Analyzing mutual funds

As you begin your search for mutual funds, make sure that your performance evaluation produces meaningful results. Performance is important because good, long-term earnings enable you to maximize your investments and ensure that your money is working for you. Gauging future performance is not an exact science. When you evaluate funds, check out the Morningstar and ValueLine mutual fund newsletters, both available at the library or online (www.morningstar.com and www.valueline.com). A fund’s prospectus, which you can request from a fund’s toll-free phone number, also outlines the important features and objectives of the fund. As an additional check on your selection process, compare all your choice funds before making a final decision; avoid choosing one fund in isolation. A single fund can look spectacular until you discover it trails most of its peers by 10%. Look for the following information when you select mutual funds:

• One-, three-, and five-year returns: These numbers offer information on the fund’s past performance. A look at all three can give you a sense of how well a fund fared over time and in relation to similar funds.
• Year-to-date total returns: This is a fund’s report card for the current year, minus operating and management expenses. The numbers can give you a sense of whether earnings are in line with competing funds, out in front, or trailing.
• Maximum initial sales charges, commissions, or loads: Unlike stocks and bonds, mutual funds have builtin operating and management expenses. These expenses are in addition to any commission you may pay to a broker or financial planner to buy a fund. A sales charge on a purchase, sometimes called a load, is a charge you pay when you buy shares. You can determine the sales charge (load) on purchases by looking at the fee and expense table in the prospectus. No-load funds don’t charge sales loads. There are no-load funds in every major fund category. However, even no-load funds have ongoing operating and management expenses. Go for lower-priced funds or no-load mutual funds, which by definition must have expenses no higher than 0.25%. Load funds can have charges of up to 5.75%. What that means is that you must deduct that 5.75% from any annual performance a fund turns in. If it’s 10%, you can expect to earn 4.25% after you pay the load or commission.
• Annual expenses: Also called annual operating expense ratios (AOERs), these costs can sap your performance. Before you settle on one fund, review the numbers on at least a few competitors to determine if the fund’s expenses are in line with typical industry charges. In general, the more aggressive a fund, the more expenses it incurs trading investments. Before you invest in a particular fund, be cautious if it has an extremely high AOER compared to that of similar funds. To develop a sense of how expenses can take a big bite out of earnings over the years, consider this example: A $10,000 investment earns 10% over 40 years with a 1% expense ratio, which yields a return of $302,771. The same investment with a 1.74% expense ratio returns $239,177, or $63,594 less.
• Manager’s tenure: Consider how long the current fund manager (or managers) has been managing the fund. If it’s only been a year or two, take that into consideration before you invest — the five-year record that caught your eye may have been created by someone who has already moved down the road. Fund managers move around a often. In an ideal world, your funds are handled by managers with staying power.
• Portfolio turnover: This tells you how often a fund manager sells stocks in a the course of a year. Selling stocks is expensive, so high turnover over the long run will probably hurt performance. If two funds appear equal in all other aspects, but one has high turnover and the other low turnover, by all means choose the fund with low turnover.
• Underlying fund investments: For your own sake, take a look at the top five or ten stocks or bonds that a fund is investing in. For example, a growth fund may be getting its rapid appreciation from a high concentration in fairly risky technology stocks, or a global fund may have more than 50% of its holdings in U.S. stocks. Neither of these strategies is a mortal sin if you know about and can live with it. If you can’t, keep looking for a fund that matches your goals. Looking at underlying investments not only helps minimize your surprises as markets and economies shift, but also enables you to create a balanced portfolio.

Considering different types of mutual funds

As you prepare to invest in mutual funds, you need to decide which type of funds best suits your goals and tastes. Basically, you have the following four types of mutual funds to consider:

• Stocks funds, which invest in stocks
• Bond funds (also considered income funds), which invest in bonds
• Balanced funds, also called hybrid funds, which invest in both stocks and bonds
• Money market funds, which invest in short-term investments

Each of these groups presents a wide variety of funds with different characteristics from which to choose. To help you further refine your search to match fund investments to your goals, the following lists offer a general look at some different types of funds available.
Stock funds include:

