The criteria that mutual fund managers use to select their assets vary widely according to the individual manager. So when choosing a fund, you should look closely at the manager's investment style to make sure it fits your risk-reward profile.
"Investment style is incredibly important because of the way that investing works," says Chris Geczy, director of The Wharton School's wealth management program at the University of Pennsylvania.
"Both risk and return are connected to style. According to current practice portfolio theory, you can optimize a blend of styles for diversification, balancing reward and risk."
Here's a look at a half-dozen common investment strategies among fund managers.
Top-down or bottom-up investing
Top-down investing strategies involve choosing assets based on a big theme. For example, if a fund manager anticipates that the economy will grow sharply, he or she might buy stocks across the board. Or the manager might just buy stocks in particular economic sectors, such as industrial and high technology, which tend to outperform when the economy is strong.If the manager expects the economy to slump, it may spur him or her to sell stocks or purchase shares in defensive industries such as health care and consumer staples.
Bottom-up managers choose stocks based on the strength of an individual company, regardless of what's happening in the economy as a whole or the sector in which that company lies.
"The great advantage of top-down is that you're looking at the forest rather than the trees," says Mick Heyman, an independent financial adviser in San Diego. That makes screening for stocks or other investments easier.
And, "When you're right, you're really right," says Tim Ghriskey, chief investment officer at Solaris Asset Management in Bedford Hills, N.Y.
Of course, managers might be wrong on their big idea. And even if they're right, that doesn't guarantee they'll choose the right investments.
"A good example is gold," says James Holtzman, a shareholder at Legend Financial Advisors in Pittsburgh. "That would make sense for a top-down investor. But what if you're looking at a gold mining stock and the company is being run into the ground? The particular stock could be ready to collapse, even though investing in gold makes sense."
A bottom-up manager benefits from thorough research on an individual company, but a market plunge often pulls even the strongest investments down.
Fundamental or technical analysis
Fundamental analysis involves evaluating all the factors that affect an investment's performance. For a stock, it would mean looking at all of the company's financial information, and it may also entail meeting with company executives, employees, suppliers, customers and competitors. "You want to analyze management, really understand what's driving the company and where growth is coming from," Heyman says.