Part III Building Wealth through Investing
U. S., international, and global funds
Unless they have words like international, global, worldwide, or world in their names, most American-issued funds focus their investments in the United States. But even funds without one of these terms attached may invest money internationally.
The only way to know for sure where a fund is currently invested (or where the fund may invest in the future) is to ask. You can start by calling the toll-free number of the fund
company you’re interested in. A fund’s annual report (which often can be found on the fund company’s website) also details where the fund is investing (the prospectus will also detail where the fund can be invested).
Funds of funds
An increasing number of fund providers are responding to overwhelmed investors by offering a simplified way to construct a portfolio: a fund that diversifies across numerous other funds — or a fund of funds. When a fund of funds is done right, it helps focus fund investors on the important big-picture issue of asset allocation — how much of your investment money you put into bonds versus stocks. Although the best funds of funds appear to deliver a high-quality, diversified
portfolio of funds in one fell swoop, funds of funds are not all created equal and not all are worthy of your investment dollars.
The fund of funds idea isn’t new. In fact, the concept has been around for many years. High fees gave the earlier funds of funds, run in the 1950s by the late Bernie Cornfeld, a bad name. Cornfeld established a fund of funds outside the United States and tacked on many layers of fees. Although the funds were profitable for his enterprise, duped investors suffered a continual drain of high fees.
The Cornfeld episode is an important reason why the SEC has been careful in approving new funds of funds.
The newer funds of funds developed by the larger fund companies are investor friendly and ones that I recommend. Vanguard’s LifeStrategy, Fidelity’s Freedom, and T. Rowe Price’s Spectrum funds of funds add no extra fees for packaging together the individual funds. Long-term
performance of many of these is solid. Annual operating fees on the underlying funds at Vanguard are less than 0.2 percent.
When a fund has the term international or foreign in its name, it typically means that the fund invests anywhere in the world except the United States. The term worldwide or global generally implies that a fund invests everywhere in the world, including the United States. I generally recommend avoiding worldwide or global funds for two reasons. First, thoroughly following the
financial markets and companies is hard enough for a fund manager to do solely in the United States or a specific international market; following the markets and companies in both is even more difficult. Second, most of these funds charge high operating expenses — often well in excess of 1 percent per year — which puts a drag on returns.
Index funds
Index funds are funds that can be (and are, for the most part) managed by a computer. An index fund’s assets are invested to replicate an existing market index such as Standard & Poor’s 500, an index of 500 large U.S. company stocks.
Over long periods (ten years or more), index funds outperform about three-quarters of their peers!
How is that possible? How can a computer making mindless, predictable decisions beat an intelligent, creative, MBA-endowed portfolio manager with a crack team of research analysts scouring the market for the best securities? The answer is largely cost. The computer doesn’t demand a high salary or need a big corner office. And index funds don’t need a team of research analysts.
Most active fund managers can’t overcome the handicap of high operating expenses that pull down their funds’ rates of return. As I discuss later in this chapter, operating expenses include all the fees and profit that a mutual fund extracts from a fund’s returns before the returns are paid to you.
For example, the average U.S. stock fund has an operating expense ratio of 1.4 percent per year.
So a U.S. stock index fund (or its peer exchange-traded fund, which is an index fund that trades on a stock exchange) with an expense ratio of just 0.1 to 0.2 percent per year has an advantage of 1.2 to 1.3 percent per year.
Another not-so-inconsequential advantage of index funds is that they can’t underperform the market. Some funds do just that because of the burden of high fees and/or poor management. For money invested outside retirement accounts, index funds have an added advantage: Lower taxable capital gains distributions are made to shareholders because less trading of securities is conducted and a more stable portfolio is maintained.
Yes, index funds may seem downright boring. When you invest in them, you give up the
opportunity to brag to others about your shrewd investments that beat the market averages. On the other hand, with a low-cost index fund, you have no chance of doing much worse than the market (which more than a few mutual-fund managers do).
