Make Sure Your Mutual Funds Are Diversified

Remember when China’s Shanghai stock market shed nine percent of its market cap on February 27, 2007, spawning a thunderous global stampede for the exits? Well, as unpleasant as it was, this particular rude awakening offered something for investors to learn, or re-learn, rather.

For the better part of last year, Canadians have been great fans of global and international mutual funds. Based on the Investment Funds Institute of Canada (IFIC), during February alone, Canadians dumped over CDN$3.2 billion into such funds. Apparently, investors are adopting diversification as a legitimate investment strategy.

However, when the grey Tuesday came along, judging by the velocity with which those same mutual fund buyers were selling off their holdings, I have a feeling they were not fully aware of certain risks associated with geographic diversification, such as political frictions, currency risks, micro and macroeconomic issues, etc.

In lieu of an explanation, not an excuse, forecasting performances of overseas markets is a tricky and, for the most part, an ungrateful job. To offset inherent risks, global and international mutual funds’ managers practice a triple whammy of diversification — investing across different sectors, regions, and asset classes. Individual investors can benefit from that same methodology, only their predicament is not knowing for sure if their global funds actually provide such broad diversification.

One of the first clues could be the performance over the past ten years. If your global mutual fund had been properly diversified, that performance should be steady, with respectable returns and risk kept at adequate levels. Also, check out performances of the fund’s top ten holdings. For example, investing in the same sector in two different countries is not proper diversification.

Another issue is foreign currency. This is not something that investors usually pay too much attention to. However, let’s say that your precious metals mutual fund is heavily invested in North American mining companies with mineral properties in South Africa. And, let’s say that those producers are reporting their revenues in the U.S. dollars and their expenses in the South African rand. In quite a few past quarters, the rand has been surging relative to the Greenback. Now, imagine the size of the foreign currency expense account on the company’s financial statements! That’s gotta hurt!

Granted, emerging markets are still a very, very viable solution, no mistake about that. Only, before you bet your shirt on infamously volatile regions, make sure you’ve done your homework, and make sure a modicum of a safety net exists, such as stop-loss limits and smaller percentages awarded to more speculative portions of your portfolios.