MINI-COURSE SERIES
MUTUAL FUNDS Part III
Copyright Š 2012 by Institute of Business & Finance. All rights reserved.
MUTUAL FUNDS
1
CLASS A, B AND C SHARES Commissions are commonly called “loads.” A number of publications question whether or not an investor should pay any kind of commission. These publications believe that anyone paying a commission is either foolish or ignorant. However, one must also ask what the investor receives in return. The periodicals that promote mutual funds are load publications—they charge a fee for their information. Yet, none of these services point out that the reader could go to the local library and get the same information free. If someone is willing to pay for advice, the question then becomes which is best for the investor, A, B or C shares? The answer depends on how the investor psychologically feels about commissions, the expected holding period, and the likelihood of finding a better investment opportunity while the mutual fund shares are owned. Some investors strongly dislike having to pay an upfront commission. For them, B or C shares are preferable because the commission is not seen and the added expenses are taken out over the course of several years. Other investors expect to hold shares for a number of years and an upfront commission may be the best value, depending upon the amount invested, assumed rate of growth, and the actual number of years owned. Still other investors prefer the flexibility of being able to exit a fund family at anytime and use the money elsewhere; for them, C shares make the most sense. As the table below shows, A or C shares result in higher returns if less than $100,000 is invested. Class A shares are the favored choice if $100,000 or more is invested. In all but two instances, B shares are the second best choice if less than $100,000 is invested.
Share Class That Produces The Highest Returns: Summary Annual return
$20,000
$50,000
$100,000
$250,000
8% (5 years)
C B A
C A B
A C B
A C B
8% (10 years)
A B C
A B C
A B C
A B C
12% (5 years)
C B A
C A B
A C B
A C B
12% (10 years)
A B C
A B C
A B C
A B C
PART III
IBF | MINI-COURSE SERIES
MUTUAL FUNDS
2
During 2006, the NASD imposed more than $40 million of fines on brokerage firms for improperly selling B and C mutual fund shares. During the early part of 2007, the SEC acknowledged that one of its key arguments no longer exists; the agency had assumed A shares were always better than B shares. The NASD commission now believes that cost alone is not the only decision in making investment recommendations. Most of the lawsuits against brokerage firms were based on one of three things: (1) failure to tell clients that A shares can be cheaper than B shares, (2) fraud, and/or (3) suitability. In a 2007 case dropped by the SEC, the agency acknowledged that even at the $250,000 breakpoint, B shares may not be more expensive for the client than A shares. One broker, now retired, spent $400,000 in legal fees and lost $1.6 million in deferred compensation in 2001 when his broker-dealer fired him over the sale of B shares. In late 2005, a NYSE arbitration panel ordered the firm to pay the terminated broker all deferred compensation plus legal fees.
REVIEWING PERFORMANCE What all this means is that a number of different asset categories have performed quite well and that investors have a choice, depending upon their objectives, time horizon, tax bracket, level of risk and ability to make a lump-sum or periodic payments. The investor must decide which of the following investment vehicles to use: (1) individual securities, (2) exchange-traded funds (ETFs), (3) exchange-traded notes (ETNs), (4) enhanced appreciation notes (EANs), (5) closed-end funds (CEFs), (6) real estate investment trusts (REITs), (7) unit investment trusts (UITs), (8) annuities and/or (9) open-end mutual funds (the emphasis of this course). The CFS program covers all of the investment vehicles described above except individual securities and annuities. Course materials provide insight into how multiple investment vehicles can be used to construct a unique and effective series of diversified portfolios. Once your clients understand the workings of mutual funds, it is doubtful they will want to use anything else for the bulk of their portfolio. Mutual funds are truly the best investment vehicle ever created. The types of assets open-end mutual funds invest in provide the flexibility, returns and risk level that your clients are looking for.
