Part One
What a Mutual Fund Is
Buying a mutual fund is a lot like going to a brand-new Chinese restaurant with friends. Maybe you crave moo shu pork, but the General Tso's chicken sounds good, too. And you have never been to this restaurant before, so picking just one dish is risky. What if the vegetables are too hard or the rice too mushy? The solution: Gather a group of friends willing to share their orders, and you can sample a little of everything. A mutual fund brings together people, too--people who want to invest. The fund pools together the group's money and invests it for them in a collection of securities, such as stocks or bonds or a combination of the two.
The Mechanics
When you buy a mutual fund, you're actually buying shares of the fund. The price of a share at any time is called the fund's net asset value, or NAV. Invest $1,000 in a fund with an NAV of $118.74, and you will get 8.42 shares. (Unlike stocks, you can own fractions of a fund share.) The fund takes your money and combines it with any other new investments and the money that's already invested with the fund. Altogether, those investments are the fund's assets. The fund invests its assets by buying stocks, bonds, or a combination of such securities. These stocks or bonds are often referred to as holdings, and all of a fund's holdings taken together are its portfolio. (A fund's type depends on the types of securities it holds. For example, a stock fund invests in stocks, while a small-company fund focuses on the stocks of small companies.)
What you get as an investor or shareholder is a portion of that portfolio. Regardless of how much or how little you invest, your shares are the portfolio in miniature. For example, Vanguard 500 Index's VFINX four largest holdings are Microsoft MSFT (3.25% of its portfolio as of June 2002), General Electric GE (3.16%), ExxonMobil XOM (3.04%), and Wal-Mart Stores WMT (2.68%). Your $1,000 investment in the fund means you own $32.50 worth of Microsoft, $31.60 of General Electric, and so on. In an indirect way, you own the 500 stocks in the fund's portfolio.
The Benefits
Mutual funds offer a handful of benefits to investors. 1. They don't demand large up-front investments. If you have just $1,000 to invest, it will be difficult for you to assemble a varied group of stocks. For example, if you had $1,000 to invest and decided to buy one share of stock from the largest U.S. company, then one from the next largest, and so on, you'd run out of money sometime before purchasing the tenth stock. If you bought a mutual fund, though, you would get much more. You can buy some funds for as little as $50 per month if you agree to dollar-cost average, or invest a certain dollar amount each month or quarter. (We'll cover different investment methods in an upcoming session.) You can make an initial investment in many funds with just $1,000 in hand; $2,500 will get you into most funds. If you invest through an Individual Retirement Account, you can often get your foot in the door with even less than $1,000. 2. They're easy to buy and sell. You can buy mutual funds three ways: through financial advisors, directly from fund families, or via no-transaction fee networks, which are also called fund supermarkets. (We'll discuss these options in later courses.) But no matter how you buy funds, you can buy and sell shares quite easily--often with just a phone call or mouse click. The exception: closed funds. Closed funds no longer accept new money, except, in some cases, from current shareholders. (In later courses, we'll discuss why some funds close.) Investors who own closed funds can sell at any time, though. And when you sell shares of a fund, you get cash in return. 3. They're regulated. Mutual funds can't take your money and head for some remote island somewhere. This security exists through regulation set by the Investment Company Act of 1940. After the stock-market madness of the two decades prior to 1940, which revealed big investors' tendencies to take advantage of small investors (to put it nicely), the government stepped in. The 1940 Act is important to investors because it makes your mutual fund a regulated investment company (regulated by the Securities & Exchange Commission), and it makes you an owner of that company. Fidelity, for example, is a company that runs dozens of mutual funds. If you invest in one of their mutual funds--say, Fidelity Magellan FMAGX--you own a piece of the mutual fund, not a piece of Fidelity itself. Every mutual fund has a board of directors that represents the fund's shareholders. Apart from a small handful, mutual funds are not insured or guaranteed. You can lose money in a mutual fund, because a fund's value is nothing more than the value of its portfolio holdings. If the holdings lose value, so will the fund. The odds of you losing all of your money are very slim, though--all of the stocks in the portfolio would have to go belly up for that to happen. And that is just not likely. 4. They're professionally managed. If you plan to buy individual stocks and bonds, you need to know how to read a cash-flow statement or calculate duration. Such knowledge is not required to invest in a mutual fund. While mutual fund investors should understand how the stock and bond markets work, you pay your fund managers to select securities for you. Mutual funds are not fairy-tale investments. As you will see in later sessions, some funds are expensive, others are poor performing, and still others are tax nightmares. But overall, mutual funds are good investments for those who don't have the money, time, or interest necessary to compile a collection of securities on their own.
What NAV Is
Mutual Funds 101: What a Mutual Fund Is teaches you that a mutual fund's NAV is its net asset value, or its price per share. At first blush, mutual fund NAVs seem just like stock prices. Both represent the price of one share of an investment. Both appear in newspapers and on financial Web sites. But that's where the similarities between NAVs and stock prices end.
Calculating NAV
A mutual fund calculates its NAV by adding up the current value of all the stocks, bonds, and other securities (including cash) in its portfolio, adjusting for expenses, and then dividing that figure by the fund's total number of shares. For example, a fund with 500,000 shares that owns $9 million in stocks and $1 million in cash has an NAV of $20.