• Aggressive growth funds: Managers of these funds are forever on the lookout for undiscovered, unheralded companies, including small and undervalued companies. The goal is to get in when the stock is cheap and realize substantial gains as it soars skyward. That dream doesn’t always come true. But if you’re willing to accept above average risk, you may reap above-average gains.
• Growth funds: These funds are among the mainstays of long-term investing. They own stocks in mostly large- or medium-sized companies whose significant earnings are expected to increase at a faster rate than that of the rest of the market. These growth funds do not typically pay dividends. Several types are available, including large-, medium-, and small-company growth funds.
• Value funds: Managers of these funds seek out stocks that are underpriced — selling cheaply, relative to the stock’s true value. The fund’s manager believes that the market will recognize the stock’s true price in the future. Stock price appreciation is long term. These funds don’t typically turn in outstanding performance when the stock market is zooming along, but tend to hold their value a good deal more than growth funds when stock prices slide. That’s why value funds are generally believed to be good hedges to more growth-oriented mutual funds. These funds come in large-, medium-, and small company versions.
• Equity income funds: These funds were developed to balance investors’ desires for current income with some potential for capital appreciation. These fund managers invest mostly in stocks — often blue chip stocks — that pay dividends. They usually make some investments in utility companies, which are also likely to pay dividends.
• Growth and income funds: These funds seek both capital appreciation and current income. Growth and income are considered equal investment objectives.
• International and global funds: These two funds may sound like the same type of mutual fund, but they’re not. International funds invest in a portfolio of only non-U.S. stocks (international securities). Global funds, also called world funds, can also invest in the U.S. stock markets. In fact, during the 1990s, many global funds handed in remarkable performances not because of their international stock-picking prowess, but because they concentrated the bulk of their assets in U.S. stocks. This is a prime example of the importance of understanding how fund managers are investing your money. I talk more about how to make this determination in the next section.
• Sector funds: The managers of these funds concentrate their investments in one sector of the economy, such as financial services, real estate, or technology. Although these types of funds may be a good choice after you’ve already built a portfolio that matches your investment plan, they have greater risk than almost any other type of fund because these funds concentrate their investments in one sector or industry. If you’re uncomfortable with the potential for significant losses, make sure that a sector fund only accounts for a small percentage of your portfolio — say, less than 10%. Remember, however, that if you invest in a balanced portfolio, your other investments should hold their own if only one industry is impacted.
• Emerging market funds: The managers of these funds seek out the stocks of underdeveloped countries and economies in Asia, Eastern Europe, and Latin America. Finding undiscovered winners can prove advantageous, but an emerging market fund — also known as an emerging country fund — isn’t a recommended mainstay for new investors because of the potential for loss. When these countries and economies suffer economic decline, they can create significant investor losses.
• Single-country funds: As their name implies, the managers of these funds look for the stock winners of one country. Unless you have close relatives running a country somewhere and have firsthand knowledge about that land’s economic prospects, you’re wise to steer clear of these funds. The reason is simple: They have unmitigated risk from concentration in one area. For example, when Japan’s economy declined in 1998, it sent mutual funds that invested exclusively in that country’s companies tumbling by more than 50%.
• Index funds: The managers of these funds invest in stocks that mirror the investments tracked by an index such as the Standard & Poors 500. Some of the advantages of investing in index funds include low operating expenses, diversification, and potential tax savings. More than 150 funds, including growth companies, track a variety of different indexes. Although they don’t necessarily rely on the performance of any one company or industry to buoy their performance, they do invest in equities that represent a market — such as the U.S. stock market. If and when that market dips, as the U.S. market did by 20% in 1987, index funds can be hit pretty hard.

Bond funds are less risky than stock funds, but also less rewarding. You can choose from the following types of bond funds:

• Corporate
• Municipal
• U.S. Treasury bonds
• International bond funds
• Mortgage bond funds

Balanced funds are another investment option. These funds are a mix of stocks and bonds that are also called blended or hybrid funds. Generally, managers invest in about 60% stocks and 40% bonds. Balanced funds are appealing to investors because even in bear markets, their bond holdings still allow them to pay dividends. (A bear market is generally defined as a market in which stock prices drop 20% or more from their previous high.)
Money market funds are arguably the least volatile type of mutual fund. Fund managers invest in things such as short term bank CDs, U.S. Treasury bills, and short-term corporate debt issued by established and stable companies. This type of mutual fund is ideal for people who may need to use the money to buy something in the short term like a down payment on a home. These funds are also a convenient place to pool money for future investment decisions.

Defining Mutual Funds

A mutual fund is managed by an investment company that invests (according to the fund’s objectives) in stocks, bonds, government securities, short-term money market funds, and other instruments by pooling investors’ money. Mutual funds are sold in shares. Each share of a fund represents an ownership in the fund’s underlying securities (the portfolio).
By law, mutual funds must calculate the price of their shares each business day. Investors can sell their shares at any time and receive the current share price, which may be more or less than the price they paid.
When a fund earns money from dividends on the securities it invests in or makes money by selling some of its investments at a profit, the fund distributes the earnings to shareholders. If you’re an investor, you may decide to reinvest these distributions automatically in additional fund shares. A mutual fund investor makes money from the distribution of dividends and capital gains on the fund’s investments. A mutual fund shareholder also can potentially make money as the fund’s share per share (called net asset value, or NAV) increases in value.

