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Mutual Funds (Open-End 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 objectives?
  • 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 in?
  • 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.

Background - By pooling 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 tools.

What are the benefits and drawbacks to mutual funds?

 Benefits:

  • Professional management – Experts are in charge of security, selection, monitoring and divestiture.
  • Diversification – Funds contain many individual securities, tailored to the objectives of the fund.
  • Flexibility – 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.
  • Regulated - 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 information, etc.

Drawbacks:

  • 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.
  • Over 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 complicated.
  • 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 funds:

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.
  • Domestic 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 sectors.  
  • International 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 bonds.  
  • 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 funds, etc.
  • 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 Expenses:

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.
  • No-Load – 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 distributed.

In January or February, the funds mail out the tax forms that you need to incorporate into your returns.

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 Distribution
    • Boxes 2b through 2f – Capital Gains Subcategories
    • Box 3 – Nontaxable Distributions
    • Box 6 – Foreign Tax Paid
  • Form 1099 B – Redemption Proceeds
  • Form 1099R – Retirement Proceeds
  • 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 schedule D.

Are there any unusual tax considerations? Yes! Here are three:

  1. 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.
     
  2. 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.
     
  1. 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 guidelines.

Industry Issues:

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 – 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.

Exaggeration of 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

 


Year

Opening
Investment

%
Return

Ending
Assets

1

$100,000

100%

$200,000

2

200,000

50%

300,000

3*

 10,300,000

10%

11,330,000

4*

111,330,000

-5%

105,763,500

Average 4 Year Return

 

38.75%

 

 

 

 

 

Calculation of Gain or Loss

 

 

 

$ Amount of deposits

$110,100,000

 

 

$ Balance after four years

105,763,500

 

 

$ Loss

($4,336,500)

 

 

              *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.  

In 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.  

 

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