that initial investment and see what happens. On the other hand, if you have good reason to think positive news will boost your upcoming investment, by all means get in before the next big rally gets underway. Either way, be sure you are making an active decision to stay in or out during a time of increased news releases because prices are likely to experience greater volatility during these times.