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Mutual Funds Before
beginning, please read the following instructions:
TEST
CHAPTER 1: Mutual Funds – Historical Overview CHAPTER 1: Mutual Funds – Historical Overview Evolution and Changing Trends Back in the 1980s, it was not that uncommon for an investment advisor to have to explain the underlying concepts of a mutual fund to a prospective investor. People had heard of the term but didn’t understand the ins and outs. Up to that time, most investing was done through one’s employer sponsored retirement plan, which was handled by the employer. The employee had little involvement other than doing some ‘side’ investing. The employer took the responsibility in developing, designing, funding, administering and all decision-making related to any employee retirement plan. Even after the employee retired, the employer played a major role in providing guidance to the employee to ensure a stable retirement income. That’s not so today. Employers have shifted much of the responsibility and decision-making to employees through employee handbooks, self-help training and the rise of profit sharing plans such as the 401(k) or Simplified Employee Pension plan (SEP). On the surface at least, it appears that just about everyone understands mutual funds, or at least can give a remotely accurate explanation of how they work. The shift in moving from ‘employer accountability’ to ‘employee accountability’ can be attributed as a major causal factor for the evolution up the ‘understanding’ curve. The result being that mutual funds are one of the most sought after investments for a wide range of investors from mom and pop to billion-dollar pension funds. Since its
beginning in 1924, the mutual fund industry has transformed into a
remarkable growth industry. According to the industry’s trade
association, the Investment Company Institute (http://www.ici.org),
there are 95 million U.S. investors in mutual funds. Success in the
industry has quickly and broadly expanded the number of mutual funds from
100 in 1951 to over 8,000 today with a 2002 year-end market value of
around $6.4 trillion. Globally, it exceeds $11 trillion. Most of that
growth has come within the last fifteen years through market segmentation
efforts. There is a mutual fund for almost every investor, regardless of
risk tolerance or investment objective. Competition The growth of the mutual fund industry has demanded the attention of all who are in the financial services industry. Demand has already caused the assets of existing companies to swell. Mutual fund companies have successfully used market segmentation efforts to develop a wide range of offerings to meet the needs of just about every investor. For example, instead of just one generalized growth fund, investors can now choose a growth fund that invests in certain industries, specific technologies or a particular place on the globe. Mutual fund companies have traditionally sold their products through either direct marketing efforts or a sales force. Direct marketing companies typically have ‘no-load’ funds, that is, mutual funds with no upfront sales charge. These types of funds usually attract investors who do their own research, make their own decisions and are do-it-yourselfers. Direct marketing companies do not provide a source for investment advice. On the other hand, many ‘fee-based’ financial planners use these no-load mutual funds to meet their client’s investment needs. Other fund companies, called wholesalers, offer their products through a sales force of “registered representatives” (RR) who must first obtain a securities license to sell. Since RRs are associated with an Investment Advisor, aka a broker/dealer or securities firm, they can, and do, give investment advice to investors. Banks With the passage of less restrictive banking laws, banks hopped on the bandwagon and started competing with other investment companies. Their transition was slower than others because banks had an image problem – they have traditionally been the safe harbor, guaranteed, or insured investment people – by venturing into the risk side of investing. First, it was the offering of tax-deferred annuities then they progressed to investment products such as mutual funds via in-house registered representatives. Since most of a bank’s traditional offerings have been tied to interest rates, the addition of mutual funds and other investments have managed to keep customer satisfaction high, which is an important point not to be overlooked since banks hold the lion’s share of global wealth. Since the terrorist’s attacks of 2001 and recession of 2002, interest rates have dropped to extreme lows making traditional bank offerings borderline ridiculous. Brokers & Brokerage Houses Before the rise of mutual funds, the typical stockbroker, as they used to be called, was a telephone cold-call wizard. Making 100 cold calls a day in order to sell stock and make small increments of commission was the common practice. Mutual funds enticed brokerage houses to make a lateral shift from selling [only] stocks to selling stocks and mutual funds. In the grasp for more of the market share, some brokerage houses made a strategic move with the creation of their own, proprietary family of mutual funds as well as additional services such as insurance, mortgage lending and banking services. In order to give the correct perception, the title of stockbroker changed to one of the new fancy buzzwords, such as “financial consultant” or “financial planner.” For brokers, this was an easy transition since mutual funds were already available but the emphasis of the job still had a ‘sell stock’ mentality. This also gave rise to total money management of a client’s wealth in the form of ‘wrap accounts.’ These accounts, for a small percentage fee, allowed the brokerage house to maintain control of a client’s total investable assets, which contained a significant percentage in mutual funds. Insurance
Agents & Companies For years, insurance agents ‘left money on the table,’ that is, they could only meet a client’s insurance needs and had to leave investment dollars (and commissions) for someone else to claim. When it came to the discussion of saving or investing, the agent only had to offer dividend-paying cash value life insurance or fixed tax-deferred annuities. Nowadays, many insurance agents have made the transformation to the ‘financial planner’ look by becoming securities licensed and offering a diversified portfolio of insurance and investments. Insurance companies started making the transition from being just an insurance company to full financial services company about the same time insurance agents made their transition. The main reason for this corporate transition was to meet the needs of their insurance agent sales force as well as the demands of the buying public. The internal rate of return of cash value life insurance was extremely low and fixed annuity rates were based on the company’s investment portfolio. In order to compete, insurance companies created ‘variable’ life and annuity products, which placed the investment part in special accounts, which were mutual fund look-alikes. In order to invest the money in these variable accounts, some insurance companies created their own mutual fund family while others contracted with well-known mutual fund families to use their funds. With the use of an already established sales force and client base, sales of these variable products have surged. Other Professionals The rise and
popularity of mutual funds has caused other professionals, such as CPAs
and Attorneys who are indirectly related to the financial services
industry, to get securities licensed and promote the selling of mutual
funds. For years, they have received fees for their advice and then sent
their clients to someone else to implement their advice as well as to
receive commissions. The regulatory agencies for these professionals have
been slow in allowing outside activities such as selling mutual funds for
a commission. In order to properly represent themselves as providing full
financial services, many have obtained additional licenses such as
Certified Financial Planner®. Longevity and Retirement What happens when people live longer? Their investments must perform longer! The life insurance industry has long produced tables based on the law of large numbers, which statistically calculate death and longevity. These tables are popularly known as the Commissioner’s Standard Ordinary Mortality Tables, referred to as the CSO Mortality Tables or CSO tables in industry lingo. These tables have been continually updated because the longevity of Americans keeps changing. The first table was just called the CSO table, the second was the 1940 CSO table, the third was the 1958 CSO table and then the 1980 CSO table. Accurately predicting claim rates and charging the appropriate premium determines profitability. This is the problem that has plagued traditional retirement plans such as defined benefit plans and social security. The success of defined benefit plans depends upon funding (primarily) and yield (secondarily). Both of these were determined by longevity statistics. It became apparent over the years that statistical validity was not dependable over the long term and employers have since transitioned into offering profit sharing plans with more employee involvement and responsibility, such as 401(k)s and SEPs. When President
Roosevelt signed the Social Security Act on August 14, 1935, its purpose
was a quick fix to a national dilemma and was never intended to be a major
source of retirement income. Original social security legislation only
provided retirement benefits to
the primary worker (www.ssa.gov).
