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From:
[email protected] (Christopher Lott)
Newsgroups: misc.invest.misc,misc.invest.stocks,misc.invest.technical,misc.invest.options,misc.answers,news.answers
Subject: The Investment FAQ (part 8 of 19)
Followup-To: misc.invest.misc
Reply-To: lott at invest-faq dot com
Summary: Answers to frequently asked questions about investments.
Should be read by anyone who wishes to post to misc.invest.*
Organization: The Investment FAQ publicity department
Keywords: invest, finance, stock, bond, fund, broker, exchange, money, FAQ
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Archive-name: investment-faq/general/part8
Version: $Id: part08,v 1.58 2002/08/14 10:20:04 lott Exp lott $
Compiler: Christopher Lott, lott at invest-faq dot com
The Investment FAQ is a collection of frequently asked questions and
answers about investments and personal finance. This is a plain-text
version of The Investment FAQ, part 8 of 19. The web site
always has the latest version, including in-line links. Please browse
http://invest-faq.com/
Terms of Use
The following terms and conditions apply to the plain-text version of
The Investment FAQ that is posted regularly to various newsgroups.
Different terms and conditions apply to documents on The Investment
FAQ web site.
The Investment FAQ is copyright 2001 by Christopher Lott, and is
protected by copyright as a collective work and/or compilation,
pursuant to U.S. copyright laws, international conventions, and other
copyright laws. The contents of The Investment FAQ are intended for
personal use, not for sale or other commercial redistribution.
The plain-text version of The Investment FAQ may be copied, stored,
made available on web sites, or distributed on electronic media
provided the following conditions are met:
+ The URL of The Investment FAQ home page is displayed prominently.
+ No fees or compensation are charged for this information,
excluding charges for the media used to distribute it.
+ No advertisements appear on the same web page as this material.
+ Proper attribution is given to the authors of individual articles.
+ This copyright notice is included intact.
Disclaimers
Neither the compiler of nor contributors to The Investment FAQ make
any express or implied warranties (including, without limitation, any
warranty of merchantability or fitness for a particular purpose or
use) regarding the information supplied. The Investment FAQ is
provided to the user "as is". Neither the compiler nor contributors
warrant that The Investment FAQ will be error free. Neither the
compiler nor contributors will be liable to any user or anyone else
for any inaccuracy, error or omission, regardless of cause, in The
Investment FAQ or for any damages (whether direct or indirect,
consequential, punitive or exemplary) resulting therefrom.
Rules, regulations, laws, conditions, rates, and such information
discussed in this FAQ all change quite rapidly. Information given
here was current at the time of writing but is almost guaranteed to be
out of date by the time you read it. Mention of a product does not
constitute an endorsement. Answers to questions sometimes rely on
information given in other answers. Readers outside the USA can reach
US-800 telephone numbers, for a charge, using a service such as MCI's
Call USA. All prices are listed in US dollars unless otherwise
specified.
Please send comments and new submissions to the compiler.
--------------------Check
http://invest-faq.com/ for updates------------------
Subject: Insurance - Variable Universal Life (VUL)
Last-Revised: 26 Jun 2000
Contributed-By: Ed Zollars (ezollar at mindspring.com), Chris Lott (
contact me ), Dan Melson (dmelson at home.com)
This article explains variable universal life (VUL) insurance, and
discusses some of the situations where it is appropriate.
Variable universal life is a form of life insurance, specifically it's a
type of cash-value insurance policy. (The other types of cash value
life insurance are whole, universal, and variable life.) Like any life
insurance policy, there is a payout in case of death (also called the
death benefit). Like whole-life insurance, the insurance policy has a
cash value that enjoys tax-deferred growth over time, and allows you to
borrow against it. Unlike either term or traditional whole-life
insurance, VUL policies allow the insured to choose how the premiums are
invested, usually from a universe of 10-25 funds. This means that the
policy's cash value as well as the death benefit can fluctuate with the
performance of the investments that the policy holder chose.
Where does the name come from? To take the second part first, the
"universal" component refers to the fact the premium is not a "set in
stone" amount as would be true with traditional whole life, but rather
can be varied within a range. As for the first part of the name, the
"variable" portion refers to the fact that the policy owner can direct
the investments him/herself from a pool of options given in the policy
and thus the cash value will vary. So, for instance, you can decide the
cash value should be invested in various types of equities (while it can
be invested in nonequities, most interest in VUL policies comes from
those that want to use equities). Obviously, you bear the risk of
performance in the policy, and remember we have to keep enough available
to fund the expenses each year. So bad performance could require
increasing premiums to keep the policy in force. Conversely, you gain
if you can invest and obtain a better return (at least you get more cash
value).
If a VUL policy holder was fortunate enough to choose investments that
yield returns anything like what the NASDAQ saw in 1999, the policy's
cash value could grow quite large indeed. The cash value component of
the policy may be in addition to the death benefit should you die (you
get face insurance value *plus* the benefit) *OR* serve to effectively
reduce the death benefit (you get the face value, which means the cash
value effectively goes to subsidize the death benefit). It all depends
on the policy.
A useful way to think about VUL is to think of buying pure term
insurance and investing money in a mutual fund at the same time. This
is essentially what the insurance company that sells you a VUL is doing
for you. However, unlike your usual mutual fund that may pass on
capital gains and other income-tax obligations annually, the investments
in a VUL grow on a tax-deferred basis. Uncle Sam may get a taste
eventually (if the policy is cashed in or ceases to remain in force),
but not while the funds are growing and the policy is maintained.
We can talk about the insurance component of a VUL and about the
investment component. The insurance component obviously provides the
death benefit in the early years of the policy if needed. The
investment component serves as "bank" of sorts for the amounts left over
after charges are applied against the premium paid, namely charges for
mortality (to fund the payouts for those that die with amounts paid
beyond the cash values), administrative fees (it costs money to run an
insurance company (grin)) and sales compensation (the advisor has to
earn a living). How this amount is invested is the principal difference
between a VUL and other insurance policies.