NAV of a mutual fund = (Assets - Liabilities) ÷ Number of shares in the fund

(Assets are the value of all securities in a fund’s portfolio; liabilities are a fund’s expenses.) The NAV of a mutual fund is affected by the share price charges of the securities in the fund’s portfolio and any dividend or capital gains distributions to its shareholders.
Unless you’re in immediate need of this income, which is taxable, reinvesting this money into additional shares is an excellent way to grow your investments.
Shareholders receive a portion of the distribution of dividends and capital gains, based on the number of shares they own. As a result, an investor who puts $1,000 in a mutual fund gets the same investment performance and return per dollar as someone who invests $100,000.
Mutual funds invest in many (sometimes hundreds of ) securities at one time, so they are diversified investments. A diversified portfolio is one that balances risk by investing in a number of different areas of the stock and/or bond markets. This type of investing attempts to reduce per-share volatility and minimize losses over the long term as markets change. Diversification offsets the risk of putting your eggs in one basket, such as technology funds.
A stock or bond of any one company represents just a small percentage of a fund’s overall portfolio. So even if one of a fund’s investments performs poorly, 20 to 150 more investments can shore up the fund’s performance. As a result, the poor performance of any one investment isn’t likely to have a devastating effect on an entire mutual fund portfolio. That balance doesn’t mean, however, that funds don’t have inherent risks: You need to carefully select mutual funds to meet your investment goals and risk tolerance. The performance of certain classes of investments — such as large company growth stocks — can strengthen or weaken a fund’s overall investment performance if the fund concentrates its investments within that class. If the overall economy declines, the stock market takes a dive, or a mutual fund manager picks investments with little potential to be profitable, a fund’s performance can suffer.
Unfortunately, unless you have a crystal ball, you have no way to predict how a fund will perform, except to look at the security’s underlying risk. If a fund has existed long enough to build a track record through ups and downs, you can review its performance during the last stressful market. Fortunately for all investors, some companies use a statistical measure called standard deviation, which measures the volatility in the fund’s performance. The larger the swings in a fund’s returns, the more likely the fund will slip into negative numbers.
Companies that track funds’ standard deviations include Morningstar Mutual Funds and Value Line Inc., which are mutual fund reporting and ranking services whose newsletters are available in most libraries. You can visit their Web sites at www.morningstar.com and www.valueline.com, respectively.

What’s new about the Roth IRA

If your income is below $ 110,000 (single) or $ 160,000 (married and filing jointly), you can contribute $2,000 a year to a Roth IRA — and this contribution is permitted even if you participate in other pension or profit-sharing plans. The Roth IRA, introduced in 1998, offers the benefit of tax free withdrawals (if you are 591⁄2 and the account has been held at least five years). If you choose a Roth IRA, your $2,000 contribution comes out of income you’ve already paid taxes on (that is, earnings). That’s very different from the traditional IRA, in which your contribution may come from pretax earnings.
Like a traditional IRA, the funds contributed to a Roth IRA accumulate tax-free. The big difference is that if you are 591⁄2 and have held the Roth IRA for five years, you never pay tax on the money you withdraw. That means that the earnings on the $2,000 you contribute annually are tax-free.
If your income is more than $ 110,000 and you’re single, or if you’re married and you and your spouse have a combined income of over $160,000, you’re not eligible for a Roth IRA. Another advantage of the withdrawal requirements of a Roth IRA is that you’re not required to take your money out of a Roth IRA when you reach 701⁄2 as you are with traditional IRAs. In fact, you can leave the money and all the earnings to your heirs, if you want to. This allowance enables you to control the timing and the pace of your withdrawals from the account, potentially allowing the funds to stay there, growing tax-free, for more years.
Investors can contribute to both a traditional IRA and a Roth IRA; however, the total contribution to the two accounts can’t exceed the $2,000 annual limit. Many financial advisors say that if you are young and in a low tax bracket, you should probably open a Roth IRA and fund it with the full $2,000 every year. For most people, it’s not worth debating over the two because only those who have relatively low incomes or no other active retirement plans can take advantage of the deductibility of the traditional IRA.