Index funds and exchange-traded funds make sense for a portion of your investments, because beating the market is difficult for portfolio managers. The Vanguard Group (phone 800-662-7447; website www.vanguard.com), headquartered in Valley Forge, Pennsylvania, is the largest and lowest-cost mutual-fund provider of these funds.
Specialty (sector) funds
Specialty funds don’t fit neatly into the previous categories. These funds are often known as sector funds, because they tend to invest in securities in specific industries.
In most cases, you should avoid investing in specialty funds. Investing in stocks of a single industry defeats one of the major purposes of investing in funds — diversification. Another good reason to avoid specialty funds is that they tend to carry much higher expenses than other funds.
Identifying socially responsible funds
Select funds label themselves socially responsible. This term means different things to different people. In most cases, though, it implies that the fund avoids investing in companies whose products or services harm people or the world at large — tobacco manufacturers, for example.
Because cigarettes and other tobacco products kill hundreds of thousands of people and add billions of dollars to healthcare costs, most socially responsible funds shun tobacco companies.
Socially responsible investing presents challenges. For example, your definition of social
responsibility may not match the definition offered by the investment manager who’s running a fund.
Another problem is that even if you can agree on what’s socially irresponsible (such as selling tobacco products), funds aren’t always as clean as you would think or hope. Even though a fund avoids tobacco manufacturers, it may well invest in retailers that sell tobacco products. Another drawback is that these funds tend to have higher-than-average costs, even when they take an indexing approach.
If you want to consider a socially responsible fund, review the fund’s recent annual report, which lists the specific investments the fund owns. Also consider giving directly to charities (and getting a tax deduction) instead.
Specialty funds that invest in real estate or precious metals may make sense for a small portion (10 percent or less) of your investment portfolio. These types of funds can help diversify your portfolio, because they can do better during times of higher inflation.
Selecting the Best Funds
When you go camping in the wilderness, you can do a number of things to maximize your chances
for happiness and success. You can take maps and a GPS to keep you on course, food for
nourishment, proper clothing to stay dry and warm, and some first-aid gear to treat minor injuries.
But regardless of how much advance preparation you do, you may have a problematic experience.
You may take the wrong trail, trip on a rock and break your ankle, or lose your food to a tenacious bear that comes romping through camp one night.
And so it is with funds. Although most fund investors are rewarded for their efforts, you get no guarantees. You can, however, follow some simple, common-sense guidelines to help keep you on the trail and increase your odds of investment success and happiness. The issues in the following sections are the main ones to consider.
Reading prospectuses and annual reports
Fund companies produce information that can help you make decisions about fund investments.
Every fund is required to issue a prospectus. This legal document is reviewed and audited by the SEC. The most valuable information — the fund’s investment objectives, costs, performance history, and primary risks — is summarized in the first few pages of the prospectus. Make sure that you read this part. Skip the rest, which is comprised mostly of tedious legal details.
Funds also produce annual reports that discuss how the fund has been doing and provide details on the specific investments a fund holds. If, for example, you want to know which countries an international fund invests in, you can find this information in the fund’s annual report.
Keeping costs low
The charges you pay to buy or sell a fund, as well as the fund’s ongoing operating expenses, can have a big impact on the rate of return you earn on your investments. Many novice investors pay too much attention to a fund’s prior performance (in the case of stock funds) or to the fund’s current yield (in the case of bond funds) and too little attention to fees. Doing so is dangerous because a fund can inflate its return or yield in many (risky) ways. And what worked yesterday may flop tomorrow.
Fund costs are an important factor in the return you earn from a mutual fund. Fees are deducted from your investment. All other things being equal, high fees and other charges depress your returns. What are a fund’s fees, you ask? Good question — read on to find the answers.
