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Many Mutual Funds
Many Mutual Funds
It's
a mutual fund jungle out there
All About
Mutual's
What exactly is a mutual fund?
A mutual fund
pools money from hundreds and thousands of investors to
construct a portfolio of stocks, bonds, real estate, or other
securities, according to its charter. Each investor in the fund gets a
slice of the total pie.
Mutual
funds make it easy to diversify.
Most funds
require a minimum investment of only a few thousand dollars,
enabling investors to construct a diversified portfolio much more
cheaply than they could on their own.
There are
many kinds of stock funds.
The number of
categories is dizzying. Some examples: growth funds,
which buy shares of burgeoning companies; sector funds, which buy
shares of companies in a particular sector, such as technology or
healthcare; and index funds, which buy shares of every stock in a
particular index, such as the S&P 500.
Bond funds
come in many different flavors too.
There are bond
funds for every taste. If you want safe investments,
consider government bond funds; if you're willing to gamble on high
risk investments, try high-yield (aka junk) bond funds; and if you want
to keep down your tax bill, try municipal bond funds.
Returns aren't everything,
also consider the risk taken
to achieve those returns.
Before buying a
fund, look at how risky its investments are. Can you
tolerate big market swings for a shot at higher returns? If not, stick
with low-risk funds. To assess risk level, check these three factors:
the fund's biggest quarterly loss, which will help you brace for the
worst; beta, which measures a fund's volatility against the S&P
500; and standard deviation, which shows how much a fund bounces around
its average returns.
Low
expenses are crucial.
In order to
cover their expenses and to make a profit funds charge a
percentage of total assets. At no more than a few percentage points,
expenses may not sound substantial, but they create a serious drag on
performance.
Taxes take
a big bite out of performance.
Even if you
don't sell your fund shares, you could still end up stuck
with a big tax bite. If a fund owns dividend-paying stocks, or if a
fund manager sells some big winners, shareholders will owe their share
of Uncle Sam's bill. Tax-efficient funds avoid rapid trading (and high
short-term capital gains taxes) and match winning trades with losing
trades.
Don't chase winners.
Funds that rank
very highly over one period rarely finish on top in
later ones. When choosing a fund, look for consistent long-term results
and low operating expenses.
Index funds
should be a core component of your portfolio.
Index funds
track the performance of market benchmarks, such as the
S&P 500. Such "passive" funds offer a number of advantages over
"active" funds: Index funds tend to charge lower expenses and be more
tax efficient, and there's no risk the fund manager will make sudden
changes that throw off your portfolio's allocation.
Don't be
too quick to dump a fund.
Any fund can and
probably will have an off year. Though you may be
tempted to sell a losing fund, first check to see whether it has
trailed comparable funds for more than two years. If it hasn't, sit
tight. But if earnings have been consistently below par, it may be time
to move on.
What is a mutual fund?
A
mutual fund pools money together from thousands of small-time investors
and then its manager buys stocks, bonds, or other securities with it.
When you contribute money to a fund, you get a stake in all its
investments. That's a big deal: Since most funds allow you to begin
investing with as little as a couple thousand dollars, you can attain a
diversified portfolio for much less than you could buying individual
stocks and bonds. Plus, you don't have to worry about keeping track of
dozens of holdings -- that's the fund manager's job.
The price for a share of a fund is determined by the net asset value,
or NAV, which is the total value of the securities the fund owns
divided by the number of shares outstanding. If a mutual fund has a
portfolio of stocks and bonds worth $10 million and there are a million
shares, the NAV would be $10. A fund's NAV changes every day, depending
on the price fluctuations of the fund's holdings.
The NAV is the price at which you can buy and sell shares, as long as
you don't have to pay a sales commission, or "load." If you're buying
directly from a fund company such as Fidelity or T. Rowe Price, you
don't have to worry, loads come up only when you buy from a broker,
financial planner, insurance agent, or other adviser.
