 |
20 things you should know before you invest in a mutual fund
by Paul A. Merriman Publisher and Editor
All our investment recommendations involve mutual funds, and we think investors will get the most from their funds if they maintain a strictly disciplined approach to creating and managing a fund portfolio in order to accomplish some clearly defined goals.
We have two favored approaches. The first calls for using market timing, an approach that uses mechanical timing systems to try to be in the market when it is rising and to be in money-market funds when the market is declining. This can be done with either index funds or actively managed ones.
The second approach calls for buying and holding asset class or index funds carefully chosen to concentrate a portfolio in the types of assets most likely to provide superior return. However, about 80 percent of the new buy-and-hold money going into mutual funds winds up in actively managed funds. We think many investors short-change themselves by choosing funds on the basis of too little information. Sometimes they discover crucial information only after it is too late to be of value to them.
If you’re going to invest in actively managed mutual funds, the following list will help you do so in an educated manner. If you gather the information that’s listed here, you’ll be far, far ahead of most investors. And when you put it all together, you’ll have a pretty good idea of where a particular fund fits into the investing universe and what, if anything, makes it stand out from the crowd.
An essential preliminary topic is asset allocation, your choices among the various types of assets you can put in a portfolio. Far too important to be on any list, asset allocation is the most important decision, or set of decisions, that you as an investor will make. We have written extensively on this topic elsewhere, and we won’t do any more here than summarize a few key points.
For buy-and-hold investors, index funds are your best bet for accomplishing our recommended asset allocations. But in real life, we know most investors use actively managed funds. If you’re one of them, the following guidelines will help you make sure those funds do the most for you.
1. Know the fund’s stated objective and how the fund plans to achieve it. Every fund’s prospectus and marketing literature includes a written objective. This is an essential place to start. Regardless of everything else, there is an important difference between a fund that says it’s after maximum growth and one that says its objective is growth and income. However, the stated objective is not always very useful. Most funds state their objectives in very broad terms, such as "achieving a reasonable balance of growth and income for long-term investors." That may sound good, but it’s too vague to tell you much. It’s sort of like describing a political candidate as a good person.
To get some perspective on what type of fund you’re dealing with, look in the annual or semiannual mutual fund editions of financial magazines like Money, Business Week and Kiplinger’s Personal Finance. They group funds into broad groups, such as growth, aggressive growth, growth and income, etc.
More important is how the fund attempts to achieve its objective. Primarily, that means: What is in the portfolio? How are those assets managed? If you go through the following checklist of information, you’ll be able to answer those questions pretty well.
2. Know the fund’s "style" of investing as it is independently measured, not just as it is described in the fund's literature. Morningstar Inc. reports, available in most public libraries, include a graphic representation that shows where each fund’s portfolio falls on the scale of growth vs. value and on another scale of large-cap vs. small-cap stocks. If you’re buying a fund because it specializes in one style or another, for instance large-cap value stocks, check the Morningstar "style box" to see if the fund actually owns the kind of stocks you are looking for.
3. Know whether the fund fits – or doesn’t fit – into your overall plan. That’s primarily going to be a function of the fund’s investment style. If you base your search for funds on recent performance, the chances are good that most or all of the funds you investigate will start to look alike, because they’ll be investing in the same type of assets, for instance the large U.S. growth stocks that have been the top performers in recent years. That’s a trap that could leave you without the diversification you need.
The best approach is to start with an asset allocation plan and then look for funds that fit into it.
4. Know if the fund charges a front-end load. If you are savvy enough to read this, you should be savvy enough to avoid paying a sales charge (that’s what a load is). The load may not seem very expensive, but a charge of $475 on a $10,000 investment means that only $9,525 of your money goes to work for you (instead of your full $10,000 in a no-load fund). That difference is much larger than you probably think. If the fund appreciates at 12 percent, your account would be worth $342,420 after 30 years. But if you invested $10,000 in a no-load fund, the account would be worth $359,496. In effect, that $475 sales charge cost you $17,076.