PART III
IBF | MINI-COURSE SERIES
MUTUAL FUNDS
3
MUTUAL FUND CATEGORY RETURNS Equity Mutual Fund Return Figures for 2011 Category
Return
Category
Return
Large Cap Growth
-2.5%
Foreign Large Growth
-12.4%
Large Cap Value
-0.7%
Foreign Large Value
-12.7%
Mid Cap Growth
-4.0%
Emerging Markets
-19.9%
Mid Cap Value
-3.9%
Precious Metals
-20.9%
Small Cap Growth
-3.6%
Health / Biotech
7.7%
Small Cap Value
-4.4%
Natural Resources
European Region
-15.0%
Real Estate
7.4%
Pacific Region
-20.6%
Technology
-7.6%
Latin America
-22.9%
Utilities
10.5%
Global
-8.0%
Foreign Small Growth
-14.7%
Foreign
-13.9%
Foreign Small Value
-16.3%
-14.1%
Equity Mutual Fund Return Figures for 2010 Category
Return
Category
Return
Large Cap Growth
15.5%
Foreign Large Growth
14.7%
Large Cap Value
13.7%
Foreign Large Value
Mid Cap Growth
24.6%
Emerging Markets
19.4%
Mid Cap Value
22.0%
Precious Metals
42.0%
Small Cap Growth
27.0%
Health / Biotech
8.9%
Small Cap Value
26.1%
Natural Resources
18.6%
European Region
9.9%
Real Estate
27.1%
Pacific Region
19.0%
Technology
20.1%
Latin America
18.7%
Utilities
Global
13.8%
Foreign Small Growth
23.0%
Foreign
10.3%
Foreign Small Value
20.9%
7.5%
7.9%
PART III
IBF | MINI-COURSE SERIES
MUTUAL FUNDS
4
Equity Mutual Fund Return Figures for 2009 Category
Return
Category
Return
Large Cap Growth
35.0%
International
32.7%
Large Cap Value
23.1%
Emerging Markets
75.7%
Mid Cap Growth
40.4%
Precious Metals
51.1%
Mid Cap Value
37.3%
Health/Biotech
22.5%
Small Cap Growth
36.2%
Natural Resources
40.5%
Small Cap Value
32.6%
Real Estate
30.3%
Equity Income
22.9%
Technology
53.8%
European Region
36.6%
Utilities
16.4%
Pacific Region
51.3%
U.S. Stock Fund
32.0%
Latin America
113.1%
S&P 500 Funds
25.9%
Global
33.9%
Balanced
23.4%
Equity Mutual Fund Return Figures for 2008 Category
Return
Category
Return
Large Cap Growth
-40.7%
International
-44.2%
Large Cap Value
-37.4%
Emerging Markets
-55.5%
Mid Cap Growth
-44.5%
Precious Metals
-28.2%
Mid Cap Value
-38.3%
Health/Biotech
-23.0%
Small Cap Growth
-42.1%
Natural Resources
-47.8%
Small Cap Value
-33.5%
Real Estate
-39.9%
Equity Income
-33.8%
Technology
-44.7%
European Region
-47.0%
Utilities
-33.5%
Pacific Region
-45.9%
U.S. Stock Fund
-38.7%
Latin America
-57.3%
S&P 500 Funds
-37.3%
Global
-41.3%
Balanced
-26.9%
PART III
IBF | MINI-COURSE SERIES
MUTUAL FUNDS
5
From 1972-2010, the S&P and 5-year government bonds never suffered losses the same calendar year; the worst loss for the S&P 500 was 2008 (-37%), while the worst loss for 5-year bonds was 1994 (-5%). Over the same period, the S&P 500 experienced negative returns 9 times (23% of the time); 20-year government bonds had negative returns 10 times (26% of the time). Yet, during these 39 years, both assets had a negative return the same year just two times (1973 and 1977).