Survivors benefits and benefits for the retiree's spouse and children were
added in 1939; and, disability benefits were added in 1956. Since
then, social security has become a politically correct legislative
nightmare. According to the SSA, the average life expectancy beyond age 65
has only increased an additional five years since 1940. This alone would
not seem to put a strain on social security that is constantly purported
in the news. So where does the problem really lie? If one couples that
fact with the phenomenal numerical growth coming out of the baby boom
generation, a real problem is on the horizon. The problem: an inverse
numerical relationship between contributors and retirees, that is, the
number of contributors per retiree is dwindling. According to the
U.S. Administration on Aging (www.aoa.gov),
persons 65 years of age or older numbered 35.0 million in 2000, which
represented 12.4% of the population, about one in every eight Americans.
By 2030, that number will be about 70.0 million or 20% of the population.
This is more than a ten-fold increase since 1900 when there were only 3
million Americans older than 65, which represented 4% of the population.
In 2000, an estimated 2 percent of the population was age 85 and older. It
is projected to increase to almost 5% by 2050. Projections by the U.S.
Census Bureau suggest that the population age 85 and older could grow from
about 4 million in 2000 to 19 million by 2050. In 2000, there were about
65,000 people age 100 or older with projections to be as many as 381,000
by 2030. As one can see, this aging of America in growing numbers is posing a major problem for pension planning, social security and investing in general. To compensate, older investors are placing a larger and larger percentage of their retirement dollars into mutual funds. Even though many financial planners still preach the old school philosophy that retirement means a shift to a more conservative portfolio, they are realizing that their philosophy does not always meet the needs of their aging clients. Since traditional products cannot keep pace with inflation, taxation and longevity, both financial planners and investors are quickly making the adjustment toward mutual funds to ensure that retirement income outlives the retiree. In response to the aging and longevity of our population, Congress is always changing the laws to keep social security afloat. It started with the taxation of benefits if one’s retirement income was over a certain level and has moved to the postponement of receiving benefits for younger generations. Prudence would dictate that one not be dependent upon social security due to political influences, law changes and its inability to meet long-term needs for retirees. Knowledgeable Investors Investors have become more investing savvy by default and by the aging of the baby boomers. Employers provided the default mechanism by moving toward profit sharing plans that require more employee participation and responsibility. With this shift, employees have taken an active role in the management of their portfolios and moved up the learning curve. The end result is that investors are no longer ignorant about investing in general and mutual funds in particular; and, they are no longer inclined to stick with traditional thinking and invest in insured and guaranteed investments. Baby Boomers span a period of twenty years with the oldest of the bunch reaching age 65 in 2011. This generation is unique in that they are inheriting the massive wealth obtained from the prior generation of savers; they are more investment savvy and risk takers; they demand more for their money; and, many are retiring much earlier than the normal retirement age of 65. Because of these unique circumstances, this generation is investing heavily in mutual funds to carry them through til the end. TEST In 1951, one million investors owned mutual funds. Today, approximately 95 million individual investors, representing 54 million households, own mutual funds. That’s 50% of all households in the United States as compared to 5.7% in 1980 and 25% in 1990. As we’ll discuss, there are a multitude of reasons for this phenomenal growth. Ease Mutual funds have made it easy for the masses to invest on a small scale and to compete with big investors. In a phrase, they have “equaled the playing field.” Let’s say an investor doesn’t have a large sum of money but can set aside $50-$100 a month. About one-fourth of mutual funds have minimum investment requirements from $0 to $500. Even those that have higher requirements will allow monthly bank draft commitments for IRAs and other plans for as low as $50 a month. Comparatively speaking, there is no other investment in the financial services industry that has similar growth potential for such a small amount. Even though small-time investors can just as well put their money in a passbook savings, the reality is that people want more for their money. [From a financial planning perspective, passbook savings are not used for the accumulation of wealth but rather serve as a temporary safe haven, a short-term purpose or a limited cash reserve.] If investors really want more bang for their buck, the natural question would be, “Why don’t they just buy their own portfolio of stocks and bonds?” One of the best places to look for stock would be on the New York Stock Exchange in the Dow Jones Industrial Average (DOW). It is made up of 30 high quality, well known and established stocks, also known as “blue chips.” For example, part of the portfolio may be in shares of IBM. However, if the price of IBM were $80 a share, our investor above would have a hard time accumulating shares. Since most shares of stock are sold/bought in 100 share increments, called a round lot, it would cost $8,000 plus broker’s commission. This one factor alone would prevent the vast majority of investors from going this route. When one also takes into consideration the principles of diversification and risk (discussed later), this investing technique is out of reach for the masses. What if our investor was more interested in bonds instead of stock? Well, most bonds, depending upon multiple factors, are priced around $1,000. It would take several months to come up with enough money to buy one bond; however, the same problems with diversification and risk still exist. Similar to bonds, some commercial Certificates of Deposit (CDs) and Treasury securities have very high minimum purchase requirements. Other than mutual funds, an investor would have to have a substantial sum to buy a diversified portfolio of stocks, bonds, CDs, and/or Treasury securities. This is contrary to the spirit and environment in which mutual funds thrive. Economies
of Scale Mutual funds pool resources, that is, they receive money from millions of investors and use this large sum to create and manage a portfolio. It only stands to reason that they have purchasing power whereas one individual does not. With this purchasing power, they are able to go into the market and negotiate a better deal for large purchases of securities. This is similar to what large store chains do; they make volume purchases and sell to the consumer at a price that smaller, local establishments cannot. For this reason alone, mutual funds can purchase a more cost effective portfolio than individual investors; and, this cost savings is passed along to the individual investor. Professional
Management It takes time and expertise to successfully manage an investment portfolio of individual securities. Working for a living prevents the vast majority of investors from doing this. However, there are those who do manage their own portfolio, but the portfolio already contains a large percentage of mutual funds. In terms of dollar value, individual securities, other than mutual funds, in an individual portfolio is typically small. Following are a few of the items a professional money manager brings to the table - An expert in the field that works for the mutual fund, which in