So Alike, Yet So Very Different
NAVs and stock prices differ in four important ways. Difference One. Stock prices change throughout the trading day, but mutual fund NAVs are usually calculated only once each day, at the end of trading. When you purchase a mutual fund, you buy shares at the NAV as of that day's close. As a result, you don't necessarily know the exact NAV of the fund when you invest. But that's okay, because funds willingly issue fractional shares, and investors purchase fund shares in dollar amounts rather than in share amounts. The result: Mutual funds can be more affordable than stocks. For example, if you have $1,250 that you'd like to put into a fund with an initial minimum investment of $500 and an NAV of $14, you'll get exactly 89.286 shares. Everything else being equal, a $100 investment is a $100 investment, and the number of shares purchased is irrelevant. In contrast, stock purchases are often made in even share amounts--you buy 50 shares of Coca Cola KO or 100 shares of Microsoft MSFT. A high stock price can therefore be a barrier to investors who don't have much money to invest. Difference Two. Stocks have a fixed number of shares outstanding. To change its number of shares outstanding, a company can either increase its share float by issuing new shares in a secondary offering or decrease its float by buying back shares in the market. In contrast, mutual funds generally have an unlimited number of shares. The number of shares changes on a daily basis, depending on how many shares investors buy and sell that day. An increase or decrease in the number of mutual fund shares doesn't result in an NAV change, though, because both the numerator and denominator of the equation (as you recall, assets and number of shares, respectively) change in equal proportion. Difference Three. You can determine whether a stock is a bargain or not by comparing its price to a "fair" price, based on such information as earnings estimates or cash flows. (The stock courses cover this process known as "valuing" a stock.) With mutual funds, however, NAV is tied solely to the current value of the fund's underlying holdings. There is no "fair" price of a mutual fund the way there might be with a stock. Difference Four. You can often use stock prices and nothing else to gauge how well a stock is performing. Mutual funds, however, distribute any income or gains they realize to shareholders as dividends, which, in turn, pulls down their NAVs. Unless you account for such distributions, you're underestimating a fund's actual performance. To accurately gauge a fund's performance, you need to examine its total return, which takes into account both the appreciation of the fund's holdings as well as any distributions that have been paid. (We'll explore this topic in our next course.)
NAV's Uses
After learning a bit more about NAVs, you may be thinking, "What the heck can I use NAV for?" Well, NAVs do provide you with some idea of what your investment is worth each day. Daily access to NAVs reassures you that your investment is being watched over, valued, and reported on. That's something.
Finding a Fund's Total Return
There's a relationship among net asset value (NAV), yield, and total return, but it's complicated. Each represents something a little different than the other, and oftentimes, the terms yield and return are used interchangeably. Did you know that a fund's NAV can fall and you can still make money? Or that a fund can yield less than 1%--heck, it can yield nothing at all--and can still be a chart-topping performer? If you remember nothing else from this course, remember this: When it comes to measuring performance, neither NAV or yield will do. Total return is the number to watch.
Distributions Muck Up NAV
As we pointed out in our last session, a change in a fund's NAV gives only a sketchy picture of the total return the fund has generated. Watching a fund's NAV is like watching a television with shaky transmission--sometimes you get an accurate picture, and sometimes you don't. With funds, interference occurs whenever a fund makes a payment to its shareholders, otherwise known as a distribution. By law, mutual funds must distribute any income they have received and capital gains they have realized from their holdings. But whenever a fund passes along either income or capital gains to shareholders, its NAV drops. If a fund with an NAV of $10 makes a $4 distribution, its NAV slips to $6. Despite the shrunken NAV, shareholders are none the poorer. They still have $10--$6 in the fund and $4 in cash. Unless they need the income, most investors reinvest their distributions; in other words, they instruct the fund company to use that cash to buy new shares of the fund. Most total return numbers reported in newspapers or on the Web, including those used by Morningstar, assume that you reinvest your distributions.
Where Does Yield Fit In?
Yield represents income that a fund distributes to its shareholders. Income comes from dividend-paying stocks and bonds owned by the fund. Income excludes any capital-gains distributions, as well as any underlying gains in the portfolio that have yet to be realized. (Capital-gains distributions are the result of the fund selling stocks or bonds that have gained in price. Unrealized gains are those made by stocks or bonds that the fund hasn't sold.) A fund's yield is therefore only the income component of its total return. That's why a fund can have a yield of 0%, meaning that it makes no income payments to shareholders, and still have a positive total return. Yield can be calculated in a variety of ways. Morningstar calculates yield on a trailing-12-month basis. In other words, we add up all of a fund's income payments over the past year and divide the total by the most recent month-end NAV. So how can you use a yield figure? Yield tends to interest those investors who need regular income, because they can reinvest any capital gains a fund generates while pulling out the income, or yield. Also, because income is taxed at a higher rate than capital gains, high-yielding funds are usually tax headaches. So if you are investing in a taxable account, as opposed to an IRA or retirement plan, watch out for funds with burly yields.
Total Return, for the Total Performance Picture
Total return encompasses everything we have discussed thus far: changes in NAV caused by appreciation or depreciation of the underlying portfolio, payment of any income (yield) or capital-gains distributions, and reinvestment of all distributions.
