Closed-End Funds (CEFs)
Exchange Traded Funds
Exactly what is a
mutual fund? A mutual fund is a
pool of individual investors’ money, invested in marketable securities, and
managed for a fee by financial professionals.
What does one need to
know when investing in mutual funds?
Start by investigating the answers to some fundamental questions:
- Do the objectives of
the fund, as stated in the fund’s prospectus, match your goals and
- Who is the fund
manager and what is his background? What is his investment philosophy?
What is his track record? How much time remains on his contract?
- Do the top holdings
of the particular fund match the types of investments you are interested
- What recent
investment changes did the fund managers make?
- Typically, how long
are securities held by the fund?
- How does the manager
determine the right time to sell?
- What rate of return
did the fund generate for the past 1, 3, 5, and 10 year periods?
- What are the
monetary, legal and operational risks?
- What is the tax
position of the fund? Are there upcoming tax distributions? Will you be
buying a dividend? Is the fund sitting on any large unrealized capital
gains or losses?
- What is the current
net asset value of the fund, and have the assets been growing or shrinking
over the past 1, 3, 5, and 10 year periods?
- Is the expected
return appropriate for the level of risk that is involved, and does it
match your goals and financial profile?
Lastly, determine and
analyze all the fees and expenses and calculate if the cost is worth the
investment. A balanced perspective is needed. On one side of the scale is
the importance of keeping expenses to the minimum, knowing that every dollar
spent is a reduction in one’s return; on the other side are the realities
that good fund managers need to be paid a fair compensation. It boils down
to a cost versus potential return decision.
Always remember that the
historical results have no bearing on future performance, but they do show
the pedigree of the fund.
funds, small investors are able to benefit from the economies of scale that
only the very rich enjoyed a century earlier. When owning a mutual fund, you
are actually hiring, and paying for, a professional portfolio manager to
navigate the financial markets for you. Open-end mutual funds are set up as
investment companies, where investment income and capital gains / losses are
passed through to the shareholders. Open-end mutual funds have a
fluctuating, constantly changing, amount of shares. Mutual funds also have
various classes of stock, usually with different fee structures. Purchases
and redemptions are made directly with the fund. Mutual funds’ shares do not
trade on the stock exchanges. With purchases, the cash inflows to the fund
are invested by the fund manager. Redemptions are cash outflows from the
fund, usually paid out of the fund’s cash accounts. If cash is unavailable,
securities are sold to meet the redemptions. The constant and sometimes
unpredictable inflows and outflows of cash, makes it difficult to manage
mutual funds. Shares are always priced at the fund’s net asset value at the
end of the day.
The net asset value of a
fund will change on a daily basis as the fund’s underlying portfolio
fluctuates in value.
How do distributions
affect the NAV? Fund
distributions reduce the NAV of the fund (on the fund’s ex-dividend date).
If reinvested in additional shares, the shareholder will have no change in
the aggregate value of his investment. He will however, have more shares at
a lower per-share price. Always check your statement to ensure that
reinvested shares are credited to your statement. When calculating your
return, you will need to factor in all distributions.
The growth of mutual
funds has availed the average investors to sophisticated money management
What are the benefits
and drawbacks to mutual funds?
management – Experts are in
charge of security, selection, monitoring and divestiture.
– Funds contain many individual securities, tailored to the objectives of
– There are enough choices to match one’s goals, objectives and risk
criteria with an appropriate fund. When the investor’s objectives change,
it’s easy to change funds, often in the same fund family
- Market returns
- Capital gains and dividends are passed through to shareholders.
- Fast liquidity
- Funds can be sold and converted into cash within a few days.
- The SEC regulates mutual funds and requires, among many things, timely
and transparent reports and disclosures, as well as a level of fairness to
all investors. The government or the FDIC does not guarantee or
insure mutual funds.
There are also secondary
benefits derived from owning mutual funds, which are really “boiler plate”
benefits, such as: convenience, affordability, summarized year-end tax
- Uncertain returns
- While market returns are available, exceptional returns are rare. It’s
difficult to find funds that consistently outperform the market. Under
performance is prevalent.
diversification – Many funds
have so many holdings that even big winners have only a negligible effect
on the per share net asset values of the funds.
- High costs and
confusing expense disclosures –
Some funds have a high level of commissions, fees and expenses.
Compounding the high cost issue is that the pricing/cost metrics are
- Uncertain tax
liabilities – A fund’s tax
liability may or may not correlate to the fund’s performance during the
timeframe held. Be careful with shrinking funds, because of the high
uncertainty of the year-end tax burden.