turn, works for the individual investor. Diversification It a nutshell, diversification is held as one of the utmost rules of investing. It is not a new concept. In early history, there are stories of caravans using multiple trade routes and supply trains [camels, not the rail type] to ensure their wares reached their destination. Shipping companies did the same. There is even a scripture verse that says, “Divide your portion to seven, or even to eight, for you do not know what misfortune may occur on the earth,” Ecclesiastes 11:2. In modern phraseology, “Don’t put all your eggs in one basket.” Nonetheless, diversification and long-term investing success are two peas in the same pod; one cannot be done without the other. The primary purpose of diversification is to reduce risk. Even though maximum statistical diversification is reached around 30 securities, mutual funds have gone beyond that by having up to hundreds of securities within a portfolio. Diversification in its general sense refers to encompassing all securities such as stocks, bonds, money markets, etc. A ‘Balanced’ mutual fund probably meets this general definition best. From there, market segmentation has given new meaning to diversification. There are funds that specialize in particular securities, industries and technologies as well as specific parts of the world, for example, sector funds, technology funds, international funds, Japan funds, Pacific Rim funds, Europe funds, junk bond funds, small cap funds, etc. All of these funds have some degree of ‘specialized’ diversification where risk is much higher and narrowly defined. Acquiring 30 securities for maximum diversification is financially impossible for most investors. That is why mutual funds are so popular. Even though mutual funds are already well diversified, specialized diversification has become a problem. As a result, financial planners are now recommending that their clients hold multiple mutual funds to obtain general diversification. Multiple
Investment Opportunities Most mutual funds are part of a larger group of funds held under one umbrella, referred to as a fund family. This fund family is the head corporate entity while all of its mutual funds are sub-entities. A similar example would be like an insurance holding company, which is the head corporation that owns other separate and distinct corporations. In this environment, investors can do one stop shopping. Earlier, it was mentioned that there is probably a mutual fund that will meet the need of any investor no matter his risk tolerance or investment objective. While some fund families have only a few mutual funds, others have over 100. If one fund proves unsatisfactory for whatever reason, the investor can make a switch to another mutual fund within the same family, typically with just a phone call. Investors need to be aware that only tax-qualified accounts, such as IRAs, do not have any tax consequences when switching from one mutual fund to another. In the same way as selling a share of stock and reaping a gain or loss and purchasing another, switching a non-qualified account does have tax consequences. Liquidity Mutual funds are said to have liquidity - capable of being readily converted to cash. Some mutual funds require written instructions to liquidate, but most enable investors to make a phone call or use the internet to liquidate their investment, which will be sold at the end of the business day and made available the next. Liquidity is irrelevant to value. When shares of a mutual fund are sold, the value will be determined at the end of the business day. Even though mutual funds are allowed several days to send the money, in practice, they usually send it the following day to the address of record unless instructed otherwise. In cases of dire need, a mutual fund company will even send money via overnight mail, bank wire or other method. Investors can even have the money deposited in another investment account or money market fund. If the value is deposited into the investor’s money market account, he can immediately write a check on it. Dollar Cost Averaging (DCA) Since investors can make small investments on a regular basis, new shares are continually added. Market conditions dictate whether a constant dollar investment will purchase more or less shares over a period of time. Let’s assume we have an investor that invests $100 the first day of every month. This month’s price was $10.99 a share and last month’s was $11.21. For the same dollar investment, our investor would be able to acquire more shares this month than last. For the moment, we’ll set aside the fact that the fund’s value has declined. We already know the price fluctuates up and down every day. DCA is the process of investing at regular intervals, making price swings advantageous over the long-term. For example:
In the third column, price per share (PPS), we know that the average price per share (APPS) was $11.092 ((11.21 + 10.99 + 10.76 + 11.07 + 11.19 + 11.33) / 6). Now, let’s see what was the average cost per share (ACPS). Our investor spent $600 and acquired 54.11 shares. That is an ACPS of $11.089. Even though the difference is very, very small in our short-sighted example, as the time lengthens and the regular investment grows, the difference between APPS and ACPS becomes very significant. For example, over a period of twenty years, the difference can amount to $0.35 a share, more or less, depending upon the price fluctuation. As the size of the monthly investment grows, the difference between APPS and ACPS gets smaller. For our example above, the advantage was only $0.16 [(11.092 – 11.089) * 54.11]; however, if one multiplied the difference by the total amount invested over many years, an investor’s advantage could be in the thousands of dollars. Optional
Features Telephone
Access. Most mutual funds have toll-free numbers for investors to
call during regular business hours and an automated system for after
hours. Some have locations in different time zones that for all practical
purposes extend business hours. For example, if an investor on the east
coast called at 7:00 p.m., his call would be routed to an office on the
west coast, which was only at 4:00 p.m. An automated system allows an
investor to do any business or access any information related to his
account or any other mutual fund in that family. It is only limited by the
absence of personal service and attention of a live person. Through telephone access, investors can make redemptions, exchanges, set up systematic payout plans, request literature or replacement statements, redirect the automatic reinvestment of dividends and capital gains to another fund, or a host of other options. Internet
Access. Most mutual fund families have a web site with just about
any information one could want about their mutual funds. Investors can
access personal investment information by creating a login name and
password. By accessing a personal account, an investor can transact the
same business as if on the phone with a customer service rep, except it
can be done 24/7. The
only limitation with the internet is one’s ability and patience in
getting familiar with the web site. Each fund family has a different look,
but generally follow a similar pattern. If one is not internet astute, it
is a good idea to access the site during business hours and get a customer
service rep on another phone to give personal guidance and answer
questions. Reps are supposed to be very familiar with the company’s web
site because much of the information they give out when handling phone
calls comes directly from it. Automatic
Investing. As previously mentioned, some mutual funds allow
investors to forego their minimum lump sum requirements to open an account
by setting up an automatic investing arrangement through the investor’s
bank account, called an automatic bank draft. This is one of the key
reasons mutual funds attract millions of investors – it’s easy and the
minimum bank draft amount can usually fit in the tightest of budgets. Some
funds will allow the investor to specify the day in which money is
withdrawn from his checking account while other funds make that
determination. As
another convenience, mutual funds will allow the same thing through
employers. The employer can set up a payroll deduction plan allowing
employees to contribute as much as they want, depending upon the type of
plan selected. The mutual fund company deals directly with the employer by
sending a bill every month for the total amount and allocates the money to
each employee’s account. Each employee is sent his own statement and can
deal directly with the mutual fund company in regards to his account. Automatic
Reinvesting. Since most mutual funds make some form of periodic
distribution, there must be some election as to what to do with this
money. Investors can choose to have the money sent to them, sent to
another companion account, or reinvested. The most popular option is
reinvestment. If one reinvests, there is no applicable sales charge.