It’s a rare case when a load fund doesn’t have a no-load equivalent. For examples, see the "Explode Loads" feature on our Web site, www.FundAdvice.com.
5. Know if the fund charges a back-end load. This too is a sales charge which the fund has tried to disguise by imposing it when shareholders sell instead of when they buy. A typical back-end load is calculated as a percentage of any withdrawal, with the percentage declining gradually to discourage short-term investments.
On the surface, it appears that the back-end load doesn’t affect you unless you sell your shares early. But in fact, a back-end load is almost always coupled with a 12b-1 marketing fee that you may not find in a true no-load fund. This fee can be even more burdensome over time than a front-end load.
The 12b-1 fee allows the mutual fund to take money from existing shareholders’ assets in order to pay for advertising, commissions and sales incentives to attract new shareholders. That fee does not benefit existing shareholders; on the contrary, it erodes the performance of the fund.
6. Know the fund’s expense ratio. It’s usually calculated as a percentage of assets on an annual basis, as in 1.2 percent. (This calculation includes any 12b-1 fees imposed by the fund.) If everything else about two funds equal, the one with the lower expense ratio is preferable. However, that holds true only among comparable funds. International funds will almost always have higher expenses than domestic funds; stock funds will have higher expenses than bond funds; bond funds will have higher expenses than money market funds. Index funds should have much lower expenses than actively managed funds.
7. Know the turnover ratio for the fund’s portfolio. This is a measure of how actively a fund manages its investments and how much buying and selling goes on. A ratio of 150 percent means that a fund with $80 million of assets sold $120 million worth of investments in 12 months. Turnover ratios span a very wide range, from the single digits in some index funds to ratios over 500 percent for bond funds and aggressive growth funds.
A high or low turnover ratio isn’t good or bad in itself. Some funds’ styles call for frequent selling, others for very low activity. But when other things are equal, a low turnover ratio means lower expenses for trading and lower taxes for shareholders.
8. Unless you are investing in a tax-deferred or tax-free account, know what percent of a fund’s assets represent unrealized gains. This figure could be a time bomb waiting to blow up on shareholders’ tax returns.
When you buy into a mutual fund portfolio, you may be starting fresh, but the fund is not. You are buying into that fund’s history, from a tax standpoint, and the consequences can be startling.
Unrealized gains are paper profits on assets in a portfolio that are worth more than the fund paid for them. These gains don’t have any impact on shareholders until the fund sells the assets. Once that sale occurs, the fund must distribute the profit to shareholders and report the distribution to the Internal Revenue Service.
Here’s an extreme example: Say you own shares in a technology fund that once bought a few thousand shares of Microsoft Corp. a few weeks after the company went public in 1986. The fund has hung onto those shares since then, and Microsoft stock now makes up 40 percent of its portfolio. Almost all that 40 percent is pure profit, based on the original purchase price, so it’s possible that 38 percent of the fund’s portfolio consisted of an unrealized gain.
If the fund ever sold all that stock, it would have to distribute that 38 percent to shareholders. That would mean a taxable capital gain distribution for every shareholder, even those who automatically reinvested the distribution in more shares and thus never saw the money.
There’s another scenario in which unrealized gains occasionally come up to bite shareholders. Sometimes a new fund manager decides to "clean house" with a portfolio, selling many or most of the stocks in the fund in order to start fresh. Tax consequences of trading don’t penalize a manager’s performance. But they penalize shareholders who have to pay the taxes.
9. Unless you are investing in a tax-deferred or tax-free account, know when the fund is going to make its next distribution of capital gains, and try to find out how big the distribution will be per share. If you are not careful, you can wind up having to pay taxes on money that you never received. Here’s an example of something that happens to unsuspecting investors every year: Suppose you put $10,000 in a stock mutual fund that has had excellent performance for the past two years. Suppose that in the most recent few months, the fund has taken a lot of its profits by selling stocks. Let’s say that those profits represent 10 percent of the value of the fund.
