The 1,000 Word Mutual Fund Primer

I was retained by the trade group, Regional Investment Bankers Association (RIBA), to produce a series of articles about the basics of investing. The articles were written for retail investors who were beginners, and they were published under the by-line of (RIBA) members in their local news and business publication. The program was a successful tool for business development for members, publicity generation for the group and its' members, and finally as an education tool to bolster RIBA's non-profit status. The article below is the sixth in the series and offers an overview of mutual fund investing. Such a series, if written today, would need to include a separate article on exchange traded funds, which offer many compelling benefits over mutual funds.

Privately Published, Spring, 1995

Mutual funds are now Americazzs most popular way to invest. Their rise has been truly dramatic, with mutual fund companies now rivaling banks and insurance companies in size and stature. Pretty good, when you consider that bankers and insurers had a 300 year lead.

For the record, a mutual fund is a portfolio of stocks, bonds or other securities that are owned by a group of investors, and which are managed by a professional money manager. This rather straightforward arrangement yields tremendous benefits for investors.

Perhaps one of the most important is diversification. While itzzs not uncommon for a fund to have 100 or more stocks or bonds in it, it would be extremely rare for an individual to achieve that level of diversification. And in addition, mutual funds offer professional management. Mutual fund companies hire the best, brightest, and most experienced talent on the street. While individuals can do well on their own, professional managers bring skills to the table about managing in all kinds of markets, and can generate gains even when market conditions are poor. Another benefit of mutual funds are liquidity. Shares of mutual funds can be redeemed (sold) at any time, something that cannot always be said for individual stocks and bonds. Finally, mutual funds offer flexibility. Itzzs easy to transfer from one fund to another within a family, or even transfer funds between families of mutual funds.

But, if mutual funds are so good though, why would anyone ever want to switch in or out of them? One reason is that like stocks, sometimes investors change their opinion about prospects for one fund versus another. Another, much more likely reason is that needs change. Over time an investor will find that instead of growing their nest egg, they may need to start drawing income.

And here is the great divide that can help investors sort through and understand the many kinds of mutual funds that are offered. Investors need not be confused by the steadily increasing kinds of mutual funds coming onto the market. Fundamentally, there are only two types of mutual funds: growth or income All the other kinds of names are just variations on one of these two basic themes. So, the reasoning goes, if you are trying to make your money grow, you buy growth funds which consist of stocks. In you need income, you buy income funds, which consist of bonds, or other fixed income instruments.

The decision that the investor has to make is the level of growth or income they are seeking, and the level of risk they are willing to shoulder in pursuit of that objective. For the investor seeking substantial gains and can weather some risk, so called aggressive growth funds might be appropriate. For the risk adverse investor seeking growth, a blue chip growth fund may be more appropriate.

The same holds true with income funds. Sometimes a fund will hold high yield bonds, also known as junk bonds. These bonds, and hence the funds, will yield higher levels of interest than fund holding government, but at the price of increased risk.

Selection is Key
Selecting the right mutual funds, like stocks, requires some research. One popular mutual fund rating guide is Morningstar, Inc. (212-696-6000). But because this resource might be too expensive for some investors, you can also check the annual mutual fund rankings published by Forbes (212-620-2200), the quarterly rankings published by Barronzzs (212-416-2000), or the annual mutual fund survey found in BusinessWeek (212-512-2000).

The key to selecting the right fund is to identify those whose performance (i.e., return to investors) measured over a three, five or 10 year performance was in the top 50% for funds in that category. (The resource guides mentioned above will offer average performance rankings for each mutual fund category, such as growth, income, growth and income, aggressive growth, etc.) This will eliminate 90% of the funds on the market from consideration. By looking at longer track records, investors will avoid getting caught up in the herd mentality of buying funds that have had a tremendous performance — but only for a quarter or two.

But investors canzzt stop after one pass through the performance rankings. There are several important qualitative aspects as well.

Quality Issues
At the most basic level, investors must select from among the top-ranked funds those which match their objectives. Itzzs no good buying aggressive growth stock funds when in fact you are seeking a conservative capital appreciation strategy.

Management is another key consideration. For instance, does the period of time the portfolio manager has been with the fund match the period of time for which a superior performance has been generated? If a fund has a superior ranking for the last 10 years, but the current portfolio manager has only been in charge for a year, he or she has had little to do with past success. Youzzve got to wonder whether or not the fund will keep the same momentum with someone new calling the shots.

And then there is avoiding what is called the cumulative performance trap. Two funds that have a very similar total return for a certain period of time may have gotten there by very different routes. For instance, after three years fund A and fund B may have each returned a total of approximately 60% to investors. But fund A did it by returning 20% per year for three years, while fund B gained 75% the first year, lost 30% the second, and gained 15% in the third. Obviously fund B is much riskier, and for the investors that got in during year two because the fund was so highly touted the year before, the situation could be disastrous.

Donzzt Forget Fees
One final consideration are fees and expenses. So called zzloadzz funds carry sales charges from 1% to 8.5% every time you invest. No load funds do not have these sales charges. While itzzs always desirable to invest with low or no fees, such a strategy does not necessarily result in the highest returns for the investor.

It used to be that there were very few mutual funds, and very many individual stocks. Now there are more mutual funds than there are stocks on the New York and American exchanges combined. Because of this, selecting the right fund can now be as challenging as picking the right stock used to be. For investors that are just starting out, or are uncertain about which funds to pick, the loaded funds that a stockbroker will select for them, could in the long run, work out much better than the poorly selected no load funds they might choose on their own.

And even for investors comfortable making their own selections, many times load funds are preferable, when their long term track record far outweighs the effects of sales charges.

And as a parting word of caution, investors should keep a close watch on fund expenses. The mutual fund managers charge the fund the expenses associated with running it. On the low side, expenses are 1/2% of total assets. On the high side, they are as much as three percent. In strong bull markets, which has been the case for the first half of this decade, mutual funds have done extremely well. Investors donzzt mind paying three percent in expenses when the fund gains 24%. But if history tells us anything, itzzs that over several decades, returns tend to converge on 10% for most stock funds. And in this scenario, three percent for expenses, or fully 30% of the return can make a mutual fund an expensive way to invest in the market.
Now that youzzve gotten an orientation on mutual funds, be sure to read this column next month which will provide an orientation on stocks, the underlying financial instrument of all growth funds.

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