Eliminating loads
Loads are upfront commissions paid to brokers who sell mutual funds. Loads typically range from 3 percent to as high as 8.5 percent of your investment. Sales loads have two problems:
Sales loads are an extra cost that drags down your investment returns. Because commissions are paid to the salesperson and not to the fund manager, the manager of a load fund doesn’t work any harder and isn’t any more qualified than a manager of a no- load fund. Common sense suggests, and studies confirm, that load funds perform worse, on average, than no-loads when factoring in the load because the load charge is subtracted from your payment before your payment is invested.
The power of self-interest can bias your broker’s advice. Although this issue is rarely discussed, it’s even more problematic than the issue of sales loads. Brokers who work for a commission are interested in selling you commission-based investment products; therefore, their best interests often conflict with your best interests.
Although you may be mired in high-interest debt or underfunding your retirement plan, salespeople almost never advise you to pay off your credit cards or put more money into your 401(k). To get you to buy, they tend to exaggerate the potential benefits and obscure the risks and drawbacks of what they sell. They don’t take the time to educate investors.
I’ve seen too many people purchase investment products through brokers without understanding what they’re buying, how much risk they’re taking, and how these investments will affect their overall financial lives.
Invest in no-load (commission-free) funds. The only way to be sure that a fund is truly no- load is to look at the prospectus for the fund. Only there, in black and white and without
marketing hype, must the truth be told about sales charges and other fund fees. When you want investing advice, hire a financial advisor on a fee-for-service basis (see Chapter 18), which should cost less and minimize potential conflicts of interest.
Decreasing operating expenses
All funds charge ongoing fees. The fees pay for the operational costs of running the fund —
employees’ salaries, marketing, servicing the toll-free phone lines, printing and mailing published materials, computers for tracking investments and account balances, accounting fees, and so on.
Despite being labeled “expenses,” the profit a fund company earns for running the fund is added to the tab, as well.
The fund’s operating expenses are quoted as an annual percentage of your investment and are essentially invisible to you, because they’re deducted before you’re paid any return. The expenses are charged on a daily basis, so you don’t need to worry about trying to get out of a fund before these fees are deducted. You can find a fund’s operating expenses in the fund’s prospectus. Look in the expenses section and find a line that says something like “Total Fund Operating Expenses.”
You can also call the fund’s toll-free number and ask a representative.
Within a given sector of funds (for example, money-market, short-term bond, or
international stock), funds with low annual operating fees can more easily produce higher total returns for you. Although expenses matter on all funds, some types of funds are more sensitive to high expenses than others. Expenses are critical on money-market funds and very important on bond funds. Fund managers already have a hard time beating the averages in these markets; with higher expenses added on, beating the averages is nearly impossible.
With stock funds, expenses are a less important (but still significant) factor in a fund’s
performance. Don’t forget that, over time, stocks average returns of about 10 percent per year. So if one stock fund charges 1 percent more in operating expenses than another fund, you’re already giving up an extra 10 percent of your expected returns.
Some people argue that investing in stock funds that charge high expenses may be justified if those funds generate higher rates of return. However, evidence doesn’t show that these stock funds actually generate higher returns. In fact, funds with higher operating expenses tend to produce lower rates of return. This trend makes sense, because operating expenses are deducted from the returns a fund generates. (One additional cost not included in a fund’s expense ratio is trading costs. The SEC is now requiring funds to report these costs in their annual reports.)
Stick with funds that maintain low total operating expenses and don’t charge loads (commissions). Both types of fees come out of your pocket and reduce your rate of return.
You have no reason to pay a lot for the best funds. (In Chapters 11 and 12, I provide some specific fund recommendations as well as sample portfolios for investors in different situations.)
Evaluating historic performance
A fund’s performance, or historic rate of return, is another factor to weigh when selecting a fund.
As all funds are supposed to tell you, past performance is no guarantee of future results. An analysis of historic fund performance proves that some of yesterday’s stars turn into tomorrow’s skid-row bums.