Sometime before the end of its fiscal year, the fund must distribute those profits to its shareholders, who in turn must pay taxes on them. That means, in this example, that you will suddenly have $1,000 of taxable income. You won’t be given a choice about it; it’s just yours. And it makes no difference to the IRS whether you take the distribution in cash or reinvest it in more shares.
If you owned the fund for the years and months it was making those profits, you watched your investment grow, and it might be easy to understand when it came time to pay the piper. But if you paid your $10,000 and one week later you took the $1,000 distribution, you essentially bought those capital gains. When you are suddenly expected to pay taxes on what seems like your own money, it is indeed unfair. But that’s the law.
Capital gains distributions (dividend distributions are handled the same way) are typically made once a year, often at the end of December. But it can happen any time. If you’re ready to invest and you find out a substantial distribution is imminent, consider waiting until after the distribution in order to make your investment.
10. Know how long the fund has been in the hands of its current manager. You have undoubtedly examined the fund’s track record and believe it has something to offer you. But was the current manager the one who compiled that record? Has the fund been in the same hands for a long time (a comforting sign of stability), or has it gone through half a dozen managers in the last decade (a possible sign the fund is adrift)?
11. Know how much of the fund’s portfolio is concentrated in the asset type you are looking for. Fidelity Magellan, the nation’s largest mutual fund, made its reputation (and earned its growth) by investing in stocks. Yet at one time about 20 percent of its portfolio was invested in bonds. If your investing plan calls for putting a specific part of your portfolio in stocks, you don’t want it in a fund that’s 20 percent invested in bonds.
12. Know how the fund treats its investors. Is the literature clear and comprehensible? How are you treated when you phone with questions or to make a change in your account information? Are the phone representatives knowledgeable, courteous and available without a long wait on hold? Do you get your questions answered the first time, or does it take several tries to get something right? The more comfortable you are with the organization, the more likely you’ll be to stick with your investment even when it gets uncomfortable.
13. Know what conveniences you need and make sure the fund offers them. These might include telephone exchange privileges, automatic investments via electronic withdrawals from your bank account and automatic payments made to you or somebody else from your fund.
14. Know what other funds are available in the same mutual fund family. If you find a superb fund that meets your needs exactly, you shouldn’t pass it up just because you don’t like the other funds in its family. But moving money among your funds, for instance for annual rebalancing or market timing, is certainly more convenient within a single family of funds.
15. Know how diversified the fund’s portfolio is. Because it reduces risk, diversification is one of the major benefits of mutual fund investing. You’ll find the greatest diversification in index funds that include hundreds or even thousands of stocks. On the other end of the scale, some actively managed funds focus on relatively few stocks, counting on a combination of their managers’ stock-picking skills and luck to beat the market. For example, the Janus 20 Fund, now closed to new investors, had an annualized return of 25.8 percent from 1989 through 1998, 36 percent better than the 19.0 percent return of the Vanguard 500 Index Fund.
But focused funds are much riskier than widely diversified funds. In that same 10-year period, Janus 20 had a standard deviation (a measure of risk) of 23.0 percent, 46 percent higher than that of the Vanguard index fund.
(This won’t work in a tax-deferred account like an IRA, but it’s interesting to note that if you were willing to accept the extra volatility of the Janus 20 Fund, you could have leveraged a Standard & Poor's 500 Index fund by 46 percent. Your volatility would have been the same, but your return, before leverage costs, would have been 27.7 percent. That substantially beat Janus 20, at the same level of risk and with higher tax efficiency.)
16. Know the fund’s top 10 portfolio holdings. You can get these from Morningstar reports, from the fund’s own periodic reports and sometimes by calling the fund company to request the information. Are these companies that you would own in your personal portfolio? Do they seem consistent with the fund’s stated philosophy and style? (For instance, a small-cap fund should not generally be loaded up with General Electric and Microsoft shares.)
If you have other mutual funds, compare the top 10 portfolio holdings for each fund. You may find out that you are getting less diversification than you thought, if a handful of the same stocks wind up on just about every fund’s list of top holdings.