- Fund overload
- There are nearly as many funds as there are companies, making it time
consuming and difficult to choose the most appropriate fund.
- Unwieldy growth
- Mutual funds that show good returns are often flooded with new money.
New money, combined with a steady inflow of cash from 401k and IRA
retirement contributions, can overwhelm even the best fund manager. Good
investments, at the right price, are hard to come by. Uncontrolled asset
growth makes it difficult to properly deploy new money with the same
criteria and due diligence that was done on prior investments. Growth
tends to cause and hide problems.
Types of mutual
The New York Time
classifies mutual funds into eight categories:
- Domestic General
Stock Funds - Structured to
increase in value by investing mainly in U.S. based equities. Equity funds
fluctuate by market swings, and include growth funds, value funds, blended
funds and equity-income funds, or combinations thereof.
Specialized Stock Funds - Sector
funds that concentrate on a particular industry or investing style.
Investors like these funds because it’s easy to rotate in an out of
Stock Funds - Focus on certain
foreign geographic locations, or U.S. companies with a large international
exposure. They can also be further segmented by investment style (i.e.
value, growth, income, etc.).
- General Bond Funds
- For income orientated
investors who focus on a particular time period on the yield curve. They
are designed to concentrate on long-term, intermediate, or short-term
- Government Bond
Funds - Highly secured (risk
free) government funds, designed to protect one’s capital. They provide
competitive market interest rates, but are not totally risk free; they
fluctuate with interest rates.
- Specialized Bond
Funds - Niche fixed income
investments, which provide interest and capital gain income to investors.
Included are the junk bond funds, emerging market debt funds, bank loan
- Municipal Bond
Funds - Mainly the individual
state funds, designed to provide tax free interest to investors.
- Money Market
Mutual Funds - With these funds,
investors usually focus on yield, but are also very interested in
investing in highly secure and liquid debt instruments. Money Market
Mutual Funds are not FDIC insured.
Commissions, Fees and
Commissions, fees and
expenses to a certain degree are part of business. Everyone understands
there are costs involved in running a fund. Professional investment and
research advisors need to be paid. Effective advertising, marketing,
selling, and distribution networks are expensive. Administrative services,
custodians, accountants and transfer agents are all necessary expenditures.
The mutual fund industry
has a wide spectrum of cost alternatives, ranging from hedge funds, load
funds and no-load funds, to exchange traded funds, index funds etc. The
appropriateness of a fund depends on the circumstances of the investor. The
main variable cost of mutual funds is payroll.
There are critics,
however, who believe that the current “pay for assets” compensation programs
now in use don’t fully align the fund managers with their shareholders.
Compensation based on a percentage of assets motivates managers to increase
assets, not necessarily emphasizing the return on those assets. The pay for
performance compensation methodology is often mentioned as an alternative
method. Of course, a base level of compensation would be needed to cover
overhead and salaries. Bonus programs, however, would be based on the
returns generated for the investors. The critics’ points are well taken; pay
for performance compensation programs may be a better way to align the
objectives of fund managers with that of their shareholders. .
The pricing structures
that the industry has adopted can be confusing to the new investor. There
are upfront sales commissions, back-end redemption fees, and advertising
costs being paid directly out of your assets. Plus, there are multiple
classes of stocks, each being charged different rates. Then you have load
versus no-load, but with different 12b1-fees. These diverse factors have led
to a lot of misunderstanding.
Below are the specific
types of expenses that investors need to evaluate for fairness:
- Front-end Load
– Sales charges paid upfront to purchase the fund. Calculated as a
percentage of the purchase price.
- Back-end Load
– A redemption fee charged to sell your fund. Calculated as a percentage
of assets, and based on the lower of your original investment or the
redemption proceeds. The back-end load usually reduces over time, and
eventually is phased-out.
– A fund with no upfront sales commissions or back-end fees. Fund
expenses, however, are incurred.
- 12b-1 Fees
– Cost of advertising, marketing, selling and distributing the fund’s
shares. These expenses are paid out of the fund’s net assets. The theory
is that if the fund advertises, it can grow its assets and spread overhead
among more assets, thereby reducing the expense ratio and increasing the
returns for all investors.
- Management Fees
– Fees paid to management
- Other Expenses and
Fees – Administration costs,
account fees, exchange fees, and other miscellaneous expenses.
The fees and expenses
are normally reported, by share class type, in the fund’s prospectus.
Are there any special
tax treatments that I should know about?