If you own a VUL policy, you can borrow against the cash value build-up
inside the policy. Because monies borrowed from a VUL policy that is
maintained through the insured's life are technically borrowed against
the death benefit, they work out tax free. This means a VUL owner can
borrow money during retirement against the cash value of the policy and
never pay tax on that money. It sounds almost too good to be true, but
it's true.
A policy holder who choose to borrow against the death benefit must be
extremely careful. A policy collapses when the cash value plus any
continuing payments aren't enough to keep the basic insurance in force,
and that causes the previously tax-free loans to be viewed as taxable
income. Too much borrowing can trigger a collapse. Here's how it can
happen. As the insured ages, Cost of Insurance (COI) per thousand
dollars of insurance rises. With a term policy, it's no big deal - the
owner can just cancel or let it lapse without tax consequences, they
just have no more life insurance policy. But with a cash value policy
such as VUL there is the problem of distributions that the owner may
take. Say on a policy with a cash value of $100,000 I start taking
$10,000 per year withdrawals/loans. Say I keep doing this for 30 years,
and then the variability of the market bites the investment and the cash
value gets exhausted. I may have put say 50,000 into the policy -
that's my cost basis, and I took that much out as withdrawals. But the
other $250,000 is technically a loan against the death benefit, and I
don't have to pay taxes on it - until there's suddenly no death benefit
because there's no policy. So here's $250,000 I suddenly have to pay
taxes on.
Once the policy is no longer in force, all the money borrowed suddenly
counts as taxable income, and the policy holder either has taxable
income with no cash to show for it, or a need to start paying premiums
again. At the point of collapse, the owner could be (reasonably likely)
destitute anyway, so there may be very little in the way of real
consequences, but if there are still assets, like a home, other monies,
etcetera, you see that there could be problems. Which is why cash value
life insurance should be the *last* thing you take distributions from in
most cases (The more tax-favored they are, the longer you put off
distributions.) What all this means is that the cash surrender value of
the VUL really isn't totally available at any point in time, since
accessing it all will result in a tax liability. If you want to
consider the real cash value, you need realistic projections of what can
be safely borrowed from the policy.
This seems like a good time to mention one other aspect of taxes and
life insurance, namely FIFO (first-in first-out) treatment. In other
words, if a policy holder withdraws money from a cash-value life
insurance policy, the withdrawal is assumed to come from contributions
first, not earnings. Withdrawals that come from contributions aren't
taxable (unless it's qualified money, a rare occurence). After the
contributions are exhausted, then withdrawals are assumed to come from
earnings.
Computing the future value of a VUL policy borders on the impossible.
Any single line projection of the VUL is a) virtually certain to be
wrong and b) without question overly simplistic. This is a rather
complex beast that brings with it a wide range of potential outcomes.
Remember that while we cannot predict the future, we know pretty much
for sure that you won't get a nice even rate of return each year (though
that's likely what all VUL examples will assume). The date when returns
are earned can be far more important than the average return earned. To
compare a VUL with other choices, you need to do a lot of "what ifs"
including looking at the impacts of uneven returns, and understand all
the items in the presentation that may vary (including your date of
death (grin)).
While I hate to give "rules of thumb" in these areas, the closest I will
come is to say that VUL normally makes the most sense when you can
heavily fund the policy and are looking at a very long term for the
funds to stay invested. The idea is to limit the "drag" on return from
the insurance component, but get the tax shelter.
Another issue is that if you will have a taxable estate and helping to
fund estate taxes is one of the needs you see for life insurance, the
question of the ownership of the insurance policy will come into play.
Note that this will complicate matters even further (and you probably
already thought it was bad enough (grin)), because what you need to do
to keep it out of your estate may conflict with other uses you had
planned for the policy.
Note that there are "survivor VULs", insuring two lives, which are
almost always sold for either estate planning or retirement plan
purposes (or both). The cost of insurance is typically less than an
annuity's M&E charges until the younger person is in their fifties.
A person who is considering purchasing a VUL policy needs to think
clearly about his or her goals. Those goals will determine both whether
a VUL is right tool and how it should be used. Potential goals include:
* Providing a pool of money that will only be tapped at my death, but
will be used by my spouse.
* Providing a pool of money that will only be used at my death, but
which we want to use to pay estate taxes.
* Providing a pool of money that I plan to borrow from in old age to
live on, and which will, in the interim, provide a death benefit
for my spouse.
Once the goals are clear, and you've then determined that a VUL would be
something that could fulfill your goals, you then have to find the right
VUL.
--------------------Check
http://invest-faq.com/ for updates------------------
Subject: Mutual Funds - Basics
Last-Revised: 11 Aug 1998
Contributed-By: Chris Lott ( contact me )
This article offers a basic introduction to mutual funds. It can help
you decide if a mutual fund might be a good choice for you as an
investment.
If you visit a big fund company's web site (e.g., www.vanguard.com),
they'll tell you that a mutual fund is a pool of money from many
investors that is used to pursue a specific objective. They'll also
hasten to point out that the pool of money is managed by an investment
professional. A prospectus (see below) for any fund should tell you
that a mutual fund is a management investment company. But in a
nutshell, a mutual fund is a way for the little guy to invest in, well,
almost anything. The most common varieties of mutual funds invest in
stocks or bonds of US companies. (Please see articles elsewhere in this
FAQ for basic explanations of stocks and bonds.)
First let's address the important issue: how little is our proverbial
little guy or gal? Well, if you have $20 to save, you would probably be
better advised to speak to your neighborhood bank about a savings
account. Most mutual funds require an initial investment of at least
$1,000. Exceptions to this rule generally require regular, monthly
investments or buying the funds with IRA money.
Next, let's clear up the matter of the prospectus, since that's about
the first thing you'll receive if you call a fund company to request
information. A prospectus is a legal document required by the SEC that
explains to you exactly what you're getting yourself into by sending
money to a management investment company, also known as buying into a
mutual fund. The information most useful to you immediately will be the
list of fees, i.e., exactly what you will be charged for having your
money managed by that mutual fund. The prospectus also discloses things
like the strategy taken by that fund, risks that are associated with
that strategy, etc. etc. Have a look at one, you'll quickly see that
securities lawyers don't write prose that's any more comprehensible than
other lawyers.
