Chapter 7 Mutual Funds—Spreading the Risk

“If you risk nothing,you risk everything.”

Do I Need to Read This Chapter?

• Do I have a basic knowledge of mutual funds,but want to know more? • Is my portfolio properly diversified for my age and investment goals? • Do I understand the difference between load and no-load funds?

• How do mutual fund investments affect my taxes? • Have I been double-taxed on mutual funds without realizing it? • Am I aware of the best time of year to invest in mutual funds? • What information can I glean from the daily mutual fund listing in the newspapers?

How Do You Choose a Mutual Fund?

In order to choose a mutual fund that is best for you,consider these factors:

1. Past performance.It is more likely that a fund with a good performance record will repeat its good record than that a company with a poor performance will turn itself around.

2. Expenses.The less a fund takes out of your payments (management fees, commissions,etc.),the better off you will be since more money is being invested on your behalf. 3. Risk.Risk comes in two forms.The first type of risk is the possibility that rising interest rates will bring down the value of the bond.As you are aware, higher interest rates have a direct reverse effect on fixed-rate securities such as bonds.Thus,short-term bond funds are less risky than intermediate- or long-term bond funds.The second area of risk involves credit risk—the risk that the issuer of the bonds will not pay.Funds that invest in government securities are therefore considered very safe. 4. Management.Good management is,of course,essential for profit.Look at the portfolio turnover of your funds (turnover rate is explored further at the end of the chapter).This will tell you how often a manager sells the instruments in the fund and buys new ones.Remember that the more the selling and buying,the more commissions that have to be paid.Also to be considered with respect to high portfolio turnover is that the manager may be buying instruments,not on their merits,but rather in anticipation of short swings in the market.This is a situation that is risky and may not work in the long run. 5. Your goals.Did you buy the fund for your child’s education? For retirement? The goal you set up will determine the type of mutual fund you will want to purchase.Thus a time horizon is very important for your financial decision making,as you may need the money in 8 years (short term) for your child’s education but in 25 years (long term) for your retirement.For a long period,up-front load is not as important as a large annual maintenance charge.

One of the great things about mutual funds is the diversification opportunities they offer. And the key to diversification, in turn, is to assess your investment needs by age and family situation. As your needs change over time, so do the types of funds that are best for you: 1.When you are young, growth funds are usually best. Your financial needs are often modest, and you can afford to take a higher risk in exchange for maximum growth potential.

Continued

2.As you and your family grow older, diversification among various types of funds is desirable. Both stock funds and bond funds belong in your portfolio in middle age. For maximum diversity, try a five-prong approach: domestic and international stock funds, domestic and international bond funds, and money market funds. In this way you enjoy the potential benefits of three types of financial instruments—stocks, bonds, and cash—in both domestic (United States) and global markets. 3.When you are nearing retirement age, current income becomes paramount.

Bond funds are probably your best choice at this point. 4.Investors of any age who find themselves in a high tax bracket should consider one of the tax-free funds that invest in municipal bonds or other tax-free investment. This type of investment can be free of federal, state, and/or local taxes.

What Are the Costs of Owning a Mutual Fund?

Depending on how they are purchased,mutual funds can be classified as either load or no-load funds.Let’s look at the difference.

There are people who use self-service gas pumps,and there are those who prefer service;the same goes for mutual funds.If you are not certain about your current income needs,your risk involvement,or the price fluctuations of market investments,or if you simply don’t have the time to be “involved,”then the load fund is for you.

Shares in a load fund are sold through a stockbroker,who charges a sales commission that is a percentage of the purchase price (this is the front load). This commission—about three-quarters of which is kept by your individual broker while the balance goes to the sponsor of the fund—is deducted from your account before any investment is made.If you deposit $10,000 in a mutual fund that charges a load of 3 percent,only $9,700 will actually be invested in the fund.Depending on the performance of the fund,it could take several months or more for you to recoup the $300 commission.However,if you plan to remain in the fund for a number of years,the initial sales charge will become relatively unimportant over time.An annual management fee of about 1⁄2 percent of your investment is usually also charged.

What does your commission fee pay for? Primarily you are paying for the advice and services provided by your broker.As an investment professional, he or she should help you select the best fund or funds for your purposes and should keep you continually informed about when you should move in or out of a particular instrument.If your broker doesn’t provide this kind of expert advice,consider changing brokers;after all,you’re paying for it.

No-load funds are usually sold through the mail by means of advertisements in newspapers or magazines.No sales advice or investment services are offered with a no-load fund because no sales broker is involved,as shares are bought directly from the funds and not a broker;therefore,no up-front commission must be paid.However,a service charge is levied each year;and in addition, you may have to pay an exit or redemption fee (back-end load) when you withdraw from the fund.