Shares are bought at the net asset value (NAV) price, which represents the
public offering price (POP) minus sales charge, if applicable. Another
advantage is the effect of dollar cost averaging (DCA) and compounding.
When one reinvests, he acquires additional shares that may cost less than
the original purchase price. Over time, this has the effect of lowering
the average cost per share. Reinvesting also has the effect of
compounding. As in the compounding effect of earning interest on interest
bearing accounts, so do reinvested dividends and annual capital gains
distributions. Exchange.
Most mutual fund families allow investors to exchange, in part or whole,
all the shares of one mutual fund for another. In previous years, most
mutual funds did not limit this option, but with the rise of timing
services, many have started limiting the number of exchanges per year or
quarter. This does not affect most investors, but for those who play an
active role in moving their money around in response to market conditions,
it poses a problem. From the mutual funds’ perspective, exchanges
increase the underlying expenses of the fund because of the buying and
selling involved as well as the additional man-hours. The spirit in which the exchange
privilege exists is for the convenience of the investor whose investment
objectives may have changed or for some reason other than timing. Mutual
funds are also perceived as long term; and, coupled with diversification
and professional management, some suggest that the use of the exchange
privilege should be infrequent at best. Systematic
Withdrawal. This service can be used in various ways and for a
multitude of reasons. Investors can request that the mutual fund company
send a part of their investment based on a specific dollar amount,
specific number of shares, specific percentage, or to be depleted over a
specific time period. Money will typically be sent to the investor via
check or automatically deposited into the investor’s checking account. The most used option is a specific
dollar amount. The reason for this is simple: when an investor needs
money, the amount is usually known and nothing else is needed to fill the
financial gap. The fund company can send the specified amount at various
time intervals but monthly is the most popular. If one specifies a certain
number of shares, then that is what the mutual fund will do giving no
regard for the value per share or amount of the check. Requesting a
specific percentage will provide an income stream longer than the other
options. However, since the amount is dependent upon the market, this
option may not be long-lived in meeting the investor’s need. When an
investor has a planned liquidation in mind, a fixed time period is usually
the method. The amount of the investment is divided by the number of years
requested and the fund liquidates the appropriate amount each year. There are many reasons why an
investor chooses a systematic withdrawal. One may have a temporary cash
flow problem, change in occupation, relocation and adjustment period, an
expense greater than the paycheck can handle, etc. The most widely known
reason is that the investor retires and needs an income stream. Check
Writing. This privilege is not automatic so it must be requested by
filling out the appropriate forms. Check writing is typically associated
with money market funds. If an investor plans ahead, he can save lots of
time and potential delays by having a money market account as a companion
fund to his other mutual funds. An investor can write checks at any time
with limitations on the number written per month and a minimum size. The
account stills earns interest on the money until the fund actually
liquidates shares to redeem the check. Unless one is already set up on
systematic withdrawal, one-time liquidations are usually sent by check or
overnight mail at the investor’s expense; therefore, check writing is a
real convenience factor when money is needed quick and waiting for the
mail is simply not an option. Tax
Reporting and Record Keeping. Mutual funds report all dividends and
capital gains distributions to the investor and IRS via Form 1099. In this
way, there is no confusion as to what is to be reported. The IRS assumes
that all forms are correct and will act upon that information. If there is
any discrepancy, investors should contact the mutual fund company to get
the issue resolved. For example, an investor has a systematic withdrawal,
or a one-time liquidation, or exchanges the money in one mutual fund for
another. These are taxable events that are not reported directly to the
IRS. The investor must take the initiative to report any gain (loss). In
prior years, the investor would have to use the first-in, first-out (FIFO)
method of accounting to figure the gain (loss) for every share that was
liquidated. Now, mutual fund companies are required to provide (upon
request) an average, per share cost basis. Mutual funds will typically mail
out statements to the investor when there is any account activity. For
example, if one invests on a monthly payroll deduction plan, a statement
will be sent each month. If one does not invest on a regular basis but the
fund pays quarterly dividends, then the investor will receive a quarterly
statement. Each statement will typically contain all the entries from
prior statements for the calendar year. In this manner, an investor can
always discard the last statement when a new one is received. It is always
recommended for investors, and required of registered representatives, to
keep the last statement of the year for every mutual fund investment. TEST A mutual fund is a portfolio of various securities, gargantuan style. It’s like an investor developing a personal portfolio of stocks, bonds, money market securities, etc. and multiplying the results several thousand times. Mutual funds are also called open-end investment companies or regulated investment companies, which is their legal name. Section 851 of the Internal Revenue Code defines a regulated investment company, in pertinent part, as any domestic corporation that is registered under the Investment Company Act of 1940 as a management company or unit investment trust…. No matter what name one chooses, we’ll refer to them as mutual funds. There are also two other types of investment companies worth mentioning so we’ll briefly discuss them. Anything else would go beyond the scope of this course. It only stands to reason that if there is an open-end investment company, there must be a closed-end investment company; and, there is. Its features are, but not limited to: - They are managed just like mutual funds The other investment company is a Unit Investment Trust (UIT). Its features are, but not limited to: - They are not managed like mutual funds The diversity of mutual funds can range from the very broad to include just about every type of security to one of narrowly defined specialization. Investors have to work their way through the maze to find a mutual fund fit for them. Fortunately, mutual funds have provided a hint as to what they are going to try and accomplish through a published investment objective. When one becomes familiar with the various investment objectives and the underlying securities needed to support that objective, then making the right choice is not far away. The first step for investors is, of course, to have some understanding of the various types of securities that can be found in mutual funds. Types