The worth of an investment with an open-end mutual fund is quoted in
terms of net asset value. Basically, this is the investment company's
best assessment of the value of a share in their fund, and is what you
see listed in the paper. They use the daily closing price of all
securities held by the fund, subtract some amount for liabilities,
divide the result by the number of outstanding shares and Poof! you have
the NAV. The fund company will sell you shares at that price (don't
forget about any sales charge, see below) or will buy back your shares
at that price (possibly less some fee).
Although boring, you really should understand the basics of fund
structure before you buy into them, mostly because you're going to be
charged various fees depending on that structure. All funds are either
closed-end or open-end funds (explanation to follow). The open-end
funds may be further categorized into load funds and no-load funds.
Confusingly, an open-end fund may be described as "closed" but don't
mistake that for closed-end.
A closed-end fund looks much like a stock of a publically traded
company: it's traded on some stock exchange, you buy or sell shares in
the fund through a broker just like a stock (including paying a
commission), the price fluctuates in response to the fund's performance
and (very important) what people are willing to pay for it. Also like a
publically traded company, only a fixed number of shares are available.
An open-end fund is the most common variety of mutual fund. Both
existing and new investors may add any amount of money they want to the
fund. In other words, there is no limit to the number of shares in the
fund. Investors buy and sell shares usually by dealing directly with
the fund company, not with any exchange. The price fluctuates in
response to the value of the investments made by the fund, but the fund
company values the shares on its own; investor sentiment about the fund
is not considered.
An open-end fund may be a load fund or no-load fund. An open-end fund
that charges a fee to purchase shares in the fund is called a load fund.
The fee is called a sales load, hence the name. The sales load may be
as low as 1% of the amount you're investing, or as high as 9%. An
open-end fund that charges no fee to purchase shares in the fund is
called a no-load fund.
Which is better? The debate of load versus no-load has consumed
ridiculous amounts of paper (not to mention net bandwidth), and I don't
know the answer either. Look, the fund is going to charge you something
to manage your money, so you should consider the sales load in the
context of all fees charged by a fund over the long run, then make up
your own mind. In general you will want to minimize your total
expenses, because expenses will diminish any returns that the fund
achieves.
One wrinkle you may encounter is a "closed" open-end fund. An open-end
fund (may be a load or a no-load fund, doesn't matter) may be referred
to as "closed." This means that the investment company decided at some
point in time to accept no new investors to that fund. However, all
investors who owned shares before that point in time are permitted to
add to their investments. (In a nutshell: if you were in before, you
can get in deeper, but if you missed the cutoff date, it's too late.)
While looking at various funds, you may encounter a statistic labeled
the "turnover ratio." This is quite simply the percentage of the
portfolio that is sold out completely and issues of new securities
bought versus what is still held. In other words, what level of trading
activity is initiated by the manager of the fund. This can affect the
capital gains as well as the actual expenses the fund will incur.
That's the end of this short introduction. You should learn about the
different types of funds , and you might also want to get information
about the various fees that funds can charge , just to mention two big
issues. Check out the articles elsewhere in this FAQ to learn more.
Here are a few resources on the 'net that may also help.
* Bill Rini maintains the Mutual Funds FAQ.
http://www.moneypages.com/syndicate/faq/index.html
* Brill Editorial Services offers Mutual Funds Interactive, an
independent source of information about mutual funds.
http://www.fundsinteractive.com/
* FundSpot offers mutual fund investors the best information
available for free.
http://www.fundspot.com/
* The Mutual Fund Investor's Center, run by the Mutual Fund Education
Alliance, offers profiles, performance data, links, etc.
http://www.mfea.com/
--------------------Check
http://invest-faq.com/ for updates------------------
Subject: Mutual Funds - Average Annual Return
Last-Revised: 24 Jun 1997
Contributed-By: Jack Piazza (seninvest at aol.com)
The average annual return for a mutual fund is stated after expenses.
The expenses include fund management fees, 12b-1 fees (if applicable),
etc., all of which are a part of the fund's expense ratio. Average
annual returns are also factored for any reinvested dividend and capital
gain distributions. To compute this number, the annual returns for a
fixed number of years (e.g., 3, 5, life of fund) are added and divided
by the number of years, hence the name "average" annual return. This
specifically means that the average annual return is not a compounded
rate of return.
However, the average annual returns do not include sales commissions,
unless explictly stated. Also, custodial fees which are applied to only
certain accounts (e.g., $10 annual fee for IRA account under a stated
amount, usually $5,000) are not factored in annual returns.
--------------------Check
http://invest-faq.com/ for updates------------------
Subject: Mutual Funds - Buying from Brokers versus Fund Companies
Last-Revised: 28 Dec 1998
Contributed-By: Daniel Pettit (dalacap at dalacap.com), Jim Davidson
(jdavidso at xenon.stanford.edu), Chris Lott ( contact me ), Michael
Aves (michaelaves at hotmail.com)
Many discount brokerage houses now offer their clients the option of
purchasing shares in mutual funds directly from the brokerage house.
Even better, most of these brokers don't charge any load or fees if a
client buys a no-load fund. There are a few advantages and
disadvantages of doing this.
Here are a few of the advantages.
1. One phone call/Internet connection gets you access to hundreds of
funds.
2. One consolidated statement at the end of the month.
3. Instant access to your money for changing funds and or families,
and for getting your money in your hand via checks (2-5 days).
4. You can buy on margin, if you are so inclined.
5. Only one tax statement to (mis)file.
6. The minimum investment is sometimes lower.
And the disadvantages:
1. Many discount brokerage supermarket programs do not even give
access to whole sectors of the market, such as high-yield bond
funds, or multi-sector (aka "Strategic Income") bond funds.