Odds of S&P 500 Outperforming Long-Term Gov’t Bonds [1961-2010] Holding Period
Stocks > Bonds
1 year
> 60%
3 years
> 70%
5 years
> 75%
10 years
> 90%
20 years
> 99%
Fixed-Income Mutual Fund Return Figures for 2011 Category
Return
Category
Return
Long-Term Government
32.7%
Municipal High-Yield
10.1%
Med.-Term Government
6.7%
Emerging Market Debt
1.8%
Short-Term Government
2.1%
High-Yield Corporate
2.8%
Long-Term Municipal
10.2%
Inflation-Protected Bonds
11.0%
Med.-Term Municipal
8.8%
World Bond
3.5%
Short-Term Municipal
3.5%
Long-Term Corporate
11.6%
PART III
IBF | MINI-COURSE SERIES
MUTUAL FUNDS
6
Fixed-Income Mutual Fund Return Figures for 2010 Category
Return
Category
Return
Long-Term Government
11.2%
Municipal High-Yield
3.7%
Med.-Term Government
5.8%
Emerging Market Debt
12.4%
Short-Term Government
3.0%
High-Yield Corporate
14.2%
Long-Term Municipal
1.6%
Inflation-Protected Bonds
5.9%
Med.-Term Municipal
2.2%
World Bond
6.3%
Short-Term Municipal
1.6%
Average Taxable Bond
8.1%
Fixed-Income Mutual Fund Return Figures for 2009 Category
Return Category
Return
Long-Term Government
-0.1%
Municipal High-Yield
30.8%
Med.-Term Government
7.8%
Insured Municipal
14.0%
Short-Term Government
3.7%
High-Yield Corporate
46.4%
Long-Term Municipal
16.9%
Mortgage
8.7%
Med.-Term Municipal
9.9%
World Bond
18.8%
Short-Term Municipal
6.6%
Average Taxable Bond
18.3%
Fixed-Income Mutual Fund Return Figures for 2008 Category
Return Category
Return
Long-Term Government
9.3%
Municipal High-Yield
- 25.1%
Med.-Term Government
-0.1%
Insured Municipal
-6.2%
Short-Term Government
4.1%
High-Yield Corporate
-26.2%
Long-Term Municipal
-9.1%
Mortgage
1.3%
Med.-Term Municipal
-1.3%
World Bond
-6.5%
Short-Term Municipal
0.0%
Average Taxable Bond
-7.7%
PART III
IBF | MINI-COURSE SERIES
MUTUAL FUNDS
7
DOMESTIC INDEX RETURNS 2010 Bonds, Bank CDs, Metals and Real Estate Barclays Indexes
Return
Bank Instruments
Return
Long-Term Treasury
9.4%
1-Year CD
0.6%
U.S. Credit AA-rated
7.1%
30-Month CD
1.0%
Municipal Bond
2.4%
Money Market Deposit
0.2%
Med-Term Treasury
5.3%
Metals (futures contracts)
Mortgage-Backed
5.5%
Platinum
19.3%
Money Market Fund
0.04%
Gold
28.7%
Silver
81.8%
Rare Coins
10.3%
Residential Real Estate OFHEO repeat-sales
-3.2%
2009 Bonds, Bank CDs, Metals and Real Estate Barclays Indexes
Return
Long-Term Treasury
-13.0%
U.S. Credit AA-rated
Bank Instruments
Return
1-Year CD
1.2%
7.6%
30-Month CD
1.4%
Municipal Bond
12.9%
Money Market Deposit
0.4%
Med-Term Treasury
-1.4%
Metals (futures contracts)
Mortgage-Backed
5.7%
Platinum
54.0%
Money Market Fund
0.2%
Gold
22.9%
Silver
47.6%
Rare Coins
-7.9%
Residential Real Estate OFHEO repeat-sales
-4.0%
2008 Bonds, Bank CDs, Metals and Real Estate Barclays Indexes
Return
Bank Instruments
Return
Long-Term Treasury
24.0%
1-Year CD
2.4%
U.S. Credit AA-rated
2.7%
30-Month CD
2.5%
Municipal Bond
-2.5%
Money Market Deposit
0.7%
Med-Term Treasury
11.3%
Metals (futures contracts)
Mortgage-Backed
8.3%
Platinum
Money Market Fund
2.0%
Gold
3.9%
Silver
-25.4%
Residential Real Estate OFHEO repeat-sales
~ -6.0%
Rare Coins
-38.2%
8.8%
PART III
IBF | MINI-COURSE SERIES
MUTUAL FUNDS
8
HEDGE FUNDS Hedge funds are loosely regulated pools of capital that invest in stocks, currencies, bonds, and/or commodities. Hedge funds are similar to mutual funds but with fewer rules, less government oversight, and much greater investment flexibility. Hedge funds are usually either limited partnerships or offshore corporations. These funds can take both long and short positions, use leverage and derivatives, and invest in many markets at the same time. Minimum initial investments typically range from $250,000 to $10 million. Frequently, these funds have a one-year lock-up for first-time investors. The median fee structure, according to TASS (which collects data on hedge fund returns), is a 1.5% management fee plus a 20% incentive fee. Over the last 10 years (ending 12-31-2005), this came out to an average fee of about 3.8% annually. Hedge funds are not required to report returns, most of the results reported to data collectors are voluntary. The