|
|
|
|
|
|
|
|
|
|
 |
 |
 |
 |
 |
|
 |
 |
 |
|
 |
|
 |
|
 |
|
 |
|
 |
|
 |
|
 |
|
 |
|
 |
|
 |
|
 |
|
 |
|
 |
|
 |
|
 |
|
 |
|
 |
|
 |
|
 |
|
 |
| Print version |  |
|
How this Tutorial can Help You
The mutual fund has become a popular way to invest, partly because it is the primary investment vehicle of the 401(k) plan. The typical 401(k) plan offers its participants investment choices in several stock mutual funds. Millions of Americans participate in 401(k) plans, indicating the widespread determination to save for retirement. It has been my experience that these participants must solve by themselves for the most part the mystery of choosing the fund or funds that make the most sense for their retirement plan. If you are investing outside a 401(k) plan, you can find thousands of mutual funds from which to choose. The number of possibilities is enough to intimidate beginners and can be overwhelming for anyone who doesn't know where to begin. This tutorial will show you how to begin, and will help you narrow your search to a manageable number of funds. Mutual funds do not have to remain a mystery. They can be broken down into ingredients that can be explained and evaluated. In this tutorial rules of thumb are identified and applied to those ingredients. You will be introduced to various kinds of investing strategies, expert opinions about fund managers, and illuminating statistics regarding a variety of mutual funds. You will also learn the evaluating criteria and guidelines to use in choosing mutual funds. The glossary provides definitions for terms you need to know. In addition, you will be directed to other free professional resources that publish similar "Investing 101" tutorials for the independent investor.
First Steps in Choosing a Mutual Fund
There are several components of choosing an appropriate fund for your portfolio, even before you are ready to evaluate fund candidates. The following sections have exercises that are the first steps toward finding a fund that is suitable for you and your objectives. Identify your investor profile You will need to determine your time horizon, i.e. how long you will be investing. Establish a realistic amount of money you will be able to invest. And try to judge how aggressive your investment style should be. Ask yourself these questions:
Determine Your Investor Profile Worksheet A:
Investments most Suitable for your Profile
The answers you selected in Worksheet A are shown in blue wherever they appear in Worksheet B. The row(s) with the most highlighted cells across it will indicate the kind(s) of investments most suitable to your investor profile: stocks, mutual funds, cash/money market fund, or bonds. Worksheet B:
For example, if you selected "Self", "Medium",
"Mod. Growth", and "$2,000" in Worksheet A, and
then everywhere those words appear in Worksheet B, you will see that
the row for "Mutual Funds" has four highlights across, indicating
mutual funds are probably the most appropriate investment for you. Make
a Plan with Your Investing Goals and Timetable
What kind of returns do you expect from your investments and by when? Will you need any of your invested money in the near future? Once you've determined your investor profile, make some goals, such as "I will invest $5000 in a mutual fund (or two or three) now, and I hope it will be worth $6000 in one year, a 20% annual return. I will review this goal and reevaluate the fund(s) I have chosen in three months." You may want to revisit your investment plan more frequently, perhaps even monthly, when you start investing, until you feel comfortable with your game plan and confident in your growing knowledge about investing. For some investors the plan will be to accumulate enough money to invest. Many mutual funds have Automatic Investment Purchase (AIP) plans that make that wait unnecessary. With these plans shares of the fund can be bought with a smaller amount of money, sometimes as low as $50 or $75, as long as an automated purchase is made on a monthly or bi-monthly basis directly to the mutual fund company. Consider all of your investments Do you have an IRA, a 401k, stock options, or any other investments? How are they invested? All of these investments should be considered as parts of your total portfolio. Any mutual fund you purchase should complement, rather than duplicate, other investments you have. See the section on "Asset and sector allocation" for an in-depth discussion of breaking down and allocating your investments. Learn
the Basic Definitions of Mutual Fund Investing
Learn the meaning of mutual fund, stock, growth and value investing, blend fund, asset allocation, and other terms defined in this tutorial. If you understand the meaning of each term in the glossary at the end of this tutorial, you should feel comfortable reading analyses of funds and making decisions on their appropriateness for you. Identify mutual funds that are suitable for your profile The above steps should have guided you to an idea of what kind of fund(s) you would like to include in your portfolio. For example, are you only interested in conservative funds because your main objective is to not lose money? Or perhaps you realize that you would like a combination of styles, such as a conservative fund for one-fourth of your investing money, something moderate for half of it, and an aggressive fund for the other quarter. When you know the general style and strategy you are looking for, you can prepare a list of funds that meet these objectives and begin your research to select the best from among them. Table 2 provides a list of funds that can be used as a guide for narrowing your search for a mutual fund or funds that suit your investment style and objectives. It begins with growth funds, followed by blend funds, value funds, and balanced funds, generally in order from most risk to least risk. The list finishes with a fund based on the S&P 500 Index. These mutual funds meet the following criteria:
Table2.