2. Most discount brokers also will not allow clients to do an exchange
between funds of different families during the same day (one trade
must clear fist, and the the trade can be done the next day).
3. Many will not honor requests to exchange out of funds if you call
after 2pm. EST. (which of course is 11am in California). This is
a serious restriction, since most fund families will honor an
exchange or redemption request so long as you have a rep on the
phone by 3:59pm.
4. You pay transaction fees on some no-load funds.
5. The minimum investment is sometimes higher.
Of course the last item in each list contradict each other, and deserve
comment. I've seen a number of descriptions of funds that had high
initial minimums if bought directly (in the $10,000+ range), but were
available through Schwab for something like $2500. I think the same is
true of Fidelity. Your mileage may vary.
--------------------Check
http://invest-faq.com/ for updates------------------
Subject: Mutual Funds - Distributions and Tax Implications
Last-Revised: 27 Jan 1998
Contributed-By: Chris Lott ( contact me ), S. Jaguiar, Art Kamlet
(artkamlet at aol.com), R. Kalia
This article gives a brief summary of the issues surrounding
distributions made by mutual funds, the tax liability of shareholders
who recieve these distributions, and the consequences of buying or
selling shares of a mutual fund shortly before or after such a
distribution.
Investment management companies (i.e., mutual funds) periodically
distribute money to their shareholders that they made by trading in the
shares they hold. These are called dividends or distributions, and the
shareholder must pay taxes on these payments. Why do they distribute
the gains instead of reinvesting them? Well, a mutual fund, under The
Investment Company Act of 1940, is allowed to make the decision to
distribute substantially all earnings to shareholders at least annually
and thereby avoid paying taxes on those earenings. Of course, they do.
In general, equity funds distribute dividends quarterly, and distribute
capital gains annually or semi-annually. In general, bond funds
distribute dividends monthly, and distribute capital gains annually or
semi-annually.
When a distribution is made, the net asset value (NAV) goes down by the
same amount. Suppose the NAV is $8 when you bought and has grown to $10
by some date, we'll pick Dec. 21. On paper you have a profit of $2.
Then, a $1 distribution is made on Dec. 21. As a result of this
distribution, the NAV goes down to $9 on Dec. 22 (ignoring any other
market activity that might happen). Since you received a $1 payment and
your shares are still worth $9, you still have the $10. However, you
also have a tax liability for that $1 payment.
Mutual funds commonly make distributions late in the year. Because of
this, many advise mutual fund investors to be wary of buying into a
mutual fund very late in the year (i.e., shortly before a distribution).
Essentially what happens to a person who buys shortly before a
distribution is that a portion of the investment is immediately returned
to the investor along with a tax bill. In the short term it essentially
means a loss for the investor. If the investor had bought in January
(for example), and had seen the NAV rise nicely over the year, then
receiving the distribution and tax bill would not be so bad. But when a
person essentially increases their tax bill with a fund purchase, it is
like seeing the value of the fund drop by the amount owed to the tax
man. This is the main reason for checking with a mutual fund for
planned distributions when making an investment, especially late in the
year.
But let's look at the issue a different way. The decision of buying
shortly before a distribution all comes down to whether or not you feel
that the fund is going to go up more in value than the total taxable
event will be to you. For instance let's say that a fund is going to
distribute 6% in income at the end of December. You will have to pay
tax on that 6% gain, even though your account value won't go up by 6%
(that's the law). Assuming that you are in a 33% tax bracket, a third
of that gain (2% of your account value) will be paid in taxes. So it
comes down to asking yourself the question of whether or not you feel
that the fund will appreciate by 2% or more between now and the time
that the income will be distributed. If the fund went up in value by
10% between the time of purchase and the distribution, then in the above
example you would miss out on a 8% after-tax gain by not investing. If
the fund didn't go up in value by at least 2% then you would take a loss
and would have been better off waiting. So how clear is your crystal
ball?
For someone to make the claim that it is always patently better to wait
until the end of the year to invest so as to avoid capital gains tax is
ridiculous. Sometimes it is and sometimes it isn't. Investing is a
most empirical process and every new situation should be looked at
objectively.
And it's important not to lose sight of the big picture. For a mutual
fund investor who saw the value of their investment appreciate nicely
between the time of purchase and the distribution, a distribution just
means more taxes this year but less tax when the shares are sold. Of
course it is better to postpone paying taxes, but it's not as though the
profits would be tax-free if no distribution were made. For those who
move their investments around every few months or years, the whole issue
is irrelevant. In my view, people spend too much time trying to beat
the tax man instead of trying to make more money. This is made worse by
ratings that measure 'tax efficiency' on the basis of current tax
liability (distributions) while ignoring future tax liability
(unrealized capital gains that may not be paid out each year but they
are still taxed when you sell).
So what are the tax implications based on the timing of any sale?
Actually, for most people there are none. If you sell your shares on
Dec. 21, you have $2 in taxable capital gains ($1 from the distribution
and $1 from the growth from 8 to 9). If you sell on Dec. 22, you have
$1 in taxable capital gains and $1 in taxable distributions. This can
make a small difference in some tax brackets, but no difference at all
in others.
--------------------Check
http://invest-faq.com/ for updates------------------
Subject: Mutual Funds - Fees and Expenses
Last-Revised: 28 Jun 1997
Contributed-By: Chris Lott ( contact me )
Investors who put money into a mutual fund gain the benefits of a
professional investment management company. Like any professional,
using an investment manager results in some costs. These costs are
recovered from a mutual fund's investors either through sales charges or
operation expenses .
Sales charges for an open-end mutual fund include front-end loads and
back-end loads (redemption fees). A front-end load is a fee paid by an
investor when purchasing shares in the mutual fund, and is expressed as
a percentage of the amount to be invested. These loads may be 0% (for a
no-load fund), around 2% (for a so-called low-load fund), or as high as
8% (ouch). A back-end load (or redemption fee) is paid by an investor
when selling shares in the mutual fund. Unlike front-end loads, a
back-end load may be a flat fee, or it may be expressed as a sliding
scale. A sliding-scale means that the redemption fee is high if the
investor sells shares within the first year of buying them, but declines
to little or nothing after 3, 4, or 5 years. A sliding-scale fee is
usually implemented to discourage investors from switching rapidly among
funds. Loads are used to pay the sales force. The only good thing
about sales charges is that investors only pay them once.