Ending position - beginning position |
| X 100 = total return |
Beginning position | ||
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Here's how it works. Say you buy 10 shares of Fund A at $9 per share. After a few months, the fund's NAV rises to $12. The fund sells some of its winning stocks and makes a $2 per-share capital-gains distribution. It makes no income distributions. As a result, the fund's NAV falls to $10. Your distribution of $20 ($2 x 10 shares) is used to buy 2 more shares at the new $10 price. Finally, say the fund's NAV rises again, this time to $11 share. So what is the yield on this investment? Zero, because it has not paid out any income. What about your overall return? Well, if you used only your NAV to calculate return, your shares would be worth the fund's final $11 NAV times your initial 10 shares, or $110. That's an NAV return of 22% on your original investment. But that figure would be inaccurate, because you need to factor in the capital-gains distribution that you reinvested. Add that back in and you'll find your investment is actually worth that $110 plus the $22 your two new shares are worth, for a grand total of $132. Your total return is really 47%. Not too shabby.
Mutual Funds and Taxes
Thus far, we have lauded mutual funds' virtues. They don't require a large up-front investment. They're professionally managed. They're easy to buy and to sell. But there is one thing that mutual funds aren't: tax friendly. Here's why, and how you can minimize the tax bite.
Funds, Capital Gains, and Income
Mutual funds can cause tax headaches because investors have no control over when and how much their funds realize in gains. Fund managers buy and sell securities for fund investors, often without taking tax considerations into account. As we touched on last session, mutual funds must pass along to their shareholders any realized capital gains that are not offset by realized losses by the end of their accounting year. Mutual fund managers "realize" a capital gain whenever they sell a security for more money than they paid for it. Conversely, they realize a loss when they sell a security for less than the purchase price. If gains outweigh losses, the managers must distribute the difference to fund shareholders. Fund managers also distribute any income that their securities generate. Obviously, a fixed-income fund, which owns bonds, will be paying out lots of income, and a stock fund that owns stocks that pay out regular dividends will also pass along dividends. While the NAVs of fixed-income funds are adjusted daily for income distributions, the NAVs of stock funds typically drop on the specific day an income distribution is made. As you may recall, when paying out capital gains or income, funds multiply the number of shares you own by the per-share distribution amount. You'll receive a check in the mail for the total amount. Or, if you choose to reinvest all distributions, the fund will instead use the money to buy more shares of the fund. After the distribution is made, the fund's NAV will drop by the same amount as the distribution. Fund companies often make capital-gains distributions in December, but they can happen any time during the year.
Distributions and Taxes
Unless you own your mutual fund through a 401(k) plan, an IRA, or some other type of tax-deferred account, you owe taxes on the distribution--even if you reinvested, or used the distribution to buy more shares of the fund. That is particularly painful if you have just purchased the fund, because you are paying taxes for gains you didn't get. Let's use an example to illustrate. Suppose you invest $250 in Fund D on Monday. The fund's NAV is $25, so you are able to buy 10 shares. If the fund makes a $5-per-share distribution on Tuesday (which means you have been handed a $50 distribution), and you reinvest, your investment is still worth the same $250:
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Monday | 10.0 shares @ $25 | = | $250 |
Tuesday | 12.5 shares @ $20 | = | $250 |
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The trouble is, you now owe capital gains taxes on that $50 distribution. We'll assume that the distribution is made up entirely of long-term gains (which means the manager sold stocks she had held for one year or longer) and is therefore taxed at 20%. (Gains on stocks held for less than one year and income are taxed at higher rates.) That would translate into a $10 tax bill for you. If you immediately sold the fund, the whole thing would be a wash, as the capital gains would be offset by a capital loss. The distribution lowers the NAV, so the amount of taxes you would pay would be lower than if you sold the fund years from now. Still, most investors would rather pay taxes later than sooner. And we're guessing that if you just invested in the fund, you weren't planning to turn around and sell it right away. Funds occasionally can add insult to injury by paying out a large capital-gains distribution in a year in which the fund lost money. In other words, you can lose money in a fund and still have to pay taxes. In 2000, for example, many specialty-technology funds made big capital gains distributions, even though almost all of them were in the red for the year. Although the funds lost money during the year, they sold some stocks bought at lower prices and had to pay out capital gains as a result. Technology fund investors lost money to both the market and Uncle Sam that year.