Mutual Funds of Varying Styles
These funds have passed my screening criteria for funds I could recommend for the style(s) that best suit the investor. The five-year performance of the S&P 500 Index as of 12/31/02 was -.59%.
Go to www.morningstar.com and type in the five-letter symbol to view Morningstar's complete analysis of the fund. You can also click on their Funds tab and use their Fund Selector to create a list of funds that meet your criteria. Take
the Mystery Out of Mutual Funds
Much of the analysis of a fund is mathematical, and rules of thumb can be used to eliminate the dependence on guessing or dart board selection. The following sections discuss the criteria you should use to evaluate a fund, with some guidelines for interpreting and judging the information you find out about each. Analysis of the fund manager This step is sometimes the least conclusive, because the information you find is not so much statistical as subjective. You may have to rely largely on opinion from mutual fund experts, but there are certain objective data to consider also. Find out how long the manager has been with this fund. What has been the performance of the fund under this manager? What other experience does this manager have? Online sources are usually the best sources for data and opinions on fund managers, but business newspapers and magazines often write excellent, in-depth commentaries on them also. Smartmoney.com's Investing 101 lists "Know Your Manager" as one of the "7 Steps to Picking A Good Fund". They also make a good point about team-managed funds: "The great intangible in all fund investing is the fund manager. . . . With a team-managed fund, you may never know exactly who is making the key decisions regarding the portfolio. However, it can be reassuring to know that several people know the ropes at the fund, and continuity is practically guaranteed if a manager departs." In Morningstar.com's Investing Classroom, they compare fund managers to football coaches: "Like college football teams, mutual funds are only as good as the people behind them: the fund managers. Managers are the people who decide what to buy and what to sell, and when. Because the fund manager is the person who is most responsible for a fund's performance, knowing who's calling the shots and for how long is a key to smart mutual fund picking. . . . So if you're looking for new investments and find two equally good funds, choose the one with the more-experienced manager."
Strategy/objective/style
of the fund
Mutual funds are categorized by their objectives: aggressive growth, growth, growth and income, value, preservation of capital, index, international, global, bond, tax-exempt, blend, balanced, and hybrid are some examples. See the glossary for definitions of these most common objectives. You should choose a fund with the same objective as your investment objective. If your objective is growth, you must then decide how much risk suits you, in order to choose from various kinds of growth funds. If your objective is to include international exposure, you may want to consider a combination of mutual funds. The strategy of the fund manager should seem reasonable, based on your growing knowledge of investing principles. The fund manager's job is to create a portfolio that achieves the maximum return for a given level of risk. Morningstar describes fund manager Tom Marsico's strategy for his Marsico Focus (a growth fund): "Marsico's methods include macroeconomic plays as well as company-specific fundamental analysis. . . . (He) combines top-down analysis with bottom-up stock-picking. He fills the bulk of the portfolio with steady-growth stocks that he intends to hold for the long haul, but he has owned more-explosive growth names in the tech and telecom areas. He also reserves a portion of the portfolio for relatively inexpensive firms that stand to benefit from a catalyst. Marsico limits the portfolio to a small number of stocks, typically around 25." This kind of focused portfolio (only 20+ holdings) is typically higher risk, because poor performance of just a few holdings can have a huge negative impact on the fund's performance. Examples
of Mutual Fund Strategies
Here are some other examples of strategies, as described by Morningstar.com:
Risk
Risk refers to the possibilities for a fund to lose value. Identifying the risk associated with a particular mutual fund is not necessarily simple, because it involves analyses of the fund manager, the strategy, and each security the fund holds. Losing value is almost always a possibility, but you can quickly identify some red flags that increase the odds of losing value, such as a small number of holdings, a tendency to overweight one sector, international exposure. You can then weigh them against the attractive features of the fund.