A closed-end mutual fund is traded like a common stock, so investors
must pay commissions to purchase shares in the fund. An article
elsewhere in this FAQ about discount brokers offers information about
minimizing commissions.
To keep the dollars rolling in over the years, investment management
companies may impose fees for operating expenses. The total fee load
charged annually is usually reported as the expense ratio . All annual
fees are charged against the net value of an investment. Operating
expenses include the fund manager's salary and bonuses (management
fees), keeping the books and mailing statements every month (accounting
fees), legal fees, etc. The total expense ratio ranges from 0% to as
much as 2% annually. Of course, 0% is a fiction; the investment company
is simply trying to make their returns look especially good by charging
no fees for some period of time. According to SEC rules, operating
expenses may also include marketing expenses. Fees charged to investors
that cover marketing expenses are called "12b-1 Plan fees." Obviously an
investor pays fees to cover operating expenses for as long as he or she
owns shares in the fund. Operating fees are usually calculated and
accrued on a daily basis, and will be deducted from the account on a
regular basis, probably monthly.
Other expenses that may apply to an investment in a mutual fund include
account maintenance fees, exchange (switching) fees, and transaction
fees. An investor who has a small amount in a mutual fund, maybe under
$2500, may be forced to pay an annual account maintenance fee. An
exchange or switching fee refers to any fee paid by an investor when
switching money within one investment management company from one of the
company's mutual funds to another mutual fund with that company.
Finally, a transaction fee is a lot like a sales charge, but it goes to
the fund rather than to the sales force (as if that made paying this fee
any less painful).
The best available way to compare fees for different funds, or different
classes of shares within the same fund, is to look at the prospectus of
a fund. Near the front, there is a chart comparing expenses for each
class assuming a 5% return on a $1,000 investment. The prospectus for
Franklin Mutual Shares, for example, shows that B investors (they call
it "Class II") pay less in expenses with a holding period of less than 5
years, but A investors ("Class I") come out ahead if they hold for
longer than 5 years.
In closing, investors and prospective investors should examine the fee
structure of mutual funds closely. These fees will diminish returns
over time. Also, it's important to note that the traditional
price/quality curve doesn't seem to hold quite as well for mutual funds
as it does for consumer goods. I mean, if you're in the market for a
good suit, you know about what you have to pay to get something that
meets your expectations. But when investing in a mutual fund, you could
pay a huge sales charge and stiff operating expenses, and in return be
rewarded with negative returns. Of course, you could also get lucky and
buy the next hot fund right before it explodes. Caveat emptor.
--------------------Check
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Subject: Mutual Funds - Index Funds and Beating the Market
Last-Revised: 26 May 1999
Contributed-By: Chris Lott ( contact me )
This article discusses index funds and modern portfolio theory (MPT) as
espoused by Burton Malkiel, but first makes a digression into the topic
of "beating the market."
Investors and prospective investors regularly encounter the phrase
"beating the market" or sometimes "beating the S&P 500." What does this
mean?
Somehow I'm reminded of the way Garrison Keillor used to start his show
on Minnesota Public Radio, "Greetings from Lake Woebegon, where all the
women are beautiful and all the children are above average" .. but I
digress.
To answer the second question first: The S&P 500 is a broad market
index. Saying that you "beat the S&P" means that for some period of
time, the returns on your investments were greater than the returns on
the S&P index (although you have to ask careful questions about whether
dividends paid out were counted, or only the capital appreciation
measured by the rise in stock prices).
Now, the harder question: Is this always the best indicator? This is
slightly more involved.
Everyone, most especially a mutual fund manager, wants to beat "the
market". The problem lies in deciding how "the market" did. Let's
limit things to the universe of stocks traded on U.S. exchanges.. even
that market is enormous . So how does an aspiring mutual fund manager
measure his or her performance? By comparing the fund's returns to some
measure of the market. And now the $64,000 question: What market is the
most appropriate comparison?
Of course there are many answers. How about the large-cap market, for
which one widely known (but dubious value) index is the DJIA? What about
the market of large and mid-cap shares, for which one widely known index
is the S&P 500? And maybe you should use the small-cap market, for which
Wilshire maintains various indexes? And what about technology stocks,
which the NASDAQ composite index tracks somewhat?
As you can see, choosing the benchmark against which you will compare
yourself is not exactly simple. That said, an awful lot of funds
compare themselves against the S&P. The finance people say that the S&P
has some nice properties in the way it is computed. Most market people
would say that because so much of the market's capitalization is tracked
by the S&P, it's an appropriate benchmark.
You be the judge.
The importance of indexes like the S&P500 is the debate between passive
investing and active investing. There are funds called index funds that
follow a passive investment style. They just hold the stocks in the
index. That way you do as well as the overall market. It's a
no-brainer. The person who runs the index fund doesn't go around buying
and selling based on his or her staff's stock picks. If the overall
market is good, you do well; if it is not so good, you don't do well.
The main benefit is low overhead costs. Although the fund manager must
buy and sell stocks when the index changes or to react to new
investments and redemptions, otherwise the manager has little to do.
And of course there is no need to pay for some hotshot group of stock
pickers.
However, even more important is the "efficient market theory" taught in
academia that says stock prices follow a random walk. Translated into
English, this means that stock prices are essentially random and don't
have trends or patterns in the price movements. This argument pretty
much attacks technical analysis head-on. The theory also says that
prices react almost instantaneously to any information - making
fundamental analysis fairly useless too.
Therefore, a passive investing approach like investing in an index fund
is supposedly the best idea. John Bogle of the Vanguard fund is one of
the main proponents of a low-cost index fund.