The different types of
stock funds
When
searching for stock mutual funds, you're going to run into all sorts of
names and categories. They are usually pretty broad, and funds don't
always live up to their names -- but at least they give you an idea of
what you are getting yourself into. Here are some of the most common
categories and sub-categories.
Value funds
Value fund managers look for stocks that they think are cheap on the
basis of earnings power (which means they often have low price/earnings
ratios) or the value of their underlying assets (which means they often
have relatively low price/book ratios).
Large-cap value managers typically look for big
battered behemoths whose shares are selling at discounted prices. Often
these managers have to hang on for a long time before their picks pan
out.
Small-cap value managers typically bottom-fish for
small companies (usually ones with market value of less than $1
billion) that have been shunned or beaten down by other investors.
Growth funds
There are many different breeds of growth funds. Some growth fund
managers are content to buy shares in companies with mildly
above-average revenue and earnings growth, while others, shooting for
monster returns, try to catch the fastest growers before they crash.
Aggressive growth fund managers are like drag-car
racers who keep the pedal to the metal while taking on some sizeable
risk. The result: These funds often lead the pack over long periods of
time -- as well as over short periods when the stock market is booming
-- but they also have some crack-ups along the way. Consider them only
if you can afford to put away your money for at least five years and if
you won't bail out when faced with downdrafts of 20 percent or more.
Growth funds also invest in shares of rapidly
growing companies, but lean more toward large established names. Plus,
growth managers are often willing to play it safe with cash. As a
result, growth funds won't zoom as high in bull markets as their
aggressive cousins, but they hold up a bit better when the market heads
south. Consider them if you're seeking high long-term returns and can
tolerate the normal ups and downs of the stock market. For most
long-term investors, a growth fund should be the core holding around
which the rest of their portfolio is built.
Small company funds
Funds within the small-company category can differ dramatically. At the
T. Rowe Price New Horizons fund, for example, the manager snaps up
shares of small and midsize companies with zooming profits. Meanwhile,
the manager of the T. Rowe Price Small-Cap Value fund is more likely to
pass on such highfliers and instead, fills his portfolio with shares of
very small companies that are trading at rock-bottom valuations.
Growth and income funds, Equity income funds, Balanced
funds
These three types of funds have a common goal: Providing steady
long-term growth while simultaneously throwing off reliable income.
They all hold some combination of dividend-paying stocks and
income-producing securities, such as bonds or convertible securities
(bonds or special types of stocks that pay interest but can also be
converted into the company's regular shares).
Growth and income funds concentrate more than the other two on growth,
so they generally have the lowest yields. Balanced funds strive to keep
anywhere from 50 to 60 percent of their holdings in stocks and the rest
in interest-paying securities such as bonds and convertibles, giving
them the highest yields. In the middle is the equity-income class. All
three types hold up better than growth funds when the market turns
sour, but lag in a raging bull market.
All of these are for risk-averse investors and anyone seeking current
income without forgoing the potential for capital growth.
Specialty and other types of funds
Rather than diversifying their holdings, sector and specialty funds
concentrate their assets in a particular sector, such as technology or
health care. There's nothing wrong with that approach, as long as you
remember that one year's top sector could crash the following year.
The different types of
bond funds
U.S.
government bond funds
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These funds invest primarily in bonds issued by the U.S. Treasury or
federal government agencies, which means you don't have to worry about
credit risk. But because of their higher level of safety, however,
their yields and total returns tend to be slightly lower than those of
other bond funds.
That's not to
say government bonds funds don't fluctuate, they do, right
along with interest rates. |
If you
can't tolerate swings of more than a few percentage points, stick to
short-term government bond funds.
If fluctuations of five percent or so don't cause you to break
out in a cold sweat, then you can pick up a bit more yield with
intermediate government bond funds. If you plan on holding on for
several years and can handle 10 percent swings, long-term government
bond funds will provide even more yield.