No-load funds are allowed to have these fees because of a little-known regulation.In 1980,the Securities and Exchange Commission (SEC) added rule 12b-1 to the Investment Company Act,permitting mutual funds to charge shareholders for the cost of getting more assets into the fund.In other words, a fund could charge the investor for advertising,sales literature,and brokers’ commissions on new fund sales.Fund managers felt that they were justified in charging these fees since,in the long run,fundholders would benefit as operating costs were spread over more assets.Thus expense ratios would go down, and all would benefit.What is considered an equitable expense ratio? A rule of thumb might be that no more than 1 percent annually for stocks and 3/4 percent annually for bonds should be charged.

In the past,funds could hide these 12b-1 costs by scattering them throughout the entire prospectus (a booklet containing information to help evaluate the investment being offered),thereby hiding the fund’s true costs.In 1989 the SEC enacted new rules that required funds to disclose all fees and expenses in one table near the front of the prospectus.This table must show all expenses (both direct and indirect) paid by the shareholders and must also disclose the cumulative expenses paid on a $100 investment (5 percent return assumed at the end of 1-,3-,5-,and 10-year periods).

Transaction Costs

All mutual funds have brokerage costs,which are costs incurred when stocks and bonds are bought and sold.These costs do not appear in any stated expense

ratio,and so they are not easily available for investors to compare one fund’s expense ratio with another’s.Yet the more trading taking place,the higher the cost to the investor.Many reasons are acceptable,to a point,on active trading or higher commissions.The speed of transaction execution is an example.But excessive brokerage commissions on trading can be a red flag.If there is too much activity in the fund,commissions will be abundant.If your fund’s entire portfolio changes over a year (100 percent),that is too much trading.

Also,it’s almost always better to invest in a mutual fund after the fund makes its distribution,which is usually between September and December. Here’s why:Funds buy and sell securities.When profits on trading exceed losses,the difference is passed along to the investor.This is known as a distribution,and you will owe tax on it.Thus,before buying any mutual fund during the last quarter of the year,ask when the next payout will be,and get an estimate of its per-share value.As a rule of thumb,if it is more than 5 percent of the net asset value (NAV),wait until after the payout to buy.

What Information Is Available?

Each newspaper that carries daily information about the value of mutual funds may list data in different ways.Figure 7.1 is a standard reading of mutual funds as listed in the financial section of your newspaper.

Figure 7.1 Sample Mutual Fund Listing

Name NAV BUY CHANGE

Fund p 12.60 13.18 Fund r 6.18 7.15 Fund t 18.01 18.02 Fund x 11.14 N.L.

Explanations NAV (bid): Net asset value per share (in dollars and cents). BUY (ask): Price paid by investors plus commissions. CHANGE: Change in NAV from yesterday. Symbols p: Fund imposes a 12b-1 charge. r: Fund imposes a back-end fee (redemption price). t: Used when both p and r are applied. x: The fund’s NAV has been reduced by a dividend payout. N.L.: Signifies no front- or back-end load. +.12 −.15 +.21 −.05

Let’s look at an example.Yields reported on the same funds may produce different amounts.The yield in an advertisement you read is called the SEC yield because it is based on a strict conservative formula devised by the SEC and can be the only rate used for advertising.The problem with this yield is that the figure suggests income you would earn if you were in the fund for a full year and the fund kept paying at its current rate,which may not always be the case.However,some publications may cite the 12-month average yield, which represents the entire fund’s income payout per share for the past year divided by the NAV.This method expresses what the fund actually paid to fundholders over the past 12 months.Thus,think of yields and NAV as opposite sides of a seesaw.The interest income is in the middle and stays the same as long as the fund’s holdings do not change.As the NAV goes up,the yield goes down.As the NAV goes down,the fund’s yield from that same amount of income goes up.

It’s easy to let your eyes glaze over when you study mutual fund literature. It’s also easy—too easy—to concentrate on the fund’s past performance,which cannot be guaranteed for the future.Here’s an alternative technique that the pros use:pay special attention to the “turnover rate”when evaluating a mutual fund.It speaks volumes about the fund’s management and philosophy.

The turnover rate refers to the dollar amount of stock the fund buys or sells in each year,calculated as a percentage of the average value of its stock holdings.A perfect 100 percent means that within a year,the management has turned over the entire value of its portfolio.That shows an extremely aggressive policy.A 25 percent turnover rate indicates a much more conservative, buy-and-hold concept.However,bear in mind that a high rate does not necessarily mean a bad policy or a low rate a good one;but in the long run,I would steer toward the lower turnover rate.Thus,turnover can yield information about very active fund managers (who are making profits for the fund or just churning the accounts) or inactive managers (who are steady in their investment policy or just sleeping at the helm of leadership).

And on the topic of information,I have noticed that when a person with money meets a person with experience,the person with the experience gets the money and the person with the money gets the experience.

It’s a Wrap

• Factors such as past performance,expenses,risk,management,and your own financial goals can help you make your mutual fund choices.

• Your age and lifestyle can help you build a portfolio suited to current income and future growth. • Load and no-load mutual funds are available. • It is generally advantageous to buy a mutual fund after its distribution, which is usually made in the last quarter of the year.

“Anger is only a letter short of danger.”

This page intentionally left blank