The people against the idea of the efficient market (including of course
all the stock brokers who want to make a commission, etc.) subscribe to
one of two camps - outright snake oil (weird stock picking methods,
bogus claims, etc.) or research in some camps that point out that the
market isn't totally efficient. Of course academia is aware of various
anomalies like the January effect, etc. Also "The Economist" magazine
did a cover story on the "new technology" a few years ago - things like
using Chaos Theory, Neural Nets, Genetic Algorithms, etc. etc. - a
resurgence in the idea that the market was beatable using new technology
- and proclaimed that the efficient market theory was on the ropes.
However, many say that's an exaggeration. If you look at the records,
there are very, very few funds and investors who consistently beat the
averages (the market - approximated by the S&P 500 which as I said is a
"no brainer investment approach"). What you see is that the majority of
the funds, etc. don't even match the no-brainer approach to investing.
Of the small amount who do (the winners), they tend to change from one
period to another. One period or a couple of periods they are on top,
then they do much worse than the market. The ones who stay on top for
years and years and years - like a Peter Lynch - are a very rare breed.
That's why efficient market types say it's consistent with the random
nature of the market.
Remember, index funds that track the S&P 500 are just taking advantage
of the concept of diversification. The only risk they are left with
(depending on the fund) is whether the entire market goes up and down.
People who pick and choose individual companies or a sector in the
market are taking on added risk since they are less diversified. This
is completely consistent with the more risk = possibility of more return
and possibility of more loss principle. It's just like taking longer
odds at the race track. So when you choose a non-passive investment
approach you are either doing two things:
1. Just gambling. You realize the odds are against you just like they
are at the tracks where you take longer odds, but you are willing
to take that risk for the slim chance of beating the market.
2. You really believe in your own or a hired gun's stock picking
talent to take on stocks that are classified as a higher risk with
the possibility of greater return because you know something that
nobody else knows that really makes the stock a low risk investment
(secret method, inside information, etc.) Of course everyone thinks
they belong in this camp even though they are really in the former
camp, sometimes they win big, most of times they lose, with a few
out of the zillion investors winning big over a fairly long period.
It's consistent with the notion that it's gambling.
So you get this picture of active fund managers expending a lot of
energy on a tread mill running like crazy and staying in the same spot.
Actually it's not even the same spot since most don't even match the S&P
500 due to the added risk they've taken on in their picks or the
transaction costs of buying and selling. That's why market indexes like
the S&P 500 are the benchmark. When you pick stocks on your own or pay
someone to manage your money in an active investment fund, you are
paying them to do better or hoping you will do better than doing the
no-brainer passive investment index fund approach that is a reasonable
expectation. Just think of paying some guy who does worse than if he
just sat on his butt doing nothing!
The following list of resources will help you learn much, much more
about index mutual funds.
* An accessible book that covers investing approaches and academic
theories on the market, especially modern portfolio theory (MPT)
and the efficient market hypothesis, is this one (the link points
to Amazon):
Burton Malkiel
A Random Walk Down Wall Street This book was written by a
former Princeton Prof. who also invested hands-on in the market.
It's a bestseller, written for the public and available in
paperback.
* IndexFunds.com offers much information about index mutual funds.
The site is edited by Will McClatchy and published by IndexFunds,
Inc., of Austin, Texas.
http://www.indexfunds.com
* The list of frequently asked questions about index mutual funds,
which is maintained by Dale C. Maley.
http://www.geocities.com/Heartland/Prairie/3524/faqperm5.html
--------------------Check
http://invest-faq.com/ for updates------------------
Subject: Mutual Funds - Money-Market Funds
Last-Revised: 16 Aug 1998
Contributed-By: Chris Lott ( contact me ), Rich Carreiro (rlcarr at
animato.arlington.ma.us)
A money-market fund (MMF) is a mutual fund, although a very special type
of one. The goal of a money-market fund is to preserve principal while
yielding a modest return. These funds try very, very, very hard to
maintain a net asset value (NAV) of exactly $1.00. Basically, the
companies try to make these feel like a high-yield bank account,
although one should never forget that the money-market fund has no
insurance against loss.
The NAV stays at $1 for (at least) three reasons:
1. The underlying securities in a MMF are very short-term money market
instruments. Usually maturing in 60 days or less, but always less
than 180 days. They suffer very little price fluctuation.
2. To the extent that they do fluctuate, the fund plays some (legal)
accounting games (which are available because the securities are so
close to maturity and because they fluctuate fairly little) with
how the securities are valued, making it easier to maintain the NAV
at $1.
3. MMFs declare dividends daily, though they are only paid out
monthly. If you totally cash in your MMF in the middle of the
month, you'll receive the cumulative declared dividends from the
1st of the month to when you sold out. If you only partially
redeem, the dividends declared on the sold shares will simply be
part of what you see at the end of the month. This is part of why
the fund's interest income doesn't raise the NAV.
MMFs remaining at a $1 NAV is not advantageous in the sense that it
reduces your taxes (in fact, it's the opposite), it's advantageous in
the sense that it saves you from having to track your basis and compute
and report your gain/loss every single time you redeem MMF shares, which
would be a huge pain, since many (most?) people use MMFs as checking
accounts of a sort. The $1 NAV has nothing to do with being able to
redeem shares quickly. The shareholders of an MMF could deposit money
and never touch it again, and it would have no effect on the ability of
the MMF to maintain a $1 NAV.
Like any other mutual fund, a money-market fund has professional
management, has some expenses, etc. The return is usually slightly more
than banks pay on demand deposits, and perhaps a bit less than a bank
will pay on a 6-month CD. Money-market funds invest in short-term
(e.g., 30-day) securities from companies or governments that are highly
liquid and low risk. If you have a cash balance with a brokerage house,
it's most likely stashed in a money-market fund.