Avoiding Over-Taxation
Alleviate tax headaches by following these tips: Tip One. Ask a fund company if a distribution is imminent before buying a fund, especially if you are investing late in the year. Find out, too, if the fund has tax-loss carryforwards--that is, if it has booked capital losses in previous years that can be used to offset capital gains in future years. Tip Two. Place tax-inefficient funds in tax-deferred accounts, such as IRAs or 401(k)s. Tip Three. Search for extremely low turnover funds, or funds whose holdings are not bought and sold constantly throughout the year. Contrary to what you may have heard, the link between how much trading a fund manager does and a fund's tax efficiency is tenuous, at best. A fund with a turnover ratio of 50% isn't four times more tax-efficient than a fund with a 200% turnover rate. But funds with turnover ratios below 10% tend to be tax-efficient. You can find turnover ratios on Morningstar's Quicktake Reports. Tip Four. Favor funds run by managers who have their own wealth invested in their funds, like Third Avenue Value Fund's TAVFX Marty Whitman or the managers of Tweedy, Browne. These managers are likely to be tax-conscious since they're in the same boat as the rest of their shareholders. You can often find fund-manager ownership information in a fund's shareholder report, prospectus, or Statement of Additional Information. (We'll go into more detail about these fund documents in later courses.) Or call the fund family for the information. Fund families are not required to disclose if their managers have a stake in the funds they manage, but if the managers are significant shareholders, they'll usually say so. Tip Five. If you want fixed-income exposure, consider municipal-bond funds. Income from these funds is usually tax-exempt. (We'll cover municipal-bond funds at length in a later course.) Tip Six. Finally, consider tax-managed funds. These funds use a series of strategies to limit their taxable distributions. Vanguard, Fidelity, and Putnam all offer tax-managed funds. (We'll cover tax-managed funds in-depth in a later course.) Even using these tips, it can be difficult to find a fund that's consistently tax-efficient. But don't get so caught up in tax considerations that you overlook good performance. After all, a tax-efficient fund that returns 7% after taxes is no match for a tax-inefficient fund that nets 15% after Uncle Sam takes his share. (You can find after-tax returns on our Quicktake Reports.) In the end, it is what you keep, not what you give away, that counts.
How to Purchase a Fund
Investing in a mutual fund may not be as easy as picking up a gallon of milk from the corner store, but it's pretty close. The trick lies in figuring out whether you want some help choosing your funds, or whether you'd rather do it on your own. Either path has its benefits and drawbacks.
Want Some Help?
Maybe you don't have the time, interest, or wherewithal to craft your own mutual fund portfolio. Fine! All sorts of financial advisors, from planners to brokers, can help you pull together a financial plan and a basket of funds that can help you achieve your goals. Of course, this service isn't free. If you work with an advisor, you might pay an up-front fee of some sort, perhaps a percentage of your investment money. Or your advisor may forgo a fee and instead earn a commission by investing your money in what are called load funds. A load, or sales charge, is deducted from your investment when you buy or sell shares, depending on the fee structure. This load is used to compensate the advisor for selling you the fund. (Note that the load does not go to the fund manager; he or she receives another fee, called the management fee, which we'll discuss in a later session.) Some advisors are fee- and commission-based, which means they'll charge you some combination of the two. The advantages of working with an advisor are clear: You have someone helping you make financial decisions, taking care of paperwork for you, monitoring fund performance, and forcing you to stick to your investment plan for tomorrow instead of cashing in for an around-the-world jaunt today. The drawbacks include cost, of course. Then there's the task of finding an advisor with whom you can work, whom you can trust to put your interests before his or her own, and who will turn your financial dreams into realities, not nightmares. Further, you want to find an advisor who is willing to take the time to teach you about investing and about what he or she is doing with your portfolio. It's your money, after all, and you need to understand why it's invested the way it is.
Go-It-Alone, Version 1
Those with the time and interest to learn about investing and to monitor their own portfolios can invest in funds without the help of an advisor. If you choose to invest on your own, focus on no-load funds, which, as their name implies, do not charge any sales commissions. Why pay a commission when you're not getting any investment advice? Go-it-alone types can buy funds directly from no-load fund groups (also called fund families) such as Fidelity, Vanguard, and T. Rowe Price. (Be careful with Fidelity: It runs load funds, too.) To buy a fund from a fund family, request an application from the fund group by calling its 800 number. You can find these numbers on Morningstar.com's Quicktake Reports. Most fund families provide applications on their Web sites, as well. New investors who plan to buy more than one fund might choose one of the larger no-load families. Why? Because these families are diversified: They offer stock and bond funds,
Go-It-Alone, Version 2
Do-it-yourselfers who want only the best and who hate paperwork, perk up: Charles Schwab came up with the solution for you. It's called a no-transaction fee network, or a mutual fund supermarket, if you really want to sound in-the-know. Schwab pioneered this idea in 1992 when he launched the Schwab OneSource program. If you invest through OneSource, you can choose from thousands of funds from dozens of fund families--and there's no direct cost to you. So you could buy one fund from Janus, another from Royce, yet another from PIMCO, and one from Scudder and receive all of your information about performance, taxes, etc., on one consolidated statement. There are a number of fund supermarkets today, including versions from Jack White and Fidelity. More and more fund families are getting into the act, too: Both T. Rowe Price and Vanguard have supermarkets that include non-T. Rowe Price and non-Vanguard funds. What could the drawbacks here possibly be? Ironically, one drawback is cost. While it is true that fund supermarkets do not charge you when you invest in a fund through their programs, they charge the fund companies to be included in their programs. That charge ranges from 0.25% to 0.35% of assets per year. However, that fee is often passed along to shareholders--that's right, to you--as part of a fund's expense ratio, the fee the fund charges you each year for managing your money. The real kicker is that shareholders are paying these fees whether they buy the funds through the fund supermarket or directly from the fund family. Observers, including Vanguard founder John Bogle, also suggest that fund supermarkets encourage rapid trading among funds. Most supermarkets offer online trading, and with so many funds from so many families investing in so many different things to choose from, the temptation is great. But trading too much can hurt your portfolio's overall performance. (We'll tackle that subject in-depth in a later course.)