Mutual funds are special pass-through
entities. The shareholders are required to pick up the fund’s taxes on their
individual returns. To avoid paying taxes, mutual funds are required to
distribute over 90% of their income to their shareholders.
Funds usually generate
income by receiving dividends or interest. Funds also incur both short-term
and long-term capital gains and losses, as securities are sold. After
expenses are paid, these items are taxable to the shareholders when
In January or February,
the funds mail out the tax forms that you need to incorporate into your
Below are the
standard tax forms that mutual fund shareholders should expect:
- Form 1099 – DIV –
Dividend and Capital Gains Distribution
- Box 1a – Ordinary Dividends
- Box 1b – Qualified Dividends
- Box 2a – Capital Gains
- Boxes 2b through 2f – Capital Gains Subcategories
- Box 3 – Nontaxable Distributions
- Box 6 – Foreign Tax Paid
- Form 1099 B –
- Form 1099R –
- Form 2439 –
Undistributed Long-Term Capital Gains that are allocated to you.
Mutual funds may also
send additional tax information, such as any exempt-interest dividends by
state, or any federal obligations that are exempt from state income tax.
When selling mutual funds, you need to report the capital gains or losses on
Are there any unusual
tax considerations? Yes! Here are
- There are ways to
convert tax drawbacks into benefits. For instance, after the year 2000
technology bubble there are mutual funds, usually growth funds, which have
significant accumulated losses. Typically, losses can be carried forward
eight years before they expire. A turnaround in the performance of theses
funds can result in price appreciation without capital gain distributions
for a few years.
- Investors are
responsible for tax distributions, regardless of how long they own the
shares. The industry uses the term “buying the dividend.” This applies
when one purchases a fund immediately before a distribution is made. Where
possible, this should be avoided! The distribution is a taxable event.
Although your money is returned, and if reinvested the dollar amount of
your investment is the same, you are responsible for taxes.
- There is also a rule
that permits funds to make distributions in January, which are taxable to
the shareholders as if they were paid in the prior December.
Mutual funds purchased
through a qualified retirement account or annuity can defer taxes on
earnings until the funds are withdrawn. Check with the IRS for more specific
Late Day Trading – Some funds allowed certain large investors to trade after the
4 P.M. closing time for the U.S. stock market.
This is when fund prices are re-calculated for the following day. By
engaging in after hours trading, large investors were able to take advantage
of market closing news and unfairly benefited at the expense of the other
shareholders of the fund. This practice is illegal under SEC rules
– Market timing is normally not illegal. To time the market correctly is the
goal of every investor. “Buy low and sell high” is the advice every parent
gives his kids. What was illegal, however, was when a fund raised money from
investors and advertised that rapid “in and out” short-term trading was
prohibited, but then allowed certain high rollers to rapid trade the fund
shares for a fee.
Returns – Big swings in asset
levels can distort the historical returns of mutual funds. The most common
example is when funds are starting out. The “incubation” process of new
funds needs more transparency. Normally, funds are started after a severe
market decline, when the conditions are ideal for a market upturn. Normally,
a big fund company will invest a small amount of seed capital and back a few
managers/funds. The best of the managers who generate solid paper trails
will be allowed to take their funds public; the rest of the funds will be
closed out. When balances start out small and grow quickly, the percentage
returns can be misleading. Here’s an example:
Assume a fund starts
with $100 thousand; it grows 100% year 1; 50% year 2; 10% year 3; and loses
5% year 4. This would result in a four year average return of 38.75%. Very
good! Additionally, assume, in the beginning of year 3, the fund opens to
the public and $10 million of new money is added. Then, again, in the
beginning of year 4, $100 million is added. Look at what happens: you can
have a fund showing an excellent average percentage return, yet its
investors can have a large dollar loss. This is why it is important to
review the growth trends before purchasing a fund.
Example of how
returns can be exaggerated
Calculation of Gain or Loss
$ Amount of
$ Balance after
*New money added
Survivorship Issue –
Poor performing funds have
a way of disappearing. When a fund materially underperforms the market, it
is closed and its remaining balances transferred to a different, usually
better performing, fund in the same fund family. The survivorship issue is
that the new fund considers the transfer as new cash, thereby eliminating
the historical poor returns of the old fund. When the fund family reports
their current funds, the old poor performing closed down funds are usually
not reported. Critics consider this another form of exaggerated returns.
conclusion, open-end mutual funds can be an excellent investment for
most individuals. Seen beyond the negatives, every investment has its own
set of nuances. If you are unfamiliar with the markets, or “have a life”
outside of finance, then using professional managers to oversee your
specific investments is a very good choice.