Everything You Ever Wanted to Know About Mutual Funds
A mutual fund is a collection of stocks, bonds and/or other securities managed by investment professionals. You may think that mutual funds (and, therefore, your investments in mutual funds) are managed by professionals who are experts at selecting securities. But, the sad truth is that, over time, about 80% of mutual funds underperform the stock market’s returns.
In this article, we’ll first convey some general information regarding mutual funds, then we’ll talk about the reasons for the under-performance, and the lack of adequate disclosure to investors by many of those who sell the funds.
Fund Categories
Mutual funds come in a variety of types and sizes. They may be closed-end funds or open-end funds. Closed-end funds comprise only a small fraction of the mutual fund universe. They have only a limited number of shares available for trading. Like stocks, these funds trade on an exchange or over the counter. The typical mutual fund is an open-end fund, offering as many shares as investors are willing to buy. Open-end fund shares are not traded in any market. But every open-end fund is required to buy back your shares on request. The following are the main categories:
Bond Funds
Bond mutual funds invest in bonds issued by companies or by governments. If you buy a bond, you are loaning money to the issuer, and will usually collect regular interest payments until the principal is returned. The interest rate is usually fixed at a set percentage of the amount loaned. That’s why bonds are called fixed income investments.
General Equity (Stock) Funds
Stock or equity mutual funds invest in stock. Shares of stock represent part ownership, or equity, in corporations. The goal is increase in value over time. These securities are sometimes categorized, in three different classes, by their market capitalization small cap, medium cap, and large cap. Many mutual funds invest primarily (or only) in companies of one of these sizes and are so classified.
Balanced Funds
Balanced funds mix stocks and bonds. For example, a balanced fund might hold 50-65% of your money in stocks and the balance in bonds.
International and Global Funds
International funds invest in companies headquartered outside of the United States. Global funds invest in U.S. companies and in companies based elsewhere.
Precious Metals Funds
Precious Metals Funds may invest in bullion, but chiefly trade mining stocks.
Sector Funds
Sector funds invest in one particular industry, or sector of the economy (e.g., technology, energy, financial, electronics, automotive, etc.), and may be extremely volatile.
Index Funds
Stock index funds seek to match the returns of a specified stock index (such as the Standard & Poor 500 Stock Index or the Dow Jones Industrial Average), by buying representative amounts of each stock in the index. Index funds do not try to beat the market, they simply seek to come as close as possible to equaling it. (Much of the discussion that follows does not apply to index funds, or if it does, to a much lesser extent. For example, expenses and turnover rations (see below) are generally much lower in Index Funds than in the others.)
Different Funds Have Different Goals
- Aggressive growth funds invest in common stock of fledgling companies and industries, out-of-favor companies and industries.
- Growth funds invest in common stock of mature companies and industries.
- Growth and income funds invest in companies with solid track records of consistent dividend payments.
- Fixed income and equity income funds both invest in high-yielding stocks and bonds.
- Option income funds invest in dividend paying common stock on which call options are traded.
- General money market funds invest in short-term debt securities.
- U.S. Government money market funds invest in treasury and agency issues.
- Balanced funds invest in a mixture of bonds, preferred stock and common stock.
- Tax-free money market funds invest in short-term municipal notes and bonds.
- Municipal bond funds invest in bonds exempt from state, local and federal taxes.
Fees, Expenses, Taxes and Confusion
Mutual funds charge fees. Fees and other expenses come off the top. But they are charged in a highly confusing manner, and without adequate disclosure. Moreover, track records (i.e., historic returns) are often presented without subtraction of fees or of expenses.
Loads
Loads, No-Loads, Back-End Loads, and Level Loads. Hold Onto Your Wallet, Here We Go!
"Loads" are sales charges. Regardless of the category, mutual funds that have sales charges are called load funds. Funds that do not have sales charges are called no-load funds. In most cases, when a broker recommends a mutual fund, there is a load. The typical maximum load is 6% of your investment in the mutual fund. The load, or sales charge, goes to the broker and/or to others involved in selling the fund to the investor.
Funds with loads must be more rewarding than no-load funds – right? No, wrong! According to Morningstar (the prominent mutual fund analyst), no-load funds have had better returns than load funds over the last three-year and five-year periods (even if the load is excluded from the calculations). The fact of the matter is that mutual funds which impose no cost to purchase have outperformed those that pay (with your investment dollars) your broker to sell you the fund.
You should almost never buy a mutual fund that has a sales charge.
Loads may have either a front-end load, a back-end load, or a level load.