Methods for Investing in Mutual Funds
It's time for a little fantasizing. Say one of your ridiculously wealthy relatives is feeling generous, so she gives each family member $10,000. (Hey, it could happen!) Her only stipulation is that you invest your gifts in a mutual fund. Would you: 1) wait to invest the 10 grand until the fund you're interested in cools off or heats up? 2) Invest the entire wad immediately? 3) Put a little bit to work at a time? Which route you choose can have a profound impact on your return.
Waiting, or Market-Timing
Let's start with waiting, or what's often called market-timing--holding off on investment until you sense the time is right. That can mean when the fund's performance falls, when it rises, or when the moon is full on an odd-numbered day of the week in a month beginning with J. As you can probably sense, we're not keen on market-timing. It just doesn't work. Predicting the future has never been easy--just ask anyone who has had his or her fortune told. Further, studies from Morningstar and others show that making the right market call just isn't good enough. Chalk it up to the cruelty of mathematics, as illustrated in an experiment conducted by Morningstar. We went back 20 years and assumed that in each quarter, an investor chose to own all stocks (represented by the S&P 500) or all cash (in our experiment, Treasury bills). A market-timer who picked the better performer half the time still ended up way behind the market after two decades. We found that not until the timer's hit rate reached 65% did he beat the S&P 500. In other words, the market-timer had to be right two out of three times to justify the effort. Why? Because the stock market makes more money than cash does over time. Botching a market-timing decision usually means sacrificing good performance. Worse still, missing a period of strong returns means giving up the chance to make even more on those strong returns, thanks to the effects of compounding. (That is, each year you earn returns on the returns you earned in prior years, as well as on your initial investment.) So unless you know something that we don't--and you wouldn't be reading this if you did--avoid market-timing.
Investing All At Once, or Lump-Sum Investing
If market-timing is a losing strategy, what about the opposite: putting all the money to work at once? Many financial advisors recommend this approach above the others, because the market goes up more often than it goes down. Here's an example. Say you decide to invest your $10,000 gift all at once in one fund while your cousin, who also received a $10,000 windfall, invests $2,000 per month in the same fund over the next five months. The fund consistently rises in value during that time. The chart below illustrates what would happen to the two investments.
Fund Value Increases | ||
Month | Your | Your Cousin's |
1 | 5,556 shares | 1,111 shares |
2 | N/A | 1,099 shares |
3 | N/A | 1,081 shares |
4 | N/A | 1,070 shares |
5 | N/A | 1,053 shares |
Total Shares | 5,556 | 5,414 |
Ending Value | $10,556 | $10,287 |
You would end up ahead, because you own more shares at the end of the five-month period. And you own more shares because, due to the consistently rising value of the fund, your cousin couldn't afford to purchase as many shares as you had purchased originally. But what happens if the value of your fund fluctuates dramatically during those five months?
Fund Value Fluctuates | ||
Month | Your | Your Cousin's Investment |
1 | 5,556 shares at | 1,111 shares at $1.80 per share |
2 | N/A | 1,667 shares at $1.20 per share |
3 | N/A | 1,081 shares at $1.85 per share |
4 | N/A | 1,481 shares at $1.35 per share |
5 | N/A | 1,053 shares at $1.90 per share |
Total Shares | 5,556 | 6,393 |
Ending Value | $10,556 | $12,147 |
In this case, your cousin ends up in the lead. By investing a fixed-dollar amount in the fund every month, your cousin bought more shares when the price was low, fewer shares when the price was high, and ended up with more shares after five months. Such drastic fluctuations in NAV are rare, though. Because funds go up more often than they go down, most investors will receive the best long-term results by lump-sum investing.
Why Dollar-Cost Average?
Investing in dribs and drabs may not be the path to greater return, but we still think dollar-cost averaging, investing a set amount every month, is a viable method of investing. In fact, you may already be investing in this way if you contribute to a 401(k) plan at work. For starters, dollar-cost averaging can reduce your risk. If your mutual fund declines in value, the worth of your investment is less, even though you still own the same number of shares. In the same way that dollar-cost averaging will net you more shares in a declining market, it can curtail your losses as the fund goes down. The chart below illustrates this point.
Fund Value Decreases | ||
Month | Your | Your Cousin's |
1 | 5,556 shares at | 1,111 shares at $1.80 per share |
2 | N/A | 1,250 shares at $1.60 per share |
3 | N/A | 1,379 shares at $1.45 per share |
4 | N/A | 1,538 shares at $1.30 per share |
5 | N/A | 1,667 shares at $1.20 per share |
Total Shares | 5,556 | 6,945 |
Ending Value | $6,667 | $8,334 |
In this example, both you and your cousin lost money (remember, you each started with $10,000), but your cousin lost less by dollar-cost averaging. She had cash sitting on the sidelines that did not lose value. And when the fund rebounds, your cousin also will be in better shape because she owns more shares of the fund than you do. The second reason we like dollar-cost averaging is that it instills discipline. Investors often chase past returns, buying funds after a hot performance streak. And they'll sell funds when returns slow or decline. Bad idea: That's a form of market-timing. But dollar-cost averaging prevents you from market-timing, because you're buying all the time. Heck, you may even forget that you're investing if you set up an automatic-investment plan with a mutual fund family. Which leads us to the final reason we love dollar-cost averaging: It's a crafty way to invest in some great mutual funds that might be inaccessible otherwise. Many fund companies will waive their minimum initial investment requirement if you agree to set up an automatic-investment plan and invest a little each month or quarter.