Corporate bond funds
Funds in this category buy the bonds issued by corporations that may
range from well-known household names to relatively obscure widget
makers most of us have never heard of. When researching corporate bonds
funds, consider the credit quality of the individual bonds they hold
(most hold highly rated bonds, AAA to BBB, but some take more risk by
adding small doses of high-yielding junk bonds.) Also consider the
average maturity of the bonds, the longer the average maturity, the
greater the volatility.
High-yield bond funds
Let's spare the euphemisms. These are junk bond funds. They invest in
debt of fledgling or small firms whose staying power is untested as
well as in the bonds of large, well known companies in weakened
financial condition. The potential that these companies will default on
their interest payments is much higher than on higher quality bonds,
but since these funds usually hold more than 100 issues, a default here
and there won't capsize the fund.
There is more risk, however, and for that, you get higher yields,
usually three to 10 percentage points more than safer bond funds. These
funds tend to shine when the economy is on a roll, and suffer when the
economy is fading (increasing the chance of default).
Who should buy them: Investors who want to boost
their income and total returns and can tolerate losses of 10 percent or
so during periods of economic turbulence.
Municipal bond funds
Tax-exempt bond funds, also known as muni bond funds, invest in the
bonds issued by cities, states, and other local government entities. As
a result, they generate dividends that are free from federal income
taxes. The income from muni bond funds that invest only in the issues
of a single state is also exempt from state and local taxes for
resident shareholders. Once you factor in the tax benefits, muni funds
often offer better yields than government and corporate funds.
Choosing stock funds
(mutual funds)
Opt
for low expenses
Fund expenses directly reduce your returns, so you'll increase your
odds of success by avoiding funds with bloated expense ratios; that's
the annual cost, divided by your investment.
Look for consistency
For a fund to fit into a diversified portfolio, it's important that the
manager stick to a particular investing style. If you bought a fund
because you want your portfolio to include, say, small value stocks,
then you don't want a fund manager jumping into large growth.
Consider risk
Returns may vary, but funds that are risky tend to stay risky. So be
sure to check out the route the fund took to rack up past gains and
decide whether you would be comfortable with such a ride. Here are some
risk measures to consider.
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Beta measures how much a fund's
value jumps around in relation to changes in the value of the S&P
500, which by definition has a beta of 1.0. A stock fund with a beta of
1.20 is 20 percent more volatile than the S&P, ie. for every move
in the S&P, the fund will move 20 percent more in either direction.
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Standard deviation tells you how
much a fund fluctuates from its own average returns. A standard
deviation of 10 means the fund's monthly returns usually fall within 10
percentage points of their average. The higher the standard deviation,
the more volatile the fund.
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Worst quarter This is a very
straightforward measure of risk: It merely shows the fund's worst
quarterly return on record, giving you a feel of what to brace yourself
for.
Check out past performance
relative to peers
When examining a fund's performance, you should look at its long-term
record (at least three years and preferably 5) versus that of its
peers, as well as how it has fared over shorter stretches. And you
should compare those results to category averages -- you can't really
fault a small-cap fund manager for a lousy year if all small-cap funds
did poorly. But it's a lot harder to be forgiving if a fund does much
worse than all its peers.
Seek low taxes
You can't forget about taxes just
because you don't have any intention
of selling your fund shares. As a fund owner, you also own all the
stocks in the fund's portfolio. If the fund manager sells a stock for a
huge capital gain, you'll have to report that gain on your tax return.
Steer clear of asset bloat
This is more of an issue with
small-cap funds than with large-cap
funds. Since the latter buy big stocks with a lot of shares
outstanding, the manager shouldn't have too much of a problem buying
more GE and IBM as investors pour money into the fund. But since
small-cap funds are buying stocks with very few shares outstanding, an
extra billion or two in total assets can tie the manager's hands. To
put the additional money to work, the small-cap fund manager may have
to drop his standards.
Choosing bond mutual
funds
Think low expenses
The single most important thing
you can do to earn competitive returns
in a bond fund is to opt for those with low expenses. As a general
rule, bond index funds will have lower expense ratios than managed
funds that invest in, say, munis and junk. With the latter, at least
stick with below-average expenses. Among the fund companies that keep
expenses in the moderate to low range are Vanguard, T. Rowe Price,
USAA, and American Century-Benham.