The key benefits of traditional IRA

If you choose a traditional IRA, your contributions may be tax-deductible, while your savings grow and compound tax deferred until you withdraw them at retirement. In certain situations, your entire contribution to a traditional IRA can be tax deductible, meaning that you get to subtract the amount that you contribute from your income, reducing the amount of taxes you have to pay overall. The rules for this tax benefit are as follows:

• If you’re single and don’t have an employer-sponsored retirement plan, the full $ 2,000 is deductible on your income tax return.
• If you’re single and covered by an employer-sponsored plan, you can contribute up to $2,000 and deduct the full amount if your annual adjusted gross income is $30,000 or less. (Annual adjusted gross income is defined as your gross income, less certain allowed business-related deductions. Deductions include alimony payments, contributions to a Keogh plan, and in some cases, contributions to an IRA.) If your income is between $30,000 and $40,000, the deduction is prorated. If you make more than $40,000, you can contribute, but you get no deduction. These numbers gradually increase to $50,000 for taking the full deduction and to $60,000 for taking no deduction, until the year 2005.
• If you’re married and file your tax returns jointly, you have an employer-sponsored plan, and your annual adjusted gross income is $50,000 or less, you can deduct the full amount. The figure is prorated from $50,000 to $60,000. After $60,000, you can’t take any deduction. By 2007, the income allowances will increase to $80,000 for taking the full deduction and $100,000 for taking no deduction.
• If your spouse doesn’t have a retirement plan at work, and you file a joint tax return, the spouse can deduct his or her full $2,000 contribution until your joint income reaches $ 150,000. After that, the deduction is prorated until your joint income is $160,000, at which time you can’t deduct the IRA contribution.
• Non-income earning spouses can also open IRAs, and the annual contribution for a married couple filing jointly is $4,000 or 100% of earned income, whichever is less, with a $2,000 maximum contribution for each spouse. Funds generally can’t be taken from a traditional IRA before age 591⁄2 without paying a penalty. If you take money out, taxes and a 10% penalty are imposed on the taxable portion of the distribution.

You can make some withdrawals without paying a penalty. Money can be taken penalty-free if you use it for a first-time home purchase or for higher education fees. You can also withdraw penalty-free in the event of death or disability, or if you incur some types of medical expenses.
After you turn age 701⁄2, you are required to take money from your traditional IRA account, either in the form of a lumpsum payout or a little at a time; withdrawing a little at a time allows you to extend the benefit of the tax shelter.

Individual Retirement Account Investment Introduction

An Individual Retirement Account (IRA) is a tax-saving program (established under the Employee Retirement Security Act of 1974) to help Americans invest for retirement. Anyone who earns money by working can contribute up to $2,000 a year, or 100% of your income, whichever is less. If you don’t have access to a 401(k) or other retirement plan, or if you’ve calculated that your current plan won’t completely cover your retirement needs, then an IRA can help. IRAs offer tax-deferred growth — you don’t pay any tax on it or the money that it earns for you until you withdraw it during retirement.

You set up your IRA on your own with a bank, mutual fund, or brokerage firm. Like a 401(k), you can invest your IRA money in almost anything you can think of, from aggressive growth stocks to conservative savings accounts. Some financial planners advise that you use your IRA for investments that produce the highest income, such as stocks paying high dividends, because you defer the taxes. Another tactic is to put the IRA funds into riskier high-growth investments, such as stocks or certain types of mutual funds, because you don’t touch the funds until retirement and can always switch them to safer investments as you get older.
I suggest investing in an IRA for the following reasons:

• If your employer doesn’t offer a 401(k) plan
• If you’ve calculated that your current retirement plan won’t completely cover your estimated retirement needs, consider investing in an IRA — if you qualify
• To invest in high-yield investments — such as stocks paying high dividends — because your investment dollars are tax-deferred
• To invest in higher risk investments, such as stocks and certain mutual funds, if you don’t plan to retire for years to come (by doing so you commit to taking the chance of receiving higher gains for your investment dollar)

You can choose from two types of IRAs: traditional IRA and Roth IRA

Getting out of a 401(k)

When you retire or leave your company, you can leave your 401(k) invested as it is, roll it over into another retirement account (such as an IRA, which I talk about in the section “Investing in Individual Retirement Accounts,” later in this chapter), or withdraw it. People usually face some penalties and an income tax liability for withdrawing the money. You can claim funds from the 401(k) without a penalty after age 591⁄2.
When you’re in your 20s and 30s, retirement may seem impossibly far off — so far off, in fact, that it’s hard to imagine planning for it now. However, start saving for your retirement, and the sooner the better. In 1998, the Social Security Administration estimated that Social Security will provide less than a quarter of the amount you’ll need to pay for housing, food, and other living expenses in your retirement. If you want to retire in comfort, you will have to provide for yourself.