Front-end Loads: Where the sales charge is in the form of a front-end load, the day that you buy the mutual fund, you pay a sales charge, which ranges from 3% to 8.5%. Simple. You immediately lose a big chunk of your investment. Shares in a front-end loaded fund may be called Class A Shares.
Back-end Loads or Contingent Deferred Sales Loads (CDSLs): These sales charges are a little trickier than the up-front charges described above. A CDSL is a full sales load that is charged over time. Instead of imposing a fee up front, a fund with a back-end load (also known as a CDSL) will impose an exit fee which declines over time. For example, instead of imposing a 5% up-front sales charge, the fund may impose an exit (or redemption) fee of 5% if an investor withdraws from the fund in the first year, 4% in the second year, 3% in the third year and so on. Shares in a back-end loaded fund may be called Class B Shares. These funds may also charge a distribution (or marketing) fee, ranging from 0.5% to 1.0% of the fund’s assets, annually. These marketing fees are called 12b-1 fees (so named because the fees are permitted under SEC Rule 270.12b-1 promulgated under the federal Investment Company Act of 1940).
Level Loads: Funds with level loads charge 12b-1 distribution fees, usually 1%, every year you own the fund. Shares in a level load fund may be called Class C Shares.
Expenses and Expense Ratios
In addition to the costs of buying a fund, there are costs of owning shares in a mutual fund. And that’s true whether it’s a load fund or a no-load fund. The mutual fund industry refers to these costs as expense ratios. Equity fund expense ratios average 1.5% annually and range from 0.2% to 2.2% or more. Balanced funds today carry average expenses of 1.4%. Bond funds range from 0.2% to 1.5% or more.
The typical expense ratio is about 1.5% of the fund’s assets. The expense ratio represents the percentage of the fund’s assets that go toward the expense of running the fund. The expense ratio includes investment advisory fees, 12b-1 distribution fees, administrative expenses, and other operating expenses. Investment advisory fees are paid to the managers of a mutual fund. These fees, on average, range from 0.5% to 1% annually of the fund’s assets. Administrative costs, which generally from 0.2% to 0.4% of the fund’s assets are the costs of record keeping, customer service, etc. 12b-1 fees range from 0.25% to 1.0% of the fund’s assets; and is used for marketing, distribution, and advertising.
Add up the expense ratio of the average equity mutual fund (1.5%), plus the minimum average transactions costs (0.5%), and the cost of a no-load mutual fund is at least 2% per year.
Taxes
Mutual funds are not tax-paying entities, and are typically managed with utter disregard for tax considerations of significance to their shareholders. Mutual funds report their annual results as if taxes did not exist, and distribute taxable gains, and the tax burden, to their shareholders. Yes, it is you, the investor, who pays the taxes on your mutual fund’s income dividends and on any capital gains distributions. Nevertheless, a mutual fund’s portfolio manager’s performance is measured on the basis of pretax returns and, therefore, few portfolio managers concern themselves with the tax consequences of their decisions and actions. Although it might be in the investor’s best interests to buy and hold stocks that are appreciating in value, thereby allowing equity to grow and compound while deferring taxes, the fund’s portfolio manager is encouraged to sell, take the profit (and the applause from the performance), and to ignore the enormous value of deferring capital gains taxes. (A tax that is deferred is the functional equivalent of an interest-free loan from the U.S. Treasury.)
Active trading (rather than investing for the long term) results in high turnover rates. Mutual fund portfolio turnover rates average nearly 90%. Many funds have turnover ratios of more than 100%, meaning their average holding period for a stock is less than one year. (Turnover is the gross proceeds from all sales divided by the total assets in the mutual fund.) Such active trading means higher costs through commissions and spreads, and sharply reduced returns for the fund’s shareholders. Moreover, high turnover is often accompanied by gains that are short term (less than one year) and are taxed at ordinary income tax rates. In recent years, about 30% of fund gains have been short term.
Mutual fund distributions are generally made in November or December. Avoid the tax by buying after the distribution is made.
Summing it All UP
Before you invest in a mutual fund, as painful as it might be, read the prospectus. The prospectus will provide most of the information you need. (Most likely, the broker or salesperson will not.) In particular, look at the sections of the prospectus that talk about fees, expenses, risks, objectives, and taxes.
- Almost never buy a fund with a load.
- Look for a fund with a relatively low expense ratio.
- Look for a fund that has a turnover rate of 50% or less.
- Index funds are generally the funds of choice.
- If you are choosing a mutual fund outside of an IRA (or other tax deferred plan), pick one that is tax friendly.
|