of Securities Money Market Many people do not understand the “money market” concept. Follow these illustrations if you will. Real estate agents work in the ‘real estate market.’ Insurance agents work in the ‘insurance market.’ There is also the ‘stock market’ and ‘bond market;’ therefore, the ‘money market’ is a market where money is bought and sold. This is not money in the currency sense; however, it is considered a currency equivalent, which is said to have the same characteristics and liquidity as currency. Well, the next question would be, “What is a currency equivalent?” They are things such as short-term Treasury securities, Repurchase Agreements, Banker’s Acceptances, Certificates of Deposit, Commercial Paper, etc. Since all of these securities have short-term maturities, are considered very secure and almost risk-less, they are given the same standing as currency. In summary, a money market fund is a type of mutual fund that holds the previous securities in its portfolio. Most mutual fund families have money market funds. Comparatively speaking, these don’t really make the fund family any money but are there as a source of convenience for investors. Most investors, whether it be a small individual investor or large corporation, use money market funds as either a temporary safe haven or a holding pen until the right investment comes along. Interest rate is not a primary reason one invests in a money market fund; however, it is an important one. After an investor decides to park money somewhere, “interest rate shopping” comes into play. Traditional ways of saving through commercial and savings banks typically pay less. However, credit unions can be competitive depending upon the size and reach. If a credit union is small and only supports the local electricians’ union, then interest rates can be equal to or more competitive than a money market fund. The reason is that small credit unions are not as profit oriented, overhead is usually smaller and members typically volunteer to help. Other features such as check writing and liquidity are also investor pleasers. Since money market funds are considered almost risk-less, their price per share is set at $1.00. By way of segmentation, some fund families even have more than one money market fund. For example, in addition to a general money market fund, a fund family may also have a government money market fund and tax-exempt money market fund. Each of these is specialized to reach and cater to particular investor needs. Bond Market A bond is a debt certificate and is issued by corporations and government agencies or organizations. We’ll refer to both as ‘entities.’ For example, ABC Corporation, Podunck County, or the Transatlantic Toll Bridge can raise money by issuing bonds. Even though an entity can raise money through a stock offering and bank loans, bonds represent another source. When an investor buys a bond, he makes a loan to the issuing entity and becomes its creditor; the issuing entity becomes the debtor of the investor. Most investors buy bonds because of the interest, which is paid semi-annually. Even though there are no time restrictions, most bonds are designed to mature between 2 to 30 years. Upon maturity, the principal is returned to the investor. The interest rate that bonds pay is set when they are originally issued and do not change for the life of the bond. Since bonds have a set interest rate, the underlying principal value changes. For example, an investor buys a newly issued bond for $1,000, aka par value or face amount, that pays 6%. This means that he will derive $30 every six months. Two years down the road, interest rates on new bonds are 8%. Our investor can spend $1,000 on a new bond and earn $40 every six months. Could he sell his old bond for what he paid for it? No! For bonds, there is an inverse relationship between interest rates and principal value. As interest rates go up, the underlying principal value in existing bonds goes down, and vise versa. Let’s say interest rates dropped to 4%. In this case, our investor would probably want to hang on to his 6% bond. However, another thing has taken place – his bond is worth more than what he paid for it. It only stands to reason that if a 4% bond is worth $1,000, then a 6% bond would be more valuable. If he wanted to sell it, he could do so for more than his original purchase price. Any amount received over the face amount is called a premium. The interest rate a bond pays is dependent upon the entity’s credit rating. As credit reporting agencies compile and evaluate personal credit worthiness, rating companies such as Standard & Poor’s, Moodys, Fitch and Duff & Phelps do the same for entities. Let’s say an individual wanted to borrow money to buy a car, but his credit was pretty bad. Even though the lending institution may loan the money, they would charge a higher rate than someone who had an impeccable credit history. In the same way, when entities are given a bond rating, their bonds must reflect the appropriate interest rate or investors will not be willing to buy them. The four highest ‘grades’ are considered investment grade. Standard & Poor’s indicates these ratings as AAA, AA, A, BBB. The entities that are rated as investment grade are considered good risks and their bonds don’t pay as much as those in the lower grades, such as BB, B, CCC, CC, C, etc. These non-investment grade bonds are referred to as ‘high yielding’ bonds, aka junk bonds, and have a higher default incident rate. When a bond does not make an interest payment on time, the entity is in default and can be forced into bankruptcy. When governments issue bonds, such as a state or city government, they are federally tax-exempt and are either backed by the entity’s taxing power or the revenue generated by the project they created by legislation. These bonds are referred to as “tax-exempts,” “municipals,” or “munis.” Munis can also be state tax-exempt for investors who are residents within the state of issue, giving them a double whammy. The popularity of munis is directly proportional to income tax rates. The higher the income tax rate, the more people will seek them out. In prior years, people aggressively bought munis just to avoid paying taxes without considering anything else. Nowadays, financial planners preach ‘the bottom line’ to investors, which considers the after-tax result of all investing. Bonds that are backed by the entity’s taxing power are referred to as general obligation bonds; and, bonds that are backed by the revenue generated from a project are called, you guessed it, revenue bonds. Bonds also have other interesting features and names. The following is a non-inclusive list. Callable. Some bonds come with indentures that allow them to call, or redeem, the bond prior to maturity if interest rates drop. Of course, callable bonds have higher interest rates to attract investors as well as pay a premium upon redemption (call premium). From the investor’s perspective, a called bond means lower interest rates. When an issuer calls and redeems a bond, it turns around and sells new, cheaper debt. Convertible. Investors who own convertible bonds can, at the investor’s option, exchange the bonds for a specified number of shares of the issuer’s common stock, referred to the conversion ratio. Upon issue, the conversion ratio is set to be unattractive. For example, if the current stock price is $20, the conversion ratio may be set at 40, making a conversion to stock only worth $800 ($20 x 40). Not a very good deal since $1,000 was spent to purchase the bond. However, if the company is successful and the stock goes to $35 a share, the stock would be worth $1,400 ($35 x 40), a forty percent profit. Debenture. Since most bonds are not secured, that is, they don’t have any property pledged as collateral, they are called debentures. Investors are classified as general creditors along with holders of promissory notes. The riskiest type of debenture is the subordinated debenture, aka junk bond, which is junior to or subordinate in regards to debentures. Interest on subordinated debentures only gets paid after debentures. Stock Market Stock represents the equity ownership interest in a company. Shares of stock represent the actual pieces of the ownership pie. For example, if a company has 1 million shares, then there are 1 million pieces of ownership with each share worth one-millionth of the company’s value. Investors who purchase stock receive a stock certificate, which is a title of ownership and shows how many pieces of the pie they own. Investors usually buy stock for one of two reasons: income and/or growth. Income from stock comes from dividends, which are paid quarterly and come out of profits. Most of the companies that pay dividends are ‘blue chips,’ those that have been around awhile, leaders in their industry, and are successful. They are also at the top of their growth cycle and have obtained substantial market share. For those who invest for dividends, the payment thereof has almost become sacred. Some companies have been religiously paying a regular dividend longer than most folks living today. It has become a matter of company pride. Dividend reinvestment is a very important part of mutual fund investing. Investors can choose this option and the mutual fund does it automatically. This feature takes advantage of dollar-cost-averaging and there is usually no sales charge attached. When looking at the mutual fund’s overall increase in value, much of it comes from dividend reinvestment. The actual growth part comes either from capital gains or capital appreciation. A capital gain comes from the sale of stock and capital appreciation comes from stock still in possession that has increased in value. Structure Even though there are multiple parties involved in the structure of a