Stick with short to intermediate maturities
Over the past 20 years or so,
long-term bond funds have provided the
highest returns. But that may not always be the case. What's more,
long-term bond funds can be surprisingly volatile. If interest rates
rise just one percentage point, a long-term bond fund can drop 10
percent or more, wiping out more than a year's interest. That may be
fine if you're a long-term investor and you don't mind such setbacks.
But if you're investing for
shorter periods (10 years or less), or if
you're using bond funds to add some ballast to a predominantly stock
portfolio, then you're better off with bond funds with short- to
intermediate-term maturities about five to 10 years. You can typically
get 75 to 80 percent of the return of long-term funds, while incurring
roughly 40 percent less volatility.
Beware tempting yields
Fund companies know that
investors home in on yields. So some do
everything they can short of putting the fund on steroids to pump up
yields. They may throw some low-grade bonds into a government
portfolio, or even throw in foreign bonds from countries where rates
are especially high.
These ploys to boost interest may or may not pay off, but they all
involve risks that are difficult to evaluate. If you see a bond fund
that's touting much higher yields than funds with similar maturities
and the fund doesn't have ultra-low expenses, then BE CARE!
The index funds (mutual
funds)
With
the best business schools in
the country churning out a steady supply of expensively educated MBAs
who go to work for fund companies, you'd think funds would have no
trouble posting above-average returns. After all, fund shareholders
(that's you) are paying fund managers big bucks to find the best stocks
in the market.
But the fact is, the majority of funds don't beat the market in most
years. That is, you're better off mindlessly buying all the stocks in
the Standard & Poor's 500 index or in the Wilshire 5000 index
(which includes just about every stock on the New York, American and
Nasdaq stock exchanges) than paying someone to select what he thinks
are the best ones.
There are several reasons so many funds fall short. First, factor in
investing costs that fund companies incur the cost of research,
administration, managers' salaries and so on. That cost is borne by the
shareholders and gets deducted from returns. A fund manager needs to
pick a lot of great stocks to make up for those costs. Index funds,
meanwhile, are much lower maintenance, and tend to have much lower
costs.
There are some caveats. Indexing seems to work better in some areas
than others. The case is most solid for large U.S. stocks and bonds,
largely because there is so much information on these big securities
that it is tough for a fund manager to gain an edge.
Active managers of small-cap funds have traditionally fared better
against their index, the Russell 2000.
Time to dump your fund
and move on
Your fund is always on the
losing side!
The mere fact that a fund has low
returns or even losses isn't a good
reason to sell. If the overall market is down, or the specific sector
your fund invests in is out of favor, you can't expect your fund
manager to be a miracle worker. But if you own a fund that trails
similar funds for two years by a substantial margin (two percentage
points or more), then I'd think about moving on.
It’s investment strategy has changed
If you've attempted to create a
diversified portfolio, then you're
probably counting on the managers of all your funds to invest a certain
way. The small-cap fund manager should be sticking to small-cap stocks,
and the large-cap value fund manager should be buying large-cap value
stocks. If they stray, it puts your entire plan into jeopardy.
A manager has taken over
In today's fund world, many
managers job-hop as often as NBA coaches.
Anytime your fund gets a new skipper, you should closely monitor the
situation to assure two things: first, that the new manager is
following the same investing style and strategy as his predecessor;
second, that performance hasn't suffered. Give a new manager one year
(and no more than two) to prove himself.
Do you need a tax loss
There are times when you might be
able to lower your tax bill by
dumping a losing fund yet still pretty much maintain your asset mix.
For example, say you own shares in a large-cap growth fund that are
worth less than you paid for them. If you sell, you can use the loss to
offset gains in other securities. Then, you can turn right around and
buy another large-cap growth fund. Or, you can buy back the very same
fund after 31 days.
Now that you have the basics,
time has come to take that first step in buliding your very own
portfolio.
Many Mutual Funds
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