What to Do?
While market-timing is out of the question for all investors (but some still try), whether you invest all at once or a little at a time depends on how much time you have to invest and whether your primary goal is maximizing return or minimizing risk. The shorter your time horizon, the greater chance you take of losing money with a lump-sum investment. However, if you had $20,000 to invest, it probably wouldn't make much sense to invest $1,000 a year for the next 20 years. Funds go up more often than they go down, and when they go down, they eventually bounce back. It is almost certain that the NAV you would pay 10 years from now would be higher than the NAV you would pay today. We suggest combining the two strategies: Invest as much as you can today, and vow to invest a little more each month or quarter. That'll keep you disciplined and have you investing right away.
Fund Costs
Too bad mutual funds aren't more like plumbers. When you call a plumber to unclog your kitchen sink, you know what it's costing you. The plumber presents you with a bill for services rendered, and you pay the bill with cash, a check, or a credit card. Mutual funds are different. You'll never write a check to a fund for its services. Instead, those costs come right off the top of your investment or straight out of your returns. Because costs are deducted this way, many investors aren't aware of how much they're paying for their mutual funds. Mutual fund fees can be broken down into two main categories: one-time fees and ongoing annual expenses. Not all funds charge one-time fees, but all funds charge ongoing annual fees of some sort. Return figures that you see for mutual funds do not take one-time fees into account, but ongoing expenses that all investors pay are deducted from return figures that you see.
One-Time Fees
There are three types of one-time fees that you may pay, all of which are usually charged when you buy or sell a fund. Remember, not all funds charge these fees; to find out if a fund does charge fees, consult its prospectus. 1. Sales Commissions. Commissions are commonly called loads. If you have to pay a sales charge when you buy a fund, that's known as a front-end load; a sales charge when you sell is a back-end load. (Some back-end loads phase out if you hold the fund for a certain number of years.) You might also pay a level load, or a percentage of your return each year for a series of five or so years. Loads come directly out of your investment. For example, if you made a $10,000 investment in a fund that carried a 4.5% front-end load, only $9,550 dollars would be invested in the fund. The remaining $450 would go to the advisor who sold you the fund. The fee goes to the advisor who sells you the investment; it's his or her compensation for doling out financial advice. So if you're buying a load fund, be sure you're getting investment advice in return. 2. Redemption Fees. Redemption fees differ from loads in that they are paid directly to the fund--in other words, they go back into the pot. You may have to pay a redemption fee if you hold a fund for only a certain period of time. In most cases, this time frame is less than 90 days, but it can be as long as a few years. These fees are an attempt to discourage market-timers from moving in and out of a fund. Why are market-timers bad? Well, a large redemption or a rash of sales can force fund managers to sell securities that they don't really want to sell; they have to get the cash from somewhere to meet the redemption. And if management has to sell securities that have gained in value, it may also pass along a taxable capital-gains distribution to shareholders who remain behind. So in a sense, redemption fees are the friend of long-term investors, because they'll never have to pay them, and the fees (in theory, at least) keep timers at arm's length. 3. Account-Maintenance Fees. Some fund companies charge account-maintenance fees, but such fees are usually for smaller accounts. Some Vanguard funds, for example, charge shareholders a $10 account-maintenance fee if their account balances dip below $10,000. Shareholders pay this fee each year until their account values rise above $10,000.
Ongoing Expenses
While the fees we've discussed so far are levied by only certain types of funds, all funds annually charge--and deduct from your return--the following fees. 1. Expense Ratio. Most fund costs are bundled into the expense ratio, which is listed in a fund's prospectus and annual report as a percentage of assets. For example, if ABC Fund has assets of $200 million and charges $2 million in expenses, it will report an expense ratio of 1%. The expense ratio has several parts. The largest element is usually the management fee, which goes to the fund family overseeing the portfolio. There are also administrative fees, which pay for things such as mailing out all those prospectuses, annual reports, and account statements. The 12b-1 fee can be another large component of the expense ratio. Roughly half of all funds levy these fees. A 12b-1 fee covers a fund's distribution and advertising costs and can be as high as 1% of assets. Those fees that fund families pay to no-transaction-fee networks, which we learned about in Funds 105, often get charged to fund shareholders via 12b-1 fees. 2. Brokerage Costs. These costs are incurred by a fund as it buys and sells securities. These costs are not included in the expense ratio, but instead are listed separately in a fund's annual report or statement of additional information. (We'll talk about these documents at length in later courses.) This figure excludes some hard-to-pin-down expenses. When a fund invests in over-the-counter stocks (typically stocks traded on the Nasdaq exchange), it doesn't pay the broker a set fee. Rather, the cost of the transaction is built into the stock price. It is a trading expense, but fund companies don't report it separately. 3. Interest Expense. If a fund borrows money to buy securities--not a very common practice among mutual funds--it incurs interest costs. Those costs are taken out of return, as well.