mutual fund and to effect its operation, it is quite the norm for more than one party to fulfill more than one role. Accountant. An independent public accountant must certify as to the correctness and accuracy of the fund’s financial statements. Administrator. Administrative services include the oversight of other companies contracted to perform services to the mutual fund, legal and compliance issues, general accounting and reporting. Board of Directors and Officers. Responsibility for any company’s operation has to fall on someone’s shoulders. The corporate world has made the headlines more than once in recent history concerning those behind the scenes – the ‘elected’ Board of Directors. The Board oversees the overall affairs of the mutual fund and operate from the ‘prudent man’ perspective and are regarded as fiduciaries. In most instances, the SEC requires that a majority of the directors be independent, that is, they do not have any significant relationship with the Investment Advisor or Distributor. Custodian. The custodian handles the money flow of the mutual fund or the fund’s assets. For example, when shares are bought and sold or there are any distributions, the custodian receives and pays out the money. Most custodians are banks and, by law, must segregate mutual fund assets from other bank assets. Distributor. The distributor of a mutual fund, aka underwriter or sponsor, is the marketing organization behind the sales force selling the mutual fund. As with any marketer, they prepare literature, advertising pieces, promotions and may even provide training if they have their own sales force. For the marketers that don’t have a sales force, they act as a middle man (wholesaler) between the public and brokers. Investment Advisor. The investment advisor is the organization responsible for investing the mutual fund’s money. This is usually a team of investment professionals typically headed by one manager or a team of managers supported by other technical specialists such as analysts and researchers. Since they are hired for the task, their compensation is a percentage, usually less than 1%, of the total assets of the mutual fund. In this manner, there is a big incentive to be successful. Shareholders. The actual ownership of a mutual fund is with the shareholders. If all of the shareholders got together and decided to cash out, the fund would actually be out of business. Others are responsible for a fund’s management and investment decision-making (discussed below). Shareholders have voting rights to elect the Board of Directors and to permit any material or fundamental change with the investment advisor or the fund’s policies. Transfer Agent. The transfer agent handles the paper flow of the fund. Normal operations include, but not limited to: maintaining shareholder statements and confirmations, tax reporting, distributions, periodic customer reports, shareholder inquiries, etc. Operation Investors and Pooled Resources. Mutual funds have pooled resources, that is, millions of investors send their money to one central collection pot, a mutual fund. For the investor’s part, they receive a certain number of shares, which is determined by the amount invested divided by the mutual fund’s price per share. Investment Portfolio. The mutual fund, in compliance with its investment objective, develops a portfolio by buying hundreds of various securities. At the end of each day, each security within the fund is valued thereby giving the mutual fund an overall value. Subtract out its liabilities, divide the result by the number of outstanding shares, and you have the price per share, which is more popularly known as the Net Asset Value (NAV). Management. Since every mutual fund has a stated investment objective, the portfolio must be managed to ensure compliance. If any security within the portfolio falls out of favor or does not meet expectations, then it is sold and replaced. Among other things, management is also responsible for maintaining a sufficient cash reserve for liquidations and buying opportunities. Inflow/Outflow Conduit. At any time, a mutual fund will invest new money from investors (optional but typical). At the same time, they must redeem an investor’s shares upon request. The direction of money flow can go both ways at any time and at the same time. Earnings. Mutual funds make four types of distributions to shareholders: dividends, capital gains, bond interest, and money market interest. Investors’ shares are also subject to capital appreciation and depreciation, but these are not considered earnings. Earnings can either be paid to shareholders or reinvested. Tax Reporting. Each shareholder receives an annual IRS Form 1099 indicating his prorata share of reportable earnings. TEST CHAPTER 4: Types of Mutual Funds As previously mentioned, there is a mutual fund for just about any investor. From the investor’s perspective, the fun begins with trying to find the right one(s), which is discussed later under Suitability. However, the first step in that direction is familiarity with the various investment objectives. The Investment Company Institute classifies mutual funds into 33 investment objective categories; however, we’ll keep it a little more generalized by showing major groups then subdivisions within each group. Please note that these are just general guides and each mutual fund family is not required to follow any pattern. Generally speaking, mutual funds will fall into one of four general categories: stock, bond, hybrid, money market. Stock
Funds Stock funds, also called equity funds, have a primary focus of investing in stocks. Investors who seek stock funds are primarily interested in capital growth. Growth or Capital Appreciation. The words ‘growth’ and ‘capital appreciation’ are used interchangeably for funds whose primary objective is appreciation as opposed to income. Mutual funds with this objective may invest with a more narrowly defined emphasis in order to accomplish their objective. For example, a mutual fund may be an aggressive growth fund (investing in midsize and smaller companies) or a sector fund (investing is some specific technology or field). Here’s an example of
a growth fund’s investment objective:
“Seeks to provide long-term growth of capital through a diversified
portfolio of common stocks.” Here’s an example of
a (midsize) aggressive growth fund’s investment objective:
“Seeks to provide long-term capital growth by investing primarily in
medium-sized companies the managers believe provide high and consistent
earnings growth potential.” Here’s an example of
a (small cap) aggressive growth fund’s investment objective:
“Seeks to provide long-term capital growth by investing primarily in
common stocks of small growth-oriented or emerging growth companies
believed to offer above-average opportunities for long-term price
appreciation.” Growth and Income. These funds have a dual objective of capital appreciation and income. Their portfolios are usually made up of blue chip companies since they are likely to pay dividends. Typically, a mutual fund will favor capital appreciation over income or vice versa. In the case of favoring capital appreciation over income, this fund is classified as ‘growth and income,’ while its opposite is ‘income equity.’ Here’s an example of a growth and income fund’s investment objective: “Seeks to provide long-term growth of capital and income primarily through investments in common stocks.” World Equity. In this type of fund, investing can take place in any part of the world. If the fund invests in any country other than the U.S., it is called an ‘international fund.’ If it includes the U.S., it is called a ‘global fund.’ Some are even named after the specific region of the world where investing takes place, such as the Pacific Rim. Others may even invest in a part of the world that was previously unknown and is now the recipient of corporate attention and development, called ‘emerging markets.’ Here’s an example of
a global fund’s investment objective: “Seeks
to provide long-term growth of capital through investments all over the
world, including the United States.” Here’s
an example of an international fund’s investment objective: “Seeks to
provide long-term growth of capital by investing in companies based
outside the United States.” Here’s
an example of an aggressive growth global fund’s investment
objective: “Seeks to provide long-term growth of capital by investing in
the stocks of smaller companies in the United States and around the
world.” Here’s an example of an emerging markets fund’s investment objective: “Seeks to achieve long-term capital appreciation by investing primarily in equity securities of issuers located or operating in emerging countries.” Hybrid