Many former high-return funds achieved their results by taking on high risk. Funds that assume higher risk should produce higher rates of return. But high-risk funds usually decline in price faster during major market declines. Thus, in order for a fund to be considered a best fund, it must
consistently deliver a favorable rate of return given the degree of risk it takes.
When assessing an individual fund, compare its performance and volatility over an extended period of time (five or ten years will do) to a relevant market index. For example, compare funds that focus on investing in large U.S. companies to the Standard & Poor’s 500 Index. Compare funds that invest in U.S. stocks of all sizes to the Wilshire 5000 Index.
Indexes also exist for bonds, foreign stock markets, and almost any other type of security you can imagine.
Assessing fund manager and fund family reputations
Much is made of who manages a specific mutual fund. As Peter Lynch, the retired and famous former manager of the Fidelity Magellan fund, said, “The financial press made us Wall Street types into celebrities, a notoriety that was largely undeserved. Stock stars were treated as rock stars. . . .”
Although the individual fund manager is important, no fund manager is an island. The resources and capabilities of the parent company are equally important. Different companies have different capabilities and levels of expertise in relation to the different types of funds.
When you’re considering a particular fund — for example, the Barnum & Barney High-Flying Foreign Stock fund — examine the performance history and fees not only of that fund but also of similar foreign stock funds at the Barnum & Barney company. If Barnum’s other foreign stock funds have done poorly, or Barnum & Barney offers no other such funds because it’s focused on its circus business, those are strikes against its High-Flying fund. Also be aware that “star” fund managers tend to be associated with higher-expense funds to help pay their rock-star salaries. (And star managers tend to leave or get hired away after three to five years of stellar performance, so you may not be getting the manager who created that good past performance in the first place. Index and asset class funds that use a team approach avoid this issue.)
Rating tax friendliness
Investors often overlook tax implications when selecting funds for nonretirement accounts.
Numerous funds effectively reduce their shareholders’ returns because of their tendency to
produce more taxable distributions — that is, capital gains (especially short-term gains, which are taxed at the highest federal income tax rate) and dividends. (See the “Dividends” and “Capital gains” sections later in this chapter.)
Fund capital-gains distributions have an impact on an investor’s after-tax rate of return. All mutual-fund managers buy and sell stocks over the course of a year. Whenever a fund manager
sells securities, any gain or loss from those securities must be distributed to fund shareholders.
Securities sold at a loss can offset securities sold at a profit. When a fund manager has a tendency to cash in more winners than losers, investors in the fund receive taxable gains. So, even though some funds can lay claim to producing higher total returns, after you factor in taxes, they actually may not produce higher total returns.
Choosing funds that minimize capital-gains distributions helps you defer taxes on your profits. By allowing your capital to continue compounding as it would in a retirement account, you receive a higher total return. When you’re a long-term investor, you benefit most from choosing funds that minimize capital-gains distributions. The more years that appreciation can compound without being taxed, the greater the value to you as the investor.
If you’re purchasing shares in funds outside tax-sheltered retirement accounts, consider the time of year when making your purchases. December is the most common month in which funds make capital-gains distributions. When making purchases late in the year, ask if and when the fund may make a significant capital-gains distribution. Consider delaying purchases in such funds until after the distribution date.
Determining your needs and goals
Selecting the best funds for you requires an understanding of your investment goals and risk tolerance. What may be a good fund for your next-door neighbor may not necessarily be a good fund for you. You have a unique financial profile.
If you’ve already determined your needs and goals — terrific! If you haven’t, refer to Chapter 4. Understanding yourself is a good part of the battle. But don’t shortchange yourself by not being educated about the investment you’re considering. If you don’t understand what you’re investing in and how much risk you’re taking, stay out of the game.
Deciphering Your Fund’s Performance
You can’t simply calculate your return by comparing the share price of the fund today to the share price you originally paid. Why not? Because funds make distributions (of dividends and capital gains), which, when reinvested, give you more shares of the fund.
Distributions create an accounting problem, because they reduce the share price of a fund.