What's Reasonable?
As you can see, mutual funds are far from a free lunch. But you can keep more of what you earn by favoring low-cost funds. What is low cost? That depends on how long you plan to own an investment, and what type of fund you're talking about. With bond funds, for example, you want to favor no-load funds with the lowest possible expense ratios. That's because the difference between the best- and worst-performing bond funds is pretty slim; because bond-fund returns differ by just small amounts, every dollar that goes to expenses really hurts your return. Our advice: Avoid bond funds with expense ratios above 1%. On the stock side, a load fund may make a perfectly fine investment, if you're a long-term investor. Load-fund investors should also look for funds with low annual costs, such as those sponsored by American Funds. Their total costs (including sales fees) over a period of years are actually more moderate than those of many no-load funds. You can find plenty of good funds investing in large-company stocks that charge less than 1% per year in expenses. As with bond funds, the range of returns doesn't vary much, so lower expenses give a fund a decided edge on the competition. With small-company and foreign-stock funds, expect to pay closer to 1.5% annually. It just takes more effort--and money--to research tiny companies or foreign firms because there isn't much readily available information about them. At Morningstar, we put a good deal of emphasis on mutual fund costs, not only because they seem so buried, but because we think favoring modest-cost funds is an easy way to improve your long-term results. We've found that over long time periods, lower-cost funds tend to outperform higher-cost funds. And costs are the only thing about a fund that are absolutely predictable, year in and year out.
Important Fund Documents, Part 1
The advertisement in the paper roars "Raging Bull Fund, a Great Investment Opportunity!" Underneath, five stars appear, as well as a growth of $10,000 graph that looks like a Himalayan ascent. Must be a great fund, right? Well, maybe it is. But you need more than stars and performance numbers to judge a fund. You need to answer questions such as: What is the fund's investment strategy? What are that strategy's risks? How much does the fund cost? And who runs the thing, anyway? What you need are three valuable fund documents: the prospectus, the Statement of Additional Information, and the annual report. When you request an information kit from a fund family, you are usually sent a prospectus and the most recent shareholder report. Sure, the documents are packed with legal jargon, convoluted sentences, and boilerplate information in order to fulfill the Security and Exchange Commission's disclosure requirements and to protect the funds from legal liability. But they're also must-reads for mutual fund investors. Here's how to get what you need from the prospectus and the Statement of Additional Information. (We'll cover the annual shareholder report in our next session.)
The Prospectus
The prospectus tells you how to open an account (including minimum-investment requirements), how to purchase or redeem shares, and how to contact shareholder services. But more importantly, you'll find the six things you absolutely need to know about a fund before you decide to buy shares in the first place. 1. Investment Objective. The investment objective is the mutual fund's purpose in life. Is the fund seeking to make money over a long-term period? Or is it trying to provide its shareholders regular income each month? If you're investing for your child's education, you'll want the former. If you're looking for a monthly dividend check, you'll want the latter. But investment objectives can be notoriously vague. That's why you'll want to check out the next section. 2. Strategy. The prospectus also describes the types of stocks, bonds, or other securities in which the fund plans to invest. (It does not list the exact stocks that the fund owns, though.) Stock funds spell out what kinds of companies they look for, such as small, fast-growing firms or big, well-established corporations. Bond funds specify what sorts of bonds they generally hold, such as Treasury or corporate bonds. If the fund can invest in foreign securities, the prospectus says so. Most (but not all) restrictions on what the fund can invest in are also mentioned. 3. Risks. This section may be the most important one of the prospectus. Every investment has risks associated with it, and a prospectus must explain these risks. For instance, a prospectus for a fund that invests in emerging markets will reveal that the fund is likely to be riskier than a fund that invests in developed countries. Bond-fund prospectuses typically discuss the credit quality of the bonds in the fund's portfolio, as well as how a change in interest rates might affect the value of its holdings. 4. Expenses. It costs money to invest in a mutual fund, and different funds have different fees. Fortunately, a table at the front of every prospectus makes it easy to compare the cost of one fund with another. Here, you'll find the sales commission the fund charges, if any, for buying or selling shares. The prospectus also tells you, in percentage terms, the amount deducted from the fund's return each year to pay for things such as management fees and operational costs. 5. Past Performance. As the saying goes, "Past performance cannot guarantee future results." But it can give you an idea of how consistent a fund's returns have been. A chart known as the "Financial Highlights" or "Per Share Data Table" provides the fund's total return for each of the past 10 years, along with some other useful information. It also breaks out the fund's income distributions and provides the year-end NAV. Some prospectuses include additional return information in the form of a bar chart, which illustrates the fund's calendar returns for the past 10 years. This chart is a good way to get a handle on the magnitude of a fund's ups and downs over time. The prospectus may also use a growth of $10,000 graph (also known as a mountain graph, because the peaks and valleys resemble the cross-section of a mountain) or a table comparing the fund's performance to indexes or other benchmarks to present return information. (Unless otherwise stated, total-return numbers do not take sales charges into account.) 6. Management. The Management section details the folks who will be putting your money to work. Hopefully, the fund actually tells you the name and experience of the fund manager or managers. However, some funds simply list "management team" or some other less-than-helpful phrase. If that's the case, consult the fund's Statement of Additional Information (more on that shortly) or annual report to see if more specific information is given there. Feel free to call up the fund itself, or check out the family's Web site. If the prospectus does name names, check how long the current manager has been running the fund--the fund's past record may have been achieved under someone else. Find out whether the manager has run other funds in the past. A peek at those funds could give you some clues about the manager's investment style and past success.