Funds Hybrid funds seek an overall return by holding various securities in stocks, bonds and money market instruments. Some have an asset allocation emphasis by allocating the weightings according to what is performing best. Others have a more balanced approach by having a three-pronged objective of capital growth, current and growing income, and preservation of capital. Some may even favor one objective, such as income, over capital appreciation. Investors who seek hybrid funds are primarily interested in two or more of the following: capital growth, dependable and/or increasing income, and safety of principal. Here’s
an example of a hybrid fund’s investment objective:
“Seeks to provide current income and, secondarily, growth
of capital through a flexible mix of equity and debt instruments.” Here’s an example of another hybrid fund’s investment objective: “Seeks to provide conservation of capital, current income and long-term growth of capital and income by investing in stocks, bonds and other fixed-income securities.” Bond
Funds Bond funds are probably as diverse as stock funds. Investors who seek bond funds are primarily interested in income. Since underlying bond values have an inverse relationship to interest rates, investors must be aware of the tradeoffs if income is not the sole objective. Taxable Investment Grade. These are bond funds that invest in high quality bonds having the highest four ratings by one of the bond rating services. Since they are taxable funds, they invest in corporate bonds (corporates), which are not exempt from either state or federal taxation. However, some investment grade bond funds are hybrids containing both government and corporate bonds. These hybrids are just called long-term bond funds. Here’s
an example of a taxable investment grade bond fund’s investment
objective: “Seeks to provide total return through a combination of
income and capital appreciation by investing primarily in U.S. corporate
bonds that have investment grade credit ratings in the four highest rating
categories.” Taxable High Yield. Just right below investment grade bonds are “junk bonds,” which are also called high yield bonds. Since these corporate bonds have lower credit ratings, they are considered higher risk and must pay a higher interest rate. Here’s an example of a taxable high yield bond fund’s investment objective: “Seeks to provide a high level of current income, with capital appreciation as a secondary goal.” Taxable World. As in global stock funds, a taxable world bond fund invests in debt securities all over the globe. Here’s an example of a taxable high yield bond fund’s investment objective: “Seeks to provide high, long-term total return consistent with prudent management by investing in quality fixed-income securities issued by major world governments and corporations around the world and in the United States.” Tax-Free Government. Depending upon the securities held, a government bond fund can be state income tax free, federal income tax free, or both. They are called government bond funds because the bonds are issued by a government agency. The U.S. Treasury issues bonds (treasuries), which are state income tax free but not federal. Since treasuries are considered the safest of all bonds (backed by the full faith and taxing power of the U.S.), and state income tax free, they pay slightly less than corporates. Treasuries are only half tax-free; therefore, they would also fit in the ‘taxable investment grade’ category. Some government bond
funds even invest in Ginnie Maes, which are technically not bonds. Ginnie
Maes are securities issued by Ginnie Mae, a federal corporation within the
U.S. Department of Housing and Urban Development (HUD). Investors buy
these securities and the money is channeled into the mortgage lending
market. Ginnie Mae guarantees the
timely payment of principal and interest on the securities and backs this
guaranty with the full faith and credit of the U.S. Government. Here’s
an example of a tax-free government bond fund’s investment objective:
“Seeks to provide a high level of current income and preservation of
capital by investing primarily in securities backed by the full faith and
credit of the U.S. Government.” Tax-Free Municipal. Investors who seek income that is free of federal income tax should seek tax-free municipal bond funds. Because these are federal income tax free, the interest rate is lower than other corporate or government bond funds. If a state issues municipal bonds, investors who are residents of the state get a double whammy - income is exempt from state and federal income taxes. Here’s
an example of a tax-free municipal bond fund’s investment objective:
“Seeks to provide a high level of current income exempt from federal
taxes, consistent with the preservation of capital.” Here’s
an example of a state municipal bond fund’s investment objective:
“Seeks to provide current income free from federal and ‘name of
state’ income taxes. Also seeks to preserve capital.” Money
Market Funds Money market funds invest in securities with maturity dates of less than one year. Short-term maturity dates and the stability of the securities generally make these types of mutual funds to be safe. As such, they maintain a constant price per share of $1. Taxable. Taxable money market funds invest in Treasury bills and securities that are taxable such as certificates of deposit, commercial paper, repurchase agreements and banker’s acceptances. Here’s an example of a taxable money market fund’s investment objective: “Seeks to provide maximum current income while preserving principal and maintaining liquidity by investing in short-term money market securities, including securities issued or guaranteed by the U.S. Government or its agencies.” Tax-Free. The only difference between a tax-free money market fund and taxable one is the types of securities that are in its portfolio, which are issued by municipalities. Here’s
an example of a tax-free money market fund’s investment objective: “Seeks
a high level of current income, exempt from federal income tax, while
preserving principal and maintaining liquidity by investing primarily in
short-term municipal money market securities that are exempt from federal
income tax.” In
summary, most published investment objectives are very general in nature
while some give a little insight as to the types of securities they will
pursue. Generally, the investment objective will be stated very
generically and any additional information, for example, types of
securities to be evaluated, will be stated in a different area, such as
‘Strategy’ or ‘Types of Investments.’ TEST CHAPTER 5: Comparing Mutual Funds Information
Sources There are many factors investors should consider when comparing mutual funds and before making investment decisions. Some of these factors are a must and some are not, depending upon each investor’s peculiarities. However, before one can make a comparison, the right information must be found. We’ll discuss information sources first. Prospectus The mutual fund’s prospectus should be the beginning point for all investing, in terms of literature. It shows the good, bad and ugly. Most of the information is like reading a boring novel with no story line. The first few pages show the ‘meat’ of the offering and the rest is required fluff. Marketing literature Marketing literature supports the information contained in the prospectus and is designed in a user friendly and easy to read fashion. It’s the sales piece, to get investors excited by showing colored charts and graphs and all the right reasons to invest. Realistically, investors can make fairly informed decisions from this material, notwithstanding the fact that the SEC requires the receipt of a prospectus prior to investing. Third party sources There are numerous third party sources of information about any mutual fund. If an investor can’t readily find information on a particular fund, then it’s probably not good enough to invest in. There are financial magazines such as Forbes, Barron’s, Wall Street Journal, Money, U.S. News & World Report, etc. There are mutual fund rating services that already perform many comparisons such as Morningstar, CDA/Weisenberger, Lipper Analytical, etc. The internet is the ultimate information source by providing a link to any of the sources mentioned above, the mutual fund’s own website, and much more. Mutual fund marketing team Each mutual fund family has a marketing department with trained individuals that can assist in answering any question except those that relate to the giving of investment advice. These folks cannot only clarify information already obtained but can make sure investors get the information they don’t have. Financial advisor Many financial advisors are trained and educated about mutual funds, especially if they hold a Series 6 or 7 securities license. A Series 6 license permits the selling of mutual funds and Series 7 adds stocks, bonds and options. The Series 7 license used to be known as a stockbroker’s license. Basis