--------------------Check
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Subject: Mutual Funds - Reading a Prospectus
Last-Revised: 9 Aug 1999
Contributed-By: Chris Stallman (chris at teenanalyst.com)
Ok, so you just went to a mutual fund family's (e.g., Fidelity) web site
and requested your first prospectus. As you anxiously wait for it to
arrive in the mail, you start to wonder what information will be in it
and how you'll manage to understand it. Understanding a prospectus is
crucial to investing in a mutual fund once you know a few key points.
When you request information on a mutual fund, they usually send you a
letter mentioning how great the fund is, the necessary forms you will
have to fill out to invest in the fund, and a prospectus. You can
usually just throw away the letter because it is often more of an
advertisement than anything else. But you should definitely read the
prospectus because it has all the information you need about the mutual
fund.
The prospectus is usually broken up into different sections so we'll go
over what each section's purpose is and what you should look for in it.
Objective Statement
Usually near the front of a prospectus is a small summary or
statement that explains the mutual fund. This short section tells
what the goals of the mutual fund are and how it plans to reach
these goals.
The objective statement is really important in choosing your fund.
When you choose a fund, it is important to choose one based on your
investment objective and risk tolerance. The objective statement
should agree with how you want your money managed because, after
all, it is your money. For example, if you wanted to reduce your
exposure to risk and invest for the long-term, you wouldn't want to
put your money in a fund that invests in technology stocks or other
risky stocks.
Performance
The performance section usually gives you information on how the
mutual fund has performed. There is often a table that gives you
the fund's performance over the last year, three years, five years,
and sometimes ten years.
The fund's performance usually helps you see how the fund might
perform but you should not use this to decide if you are going to
invest in it or not. Funds that do well one year don't always do
well the next.
It's often wise to compare the fund's performance with that of the
index. If a fund consistently under performs the index by 5% or
more, it may not be a fund that you want to invest in for the
long-term because that difference can mean the difference of
retiring with $200,000 and retiring with $1.5 million.
Usually in the performance section, there is a small part where
they show how a $10,000 investment would perform over time. This
helps give you an idea of how your money would do if you invested
in it but this number generally doesn't include taxes and inflation
so your portfolio would probably not return as much as the
prospectus says.
Fees and Expenses
Like most things in life, a mutual fund doesn't operate for free.
It costs a mutual fund family a lot of money to manage everyone's
money so they put in some little fees that the investors pay in
order to make up for the fund's expenses.
One fee that you will come across is a management fee, which all
funds charge. Mutual funds charge this fee so that the fund can be
run. The money collected from the shareholders from this fee is
used to pay for the expenses incurred from buying and selling large
amounts of shares in stocks. This fee usually ranges from about
0.5% up to over 2%.
Another fee that you're likely to encounter is a 12b-1 fee. The
money collected from charging this fee is usually used for
marketing and advertising the fund. This fee usually ranges
between 0.25-0.75%. However, not all funds charge a 12b-1 fee.
One fee that is a little less common but still exists in many funds
is a deferred sales load. Frequent buying and selling of shares in
a mutual fund costs the mutual fund money so they created a
deferred sales charge to discourage this activity. This fee
sometimes disappears after a certain period and can range from 0.5%
up to 5%.
When you are looking through a prospectus, be sure that you look
over these fees because even if a mutual fund performs well, its
growth may be limited by high expenses.
How to Purchase and Redeem Shares
This section provides information on how you can get your money
into the mutual fund and how you can sell shares when you need the
money out of the fund. These methods are usually the same in every
fund.
The most common method to invest in a fund once you are in it is to
simply fill out investment forms and write a check to the mutual
fund family. This is probably the easiest but it often takes a few
days or even a week to have the funds credited to your account.
Another method that is common is automatic withdrawals. These
allow you to have a certain amount which you choose to be deducted
from your bank account each month. These are excellent for getting
into the habit of investing on a regular basis.
Wire transfers are also possible if you want to have your money
invested quickly. However, most funds charge you a small fee for
doing this and some do not allow you to wire any funds if you do
not meet their minimum amount.
The fund will also provide information on how you can redeem your
shares. One common way is to request a redemption by filling out a
form or writing a letter to the mutual fund family. This is the
most common method but it isn't the only one.
You can also request to redeem your shares by calling the mutual
fund itself. This option saves you a few days but you have to make
sure the fund has this option open to the shareholders.
You can also request to have your investment wired into your bank
account. This is a very fast method for redeeming shares but you
usually have to pay a fee for doing this. And like redeeming
shares over the phone, you have to make sure the mutual fund offers
this option.
Now that you understand the basics of a prospectus, you're one step
closer to getting started in mutual funds. So when you finally receive
the information you requested on a mutual fund, look it over carefully
and make an educated decision if it is right for you.
For more insights from Chris Stallman, visit
http://www.teenanalyst.com
--------------------Check
http://invest-faq.com/ for updates------------------
Subject: Mutual Funds - Redemptions
Last-Revised: 5 May 1997
Contributed-By: A. Chowdhury
On the stock markets, every time someone sells a share, someone buys it,
or in other words, equal numbers of opposing bets on the future are
placed each day. However, in the case of open-end mutual funds, every
dollar redeemed in a day isn't necessarily replaced by an invested
dollar, and every dollar invested in a day doesn't go to someone
redeeming shares. Still, although mutual fund shares are not sold
directly by one investor to another investor, the underlying situation
is the same as stocks.
If a mutual fund has no cash, any redemption requires the fund manager
to sell an appropriate amount of shares to cover the redemption; i.e.,
someone would have to be found to buy those shares. Similarly, any new
investment would require the manager to find someone to sell shares so
the new investment can be put to work. So the manager acts somewhat
like the fund investor's representative in buying/selling shares.
A typical mutual fund has some cash to use as a buffer, which confuses
the issue but doesn't fundamentally change it. Some money comes in, and
some flows out, much of it cancels each other out. If there is a small
imbalance, it can be covered from the fund's cash position, but not if
there is a big imbalance. If the manager covers your sale from the
fund's cash, he/she is reducing the fund's cash and so increasing the
fund's stock exposure (%), in other words he/she is betting on the
market at the same time as you are betting against it. Of course if
there is a large imbalance between money coming in and out, exceeding
the cash on hand, then the manager has to go to the stock market to
buy/sell. And so forth.