17. Know the size of the fund, in total assets. You can’t judge a fund just by its size, but you can be wary of very large funds and of those that are growing very rapidly. When a fund has outstanding performance for a year or so, it often gets so much attention that new money starts to pour in at a frantic pace. The fund manager then must put all that cash to work by buying more stocks – whether or not the manager thinks the timing is right.
There are few hard-and-fast rules about fund size. But the problems are particularly easy to notice in small-cap stock funds. By definition, such a fund buys companies that are relatively small. No investor, including a mutual fund, can buy billions of dollars of stock in those companies without driving up the prices to the point where they could cease to be bargains. That means the manager of a small-cap fund that’s growing fast must look farther and farther for bargains. At some point, rapid growth and large size become counter-productive.
18. Know the fund’s standard deviation and a few other statistical measures of its performance. You’ll find these in the Morningstar report on each fund. Here are three numbers to look for: Standard deviation measures the volatility of the returns of a fund. If all other things are equal, the lower the figure, the better. Beta is a measurement of fluctuations in the fund’s price, compared with the Standard & Poor's 500 Index. It’s another measure of volatility. The lower the number, the less likelihood that you’ll experience a rude surprise from this fund. (On the other hand, you’ll be less likely to experience a spectacularly pleasant surprise, either.) Alpha measures how much "extra" return a fund produced for the level of risk that it took above a risk-free investment such as Treasury bills. In alpha, the higher the number, the better.
19. Know how the fund performed in the worst market periods lasting one, three and five years. This may be difficult to find out, but some popular magazines such as Money, Business Week and Kiplinger’s Personal Finance have annual and semi-annual fund rating issues that give each fund a score for its performance during times when the market had big moves either upward or downward. Look for funds that did the best job of preserving their capital during the bad times.
If you’re considering a fund with a more limited track record, look back to the early 1970s to determine the worst-case performance of similar asset classes. Assume your fund matched that performance.
20. Know whether the fund manager has a defensive strategy to protect shareholders in case of a market downturn. If so, know what that strategy is. Will the manager sell equities (or bonds, in the case of a bond fund) in order to retreat to the safety of cash? Just because the prospectus says a fund may deviate from its primary asset class, it won’t necessarily happen. Many, perhaps most, funds have no formal defensive strategy, intending to remain fully committed to the asset classes in which they specialize regardless of what happens in the market.
Now let’s look back over this list briefly to see why we believe so strongly in using index funds. An index fund’s objective is easy to determine and unambiguous: to replicate the returns of a particular asset class. Its style is also easy to determine. Because of this, it’s easy to determine whether or not it fits into your own plan. Index funds rarely charge front-end loads, back-end loads or 12b-1 marketing fees. Their expense ratios and portfolio turnover ratios are very low, meaning lower costs for investors.
Index funds may have large unrealized capital gains, but that’s not a problem because an index fund has little need to do much selling of its portfolio holdings. For that reason, capital gains distributions are kept to a minimum. Manager tenure is not an issue because there’s little for a manager to do, and most index funds don’t even have managers. Portfolio concentration, style drift and diversification also are non-issues with index funds.
Size can be a problem, but it’s a problem for the universe of index funds, not any particular fund. For example, when a stock is added to the Standard & Poor's 500 Index, all S&P 500 Index funds have to buy that stock right away. The surge of demand inevitably boosts the price of that issue, at least temporarily, and the last index funds to place their orders may pay more than the first ones. However, the impact on the entire fund is likely to be small, because we’re talking about the price of a single stock in a portfolio of 500.
With index funds, it’s easy to find out standard deviation and worst-period performances. Finally, just as they don’t pick stocks in hopes of beating the market, index fund managers won’t have any defensive strategy. The job of these funds is to be fully invested at all times in a particular class of assets, and they don’t try to protect investors from market declines. That becomes your job, and you can do it using any or all of three major tools: diversification, market timing and the inclusion of fixed-income funds in your portfolio to add stability.
Source: http://www.fundadvice.com
Article viewed 592 time(s). Read more: 1 | 2 | 3 | 4 | 5 | 6 | 7 | 8 | 9 | 10 | 11 | 12 | 13 | 14 | |