Costs/expenses
of the fund
These facts are readily available from the fund or a rating service, and they are easy to compare. The expense ratio reflects the fund's efficiency of operation. This cost is "invisible" to the shareholder, as it is calculated into the Net Asset Value (N.A.V.) each day and never actually charged to the buyer of the fund. A load is a percentage fee that is paid to the fund and/or to the broker, either by reducing the dollar amount purchased or the proceeds of a sale. A front-end load fee, typically about 5%, is charged at the time of purchase. If you pay $5,000 to buy a fund with a 5% load, the $250 fee reduces the purchase amount to $4,750 worth of the fund. A "back-end" or deferred fee is charged when the fund is sold. If your proceeds from the sale are $10,000, and the fee is 5%, $500 will be kept by the fund, and you will receive $9,500 for the sale. A redemption fee is usually a smaller percentage and is charged if you sell a fund before the fund's required holding period has expired.
According to NAIC's (National Association of Investors Corporation's) Mutual Fund Resource Center, "While an investor in a load fund pays for a broker or financial planner's expertise via the sales charge, there is no guarantee that the load-fund will out-perform a similar no-load fund. In fact, a loaded fund would have to perform several percentage points better than the no-load fund to make up for the fact that the load-fund investor initially gets fewer fund shares. There is no proven correlation between high fees and high returns." Performance
Performance can be stated in a number of ways: year-to-date (YTD), one-year, three-years, five-years, etc. Most ratings also show the peer group average performance for comparison. See Table 3 for the breakdown of performances for the last five years for various fund styles. The S&P 500 (Large Cap) returned -2.39% for this period. Table 3. Five-Year Total Returns for Various Fund Styles (through 2/6/03)
Rule of Thumb: Look at long-term performance records for consistency. A spectacular one-year performance could be a fluke. The Motley Fool (www.fool.com) says in "A Fool's Guide to Mutual Funds", " … for your long-term success in investing in mutual funds: Buy an index fund." Their reason is historical performance: "Though you would think that mutual funds provide benefits to shareholders by hiring 'expert' stock pickers, the sad truth of the matter is that over time, the vast majority -- approximately 80% -- of mutual funds underperform the average return of the stock market … . Why the underperformance? … Quite simply, the majority of mutual funds fall short because of the fees they charge you to be a shareholder."
Asset and sector allocation
Overall asset allocation refers to the ratio of equities to fixed income securities (debt) and cash. Rule of Thumb: During a healthy economy, strategists typically recommend an asset allocation of 65%-70% equities and 30%-35% bonds and cash. When the economy is weak, the equity weighting is reduced usually by 5%-10%. Within the equity portion of a portfolio the allocation among industry sectors should be monitored and adjusted to be in sync with your objective. The technology, healthcare, and financial sectors have historically provided more growth than the other sectors, which is why they have had larger allocations in growth funds. Since the outlook for most of technology has been negative the last couple years, and it is expected to continue to be negative, growth funds should have made appropriate adjustments in their portfolio allocation. To determine the industry allocation of a mutual fund, identify the stocks held by the mutual fund, the industries they represent, and the proportions in each industry sector. You can compare this allocation to your ideal allocation. The industry sector allocation of the S&P 500 Index (as of 12/31/02), as shown in Table 4, can be used as a model for equities in your portfolio. Table 5 proposes allocations for an aggressive growth portfolio and a less aggressive growth portfolio.