two main biases that pump up hedge fund returns are survivorship and backfill. When a hedge fund fails, the fund, along with its poor performance, is frequently removed from the index and data set. This leaves an artificially inflated index composed solely of surviving funds that have all had some level of success. And because hedge funds must report returns in order to join an index, they frequently tend to join only after a period of solid performance—what is referred to as “backfill.” Today, the SEC is looking into a number of potentially abusive hedge fund practices. One is secret agreements, known as “side letters,” that give certain investors privileged information about holdings or special redemption terms. These side letter agreements are not part of a hedge fund’s general offering memorandum; they can provide increased liquidity, lower management fees, greater portfolio transparency, and/or access to the fund’s prime brokers, lawyers, and accountants. Side letters give some investors preference over others without disclosing such information to all shareholders. It is estimated that roughly half of all hedge fund managers make separate deals with certain investors. The majority of side letters are with hedge funds that manage less than $1 billion. Hedge funds are also under scrutiny for improperly valuing holdings to hide losses or trump up returns (which increases management fees). SEC examiners believe that some hedge funds are invested heavily in exotic instruments that lack marketability. There is also the question of internal controls; a failure by some hedge funds to separate their business practices. For 2011, hedge funds lost an average of 5%.
PART III
IBF | MINI-COURSE SERIES
MUTUAL FUNDS
9
Portfolio valuation is a major concern of hedge fund observers. Many of these funds own thinly traded securities and complex derivatives whose values can be subjective. A number of past enforcement cases against hedge funds have involved valuation methods that mask or hide losses or artificially inflate returns. Some funds, claiming certain holdings are difficult to value, put 10-15% of their portfolios in so-called “side pockets,” which are sequestered from the overall package. A few funds have up to 25% of their holdings in side pockets—a warning sign. A study in the November/December 2005 issue of the Financial Analyst Journal found that average hedge fund returns lagged behind the S&P 500 (from 1996-2003); some performed so poorly they went out of business (600 in 2005—this works out to almost three per trading day). According to a report by Dresdner Kleinwort, hedge funds need to generate returns of 18-19% in order to deliver a 10% return to investors, once fees, incentives and trading costs are factored in. Hedge funds can improve returns through leverage. It is estimated that the $1.3 trillion invested (as of early 2010) in hedge funds borrows from $1.2 to $5.5 trillion at any given time.
THINGS TO DO Your Practice For clients who want to make a gift to a newborn grandchild, consider having them buy one share of Disney stock. This is one of the few stock certificates that is very colorful and includes a number of Disney characters—a perfect gift to frame next to a crib. The Next Installment Your next installment, Part IV, will cover four topics: after-tax returns, tax efficiency, systematic withdrawal plans and growth vs. value. You will receive Part IV in a week.
PART III
IBF | MINI-COURSE SERIES
MUTUAL FUNDS
10
Learn Are you ready to take your practice to the next level? Contact the Institute of Business & Finance (IBF) to learn about one of its five designations: o o o o o
Annuities – Certified Annuity Specialist® (CAS®) Mutual Funds – Certified Fund Specialist® (CFS®) Estate Planning – Certified Estate and Trust Specialist™ (CES™) Retirement Income – Certified Income Specialist™ (CIS™) Taxes – Certified Tax Specialist™ (CTS™)
IBF also offers the Master of Science in Financial Services (MSFS) graduate degree. For more information, phone (800) 848-2029 or e-mail adv.inv@icfs.com.
PART III
IBF | MINI-COURSE SERIES