Statement of Additional Information
While the prospectus is packed with great information, it shouldn't be your sole source of data on a fund. A fund's Statement of Additional Information (SAI) contains more great tidbits about the fund's inner workings. Be sure to ask for this document specifically: Funds routinely send out prospectuses and annual reports, but
Important Fund Documents, Part 2
A mutual fund's shareholder report is part biography, part blueprint, and part ledger book. A good shareholder report is like a biography in that it sets out what happened to the fund over the past quarter, six months, or year, and why. It's like a blueprint because it sets before you all the investments--stocks, bonds, and other securities--that the fund has made. And it's like a ledger book because it discloses a fund's costs, profits, and many other financial facts. Mutual funds are required to release a shareholder report at least twice a year, though some fund families publish them quarterly. Not all of the items discussed below are required by law to appear in a mutual fund's report. The SEC allows some of the information to be included in other documents, such as a fund's prospectus or Statement of Additional Information. However, a good report will contain all of the elements discussed below.
Letter from the President
Typically, the first item you'll find in a shareholder report is the letter from the president of the company that advises, or runs, your fund. The best letters will contain straightforward, useful discussions of the economic trends that have affected the markets during the past six or 12 months. This discussion provides some context for evaluating your fund. Poor letters, in contrast, will discuss anything but the current financial climate.
Letter from the Portfolio Manager
This is similar to the President's letter, but much more fund-specific--and therefore much more important to you as a fund shareholder. Well-written shareholder letters discuss individual stocks that the fund owns and industries to which it is exposed.
Recent Fund Performance
After reading your manager's comments, look to see how the fund has performed. A good report will compare your fund's performance to both a benchmark, such as the S&P 500 index (the standard benchmark for large-company funds) or the Russell 2000 index (for small-company funds), as well as to the average performance of funds with similar investment strategies. When evaluating your fund's performance, be careful that the benchmark the fund chooses is appropriate for its style. For example, a technology fund shouldn't compare itself to the S&P 500 and nothing else; it should measure its performance against a technology benchmark. (We'll cover benchmarks in more detail in a later course.) In addition to benchmark comparison, a good report should give you an idea of how the fund has performed over various time frames, both short- and long-term
Portfolio Holdings
Funds often list the portfolio's largest holdings and provide some information about what these companies do or why the manager owns them. Some reports will also indicate, via a pie chart or table, the sectors in which the fund is heavily invested. This general overview is complemented by a complete list of the fund's portfolio holdings--including stocks, bonds, and cash--as of the date of the report. These holdings are usually broken down by industry. (Foreign funds may break holdings down by country.) While you might not recognize all the names of the stocks in the portfolio, this listing is useful if you're wondering whether the fund is holding many names in an industry or making a few selected bets.
Footnotes
Don't forget to read the fine print. In the footnotes, you can find out if fund managers are practicing such strategies as shorting stocks or hedging currencies, which can significantly affect the fund's performance. Footnotes can also provide insights into particular portfolio holdings. For instance, the footnotes of Baron Asset's BARAX
Financial Statements
A fund's annual report concludes with its financial statements. Brace yourself: There's a lot of data here. In fact, this is where Morningstar gets a lot of the data it presents in its Quicktake Reports--and if we do say so ourselves, we do a pretty good job of clarifying that data and putting it into context. However, if raw numbers are your thing, here's what you should focus on. First, examine what's known as the fund's Selected Per-Share Data. This is usually the last page of actual information, located just before the legal discussion of accounting practices. Here you'll find the fund's NAVs, expense ratios, and portfolio turnover ratios for each of the past five years (or more). Check to see if the fund's expense ratio has gone down over time (hopefully it has) and whether its turnover rate has changed much over time (if so, you may want to find out why). Cost-conscious students can check out the breakdown of fund's expenses, including management fees, under the Statement of Operations. Finally, find out how much unrealized or undistributed capital gains a fund has in the Statement of Assets and Liabilities. (A gain is unrealized when a stock has gone up but the fund hasn't sold it. When the fund sells the stock, that's a realized gain, which has to be distributed to shareholders.)
What To Do Next
You can request a prospectus, SAI, or annual report by phone, by direct mail, and sometimes by e-mail. Many funds have their prospectuses available online at their Web sites. All mutual funds have their prospectuses filed with the SEC. You can view these at the SEC's Website: www.sec.gov. While we suggest that you begin your fund evaluation with these documents, don't stop there. Seek out third-party sources, such as Morningstar, to help put your fund into context. Compare it with other funds that do similar things. You need to see how its costs stack up, if its performance is competitive, and if it compensates for the risks it is taking on. The Funds 200 Level of Interactive Classroom teaches you how to do just that.