Sources
for data on funds
There are a number of free online mutual fund rating services that also give analyses of funds. Morningstar.com provides "Snapshots" for free, which provide details on fund performance history, fees, and asset and sector allocation. This site and others will usually show the top holdings in the fund and give a brief opinion about the fund managers and their strategies. In-depth analyses are available to paying subscribers on Morningstar. They feature commentary on profitability, valuation, growth and financial health of individual companies, as well as valuable insight into strategies of mutual fund managers. Other free online sources are maxfunds.com, smartmoney.com, money.com, and fool.com. Each of these has Investing 101 departments that feature mutual funds. Most of these sites have a version of a fund-finder, an interactive program that responds to parameters you choose with a list of funds that meet your criteria. For example, you might choose a) growth fund, b) same manager for at least three years, c) has out-performed the S&P 500 Index for at least three years, and d) expense ratio under 2%. The fund-finder will pull up a list of funds meeting these requirements for you to research further. Money.com's Find-a-Fund is the simplest to use. Timing
the Market
Awareness of the health of the economy can be helpful in timing when to buy and sell investments. Generally, a healthy economy and a healthy stock market coincide, but their turning points may not, and not all sectors move in tandem with each other. Learning to recognize patterns and signals of imminent turning points in sectors, in the market, and in the economy is the best chance at successfully timing the market. Rule of Thumb: It is difficult to consistently time the market successfully. An alternative to trying to time the market is doing research to find the best quality investments that are appropriate for your investor profile. Then buy and hold these quality securities for the long-term, if their quality and your objectives do not change. There is another timing consideration with regard to mutual funds. Each December mutual funds distribute their capital gains and dividends for the year. All shareholders receive these distributions, which can be in cash or in more shares of the fund, as long as they own the fund by the date of the distribution. Some people prefer to wait until after this date to purchase funds, because they do not want to pay taxes on these capital gains and dividends. Taxes
and Mutual Funds
Taxes on mutual funds are a little tricky. Detailed tax information can be found online. The best and most thorough guide I know is fairmark.com, a plain language tax guide for investors. Shareholders are taxed on the distributions paid by the fund in December. The dividend distributions are straightforward in that they are simply taxed as ordinary income for the year in which they are received, whether the dividends are received in cash or are automatically reinvested into more shares of the fund. One of the tricky parts is that a fund's short-term capital gains are also passed onto the shareholder as ordinary dividends and must be treated as dividends. They cannot be used to offset capital losses. The capital gains the fund passes on to its shareholders are taxed as long-term gains, meaning they are the result of the fund owning the securities more than one year when they sold them. Shareholders are taxed on a long-term capital gain, even if they just bought the mutual fund a month earlier. The mutual fund company sends a Form 1099 to each shareholder; the 1099 identifies how much of the distributions paid to the shareholder were for dividends or long-term capital gains. Short-term gains and ordinary dividends are taxed as ordinary income, i.e. at whatever your income tax bracket is. Long-term gains are taxed at 20% for most shareholders under current tax laws. Shareholders will also realize a capital gain or loss when they sell the mutual fund, and this gain will also be taxed as long-term or short-term, depending on how long the fund was owned by the shareholder. Here's another tricky part. How do you calculate your gain or loss if you have been reinvesting dividends over a period of time? Your cost basis increases by the value of each reinvested dividend, so you'll want to keep thorough and accurate records of the dividends. Keep in mind that income and capital gains received from mutual funds in retirement accounts, such as IRAs and 401(k)s, are not taxed until distributions are made from the account. Putting
It All Together to Make Choices
You can now begin your research to find the best mutual funds for your portfolio. But first, here are a couple examples of typical investors on the same quest and the results of their efforts. Example investor A Potential investor A determines her investor profile by completing Worksheet A. She answers that she wants to be involved in investment decisions for her portfolio. Her time horizon is at least 15 years, so she feels she can be slightly aggressive; she answers "Long" and both "Agg. Growth" and "Mod. Gr." Since she already has $3,500 to invest, her answer is "2-10K". In Worksheet B "Self", "Long", "Agg. Growth", "Mod. Gr.", and "2-10K" are highlighted wherever they appear. Highlights all across the top two rows indicate that both stocks and mutual funds would be suitable for her. Next she researches the first three funds in the list beginning on page 7, since they are growth funds. Using an online fund-finder and the screening criteria that seemed most important to her, she compiled a list of five more funds that seemed attractive to her, based on their objectives and the fund managers' styles. She examined the industry allocation for each of the eight funds and found that some of them owned more than 30% technology stocks, and none of them really had adequate allocations in all of the other sectors. Since she also has an IRA with a few thousand dollars and a 401(k) that offers a variety of mutual funds, she decides to:
Example
investor B
B's worksheet results pointed to mutual funds as appropriate for his $3,000 and conservative, long-term profile. He followed the same steps as Investor A, but he focused on the more conservative value funds on the list and from online sites. Since he has no other investments and prefers a professionally managed portfolio, he will rely on the mutual funds he chooses for sector allocation. He decides to:
When you go through the same steps as our example investors, you should be able to identify your investor profile, goals, and investing strategy. With that in mind, and some research of suitable funds, you will be on your way to choosing mutual funds that make sense for you. Glossary Contrarian - an investor who does the opposite
of what most investors are doing, including buying stocks that are
hated and/or selling stocks that are loved. If everyone loves a stock,
everyone already owns it, so it can only go down. |
|||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