--------------------Check
http://invest-faq.com/ for updates------------------
Subject: Mutual Funds - Types of Funds
Last-Revised: 12 Aug 1999
Contributed-By: Chris Lott ( contact me )
This article lists the most common investment fund types. A type of
fund is typically characterized by its investment strategy (i.e., its
goals). For example, a fund manager might set a goal of generating
income, or growing the capital, or just about anything. (Of course they
don't usually set a goal of losing money, even though that might be one
of the easist goals to achieve :-). If you understand the types of
funds, you will have a decent grasp on how funds invest their money.
When choosing a fund, it's important to make sure that the fund's goals
align well with your own. Your selection will depend on your investment
strategy, tax situation, and many other factors.
Money-market funds
Goal: preserve principal while yielding a modest return. These
funds are a very special sort of mutual fund. They invest in
short-term securities that pay a modest rate of interest and are
very safe. See the article on money-market funds elsewhere in this
FAQ for an explanation of the $1.00 share price, etc.
Balanced Funds
Goal: grow the principal and generate income. These funds buy both
stocks and bonds. Because the investments are highly diversified,
investors reduce their market risk (see the article on risk
elsewhere in this FAQ).
Index funds
Goal: match the performance of the markets. An index fund
essentially sinks its money into the market in a way determined by
some market index and does almost no further trading. This might
be a bond or a stock index. For example, a stock index fund based
on the Dow Jones Industrial Average would buy shares in the 30
stocks that make up the Dow, only buying or selling shares as
needed to invest new money or to cash out investors. The advantage
of an index fund is the very low expenses. After all, it doesn't
cost much to run one. See the article on index funds elsewhere in
this FAQ.
Pure bond funds
Bond funds buy bonds issued by many different types of companies.
A few varieties are listed here, but please note that the
boundaries are rarely as cut-and-dried as I've listed here.
Bond (or "Income") funds
Goal: generate income while preserving principal as much as
possible. These funds invest in medium- to long-term bonds
issued by corporations and governments. Variations on this
type of fund include corporate bond funds and government bond
funds. See the article on bond basics elsewhere in this FAQ.
Holding long-term bonds opens the owner to the risk that
interest rates may increase, dropping the value of the bond.
Tax-free Bond Funds (aka Tax-Free Income or Municipal Bond Funds)
Goal: generate tax-free income while preserving principal as
much as possible. These funds buy bonds issued by
municipalities. Income from these securities are not subject
to US federal income tax.
Junk (or "High-yield") bond funds
Goal: generate as much income as possible. These funds buy
bonds with ratings that are quite a bit lower than
high-quality corporate and government bonds, hence the common
name "junk." Because the risk of default on junk bonds is high
when compared to high-quality bonds, these funds have an added
degree of volatility and risk.
Pure stock funds
Stock funds buy shares in many different types of companies. A few
varieties are listed here, but please note that the boundaries are
rarely as cut-and-dried as I've listed here.
Aggressive growth funds
Goal: capital growth; dividend income is neglected. These
funds buy shares in companies that have the potential for
explosive growth (these companies never pay dividends). Of
course such shares also have the potential to go bankrupt
suddenly, so these funds tend to have high price volatility.
For example, an actively managed aggressive-growth stock fund
might seek to buy the initial offerings of small companies,
possibly selling them again very quickly for big profits.
Growth funds
Goal: capital growth, but consider some dividend income.
These funds buy shares in companies that are growing rapidly
but are probably not going to go out of business too quickly.
Growth and Income funds
Goal: Grow the principal and generate some income. These
funds buy shares in companies that have modest prospect for
growth and pay nice dividend yields. The canonical example of
a company that pays a fat dividend without growing much was a
utility company, but with the onset of deregulation and
competition, I'm not sure of a good example anymore.
Sector funds
Goal: Invest in a specific industry (e.g.,
telecommunications). These funds allow the small investor to
invest in a highly select industry. The funds usually aim for
growth.
Another way of categorizing stock funds is by the size of the
companies they invest in, as measured by the market capitalization,
usually abbreviated as market cap. (Also see the article in the
FAQ about market caps .) The three main categories:
Small cap stock funds
These funds buy shares of small companies. Think new IPOs.
The stock prices for these companies tend to be highly
volatile, and the companies never (ever) pay a dividend. You
may also find funds called micro cap, which invest in the
smallest of publically traded companies.
Mid cap stock funds
These funds buy shares of medium-size companies. The stock
prices for these companies are less volatile than the small
cap companies, but more volatile (and with greater potential
for growth) than the large cap companies.
Large cap stock funds
These funds buy shares of big companies. Think IBM. The
stock prices for these companies tend to be relatively stable,
and the companies may pay a decent dividend.
International Funds
Goal: Invest in stocks or bonds of companies located outside the
investor's home country. There are many variations here. As a
rule of thumb, a fund labeled "international" will buy only foreign
securities. A "global" fund will likely spread its investments
across domestic and foreign securities. A "regional" fund will
concentrate on markets in one part of the world. And you might see
"emerging" funds, which focus on developing countries and the
securities listed on exchanges in those countries.
In the discussion above, we pretty much assumed that the funds
would be investing in securities issued by U.S. companies. Of
course any of the strategies and goals mentioned above might be
pursued in any market. A risk in these funds that's absent from
domestic investments is currency risk. The exchange rate of the
domestic currency to the foreign currency will fluctuate at the
same time as the investment, which can easily increase -- or
reverse -- substantial gains abroad.
Another important distinction for stock and bond funds is the difference
between actively managed funds and index funds. An actively managed
fund is run by an investment manager who seeks to "beat the market" by
making trades during the course of the year. The debate over manged
versus index funds is every bit the equal of the debate over load versus
no-load funds. YOU decide for yourself.
--------------------Check
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Compilation Copyright (c) 2002 by Christopher Lott.