of Comparison Many investors err in their basis of comparison, that is, they compare funds on an unequal playing field, for example, comparing and choosing between a growth fund and a balanced fund. It would also be fair to say that most investors can articulate what they want instead of how to achieve it. In other words, investors are more inclined to say they want to get a twenty percent return and principal guarantee instead of giving a well-defined investment objective to accomplish their goals. In light of this fact, their decisions are also based on that type of comparison – choosing an aggressive growth fund with a great three-year track record instead of a more suited hybrid fund with a steady ten-year track record. The following are a few techniques investors can use to make informed comparisons of mutual funds. Only when an investor uses several techniques will he be well informed. Investment Objective Chapter 4 discussed, in-depth, investment objectives. Before anything else is done in choosing the right investment, it only stands to reason that an investor must ‘find’ the right investment objective(s) that meets his profile. In that regard, it may take more than one investment objective to fulfill an investor’s goals, mainly because of multiple needs occurring at various times during the investor’s lifetime. Once an investment objective is chosen in order to meet a goal, an investor can proceed with comparing multiple mutual funds with that same investment objective. Performance Mutual fund performance is typically next on the comparison list. Many feel that this is the end of the search because from here everything else is a ‘no-brainer.’ The logic usually follows along these lines, “Since performance takes into consideration costs, sales charges, risk, style of management, etc., then there is no need to go beyond performance.” In a manner of speaking, this is true. However, other factors will give a clearer picture of how a mutual fund got its performance. These other factors may be significant under different market conditions; therefore, they should never be overlooked. Mutual funds also make money in different ways: interest, dividends, capital gains (losses) and capital appreciation (depreciation). Historically, interest and dividend income have been more consistent and predictable. For the most part, a mutual fund reports its performance as “total return” by taking into consideration the effects of interest, dividends, capital gains (losses) and capital appreciation (depreciation), thereby making an overall performance comparison easy. Most of the mutual funds in today’s market have not been “tried and tested” for multiple recessions and adverse market conditions. Of the 8,000+ mutual funds in existence today, less than 1 (one) percent are 30 (thirty) years old or older. In most comparisons, the average return over a certain time period is all that is looked at. Most mutual funds are not compared from how they performed during a market downturn or recession. Investors don’t get out of the market when things are going good and money is being made; they get out when their mutual funds don’t resist the downturns and fall like a rock. Mutual funds that perform great during bull markets may become a sour apple during bear markets. From this one factor alone, many investors who started out as long-term investors are no longer in the mutual fund market. Let’s use Fund A and Fund B. Both have identical investment objectives and an annualized 5-year performance of 10%. Fund A’s record has been +19, -4, +32, +14, -11. Fund B’s record has been +14, +1, +27, +9, -1. Since both funds have an identical 5-year track record, does it really make a difference which fund is chosen? Of course, it does! Remember, one must look beyond performance to see how it arrived at that performance. This takes us to our next comparison technique, risk. Risk The degree of risk, real or perceived, is in the eye of the beholder. Every investor understands risk based on his own experiences. What one investor may consider risky, another will not. For example, most people think that crude oil exploration or development is very risky and wouldn’t touch such a venture with a ten-foot pole. However, it’s just another day of doing business as usual for those who live in parts of Texas where the horizon is dotted with oilrigs. Once an investor jumps the perceived risk hurdle, he can then look at the real risk of investing in mutual funds, which are numerous, but we’ll only discuss a couple. From an investing viewpoint, risk has two definitions – informally, the chance of financial loss, and, more formally, the variability of an investment’s return. Generally, all investors are more concerned about the chance of financial loss than the variability of an investment’s return. If there were a greater than average chance for loss, most investors would not invest; however, they do expect some variability in their investments’ return. Of all the mutual funds on the market today, each has a chance of going broke, but the odds are infinitesimal. For the most part, investors comprehend informal risk, the chance of financial loss. Every mutual fund is subject to other risks, such as the variability of its return. Variability is measured by using a statistical formula called standard deviation, which measures the variation of an investment’s return around its average. This brings us back to Fund A and Fund B above. Even though both funds averaged 10% over a five-year period, the standard deviation was 15.61 and 10.08 for Fund A and Fund B, respectively. Now, armed with this knowledge, which fund should an investor pick? Fund B, of course. Why? Fund A is 55% more volatile than Fund B. Even though the end result was the same, it is obvious that Fund B was more efficient and consistent at arriving at its average return; Fund A was too upsy-downsy. Costs All of a mutual fund’s costs will be shown in its prospectus. Any cost takes away from the bottom line; however, an understanding of how costs affect one’s value is an additional asset. No load mutual funds don’t have upfront sales charges, so 100% of one’s investment goes to work immediately. Load funds have a sales charge, or front-end load (Class A shares), that takes a percent of the initial investment right off the top with the net result being invested. These loads only apply to any “new money” invested. Typical loads start from 4%-5.75% and go down as the size of the investment grows. Some of these costs are shown as a declining exiting charge, contingent deferred sales charge (Class B shares), if the fund is liquidated within a certain number of years. There are other types of charges, but these two make up the majority. Many investors perceive they should [only] consider the lowest sales charge or the complete avoidance thereof as in no load funds. For the short-term, this can probably be justified. However, for the long-term, which includes most mutual fund investors, this is not necessarily the case. The second type of cost, which is printed in the fund’s prospectus, is the expense ratio (ER) and should be included in the comparison. It includes all the various expenses of operating the fund and is based on a percentage of the fund’s assets. From an investor’s perspective, it is a percentage of his investment’s value. Assuming one’s investment grows, the cost grows in direct proportion. Let’s compare the significance of a sales charge and ER. If one invests $10,000 a year in a fund that charges 5% up front, the cost is $500 every year. For twenty years, the upfront sales charge would total $10,000 [break points are not included, which would lower the total]. Compared to a no-load fund with the same performance, this would be a no-brainer decision. Next, let’s consider the effects of the expense ratio using a national average of 1.25%. Again, if we compare the loaded fund with a no load and both having the same ER, then the decision would still be obvious. However, what if an investor found a loaded mutual fund with a lower ER. What would the results be? See Table 5-1.
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