Alpha Teach Yourself Investing in 24 Hours: An Analysis (part 10)

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Mutual Funds

by

Charles Lamson

A mutual fund is characterized as a pool of money managed by professionals with specific investment goals and objectives. These goals and objectives drive the investment decisions of the professional managers.

Every thing you want to know about the fund is found in a document called a prospectus. 

Investment Goals and Objectives

Every mutual  fund has a well-defined set of goals and objectives. These allow investors to choose the type of fund that fits their particular investment strategy. Fund managers cannot deviate from these stated objectives.

JUST A MINUTE Mutual funds often are named with an eye to marketing rather than being an accurate description of the fund. For example, ACME Mutual Funds might offer a fund called "American Stock Growth Fund." However, when you read the prospectus you discover that 40 percent of the fund is in bonds. Investing in bonds is not a growth strategy.

There are many varieties and flavors of mutual funds. In later posts, we will examine them more closely, but for now, let us broadly classify them:

• Stock funds---mainly invest in common stocks
• Bond funds---mainly invest in bonds
• Combination funds---may invest in both stocks and bonds
• Money market funds---mainly invest in cash instruments

These funds can be further broken down as taxable and tax-free funds, and again by whether the fund is actively managed or an index fund.

If you are getting a mental image of a massive grill filled in with many different combinations of funds, you are right on target. However, it is not as confusing as it may seem at this point.

Right now, we are stepping back and looking at the big picture. In later posts, we will focus on the main types of mutual funds and this will all seem much clearer.

Performance History

The prospectus will also provide a section with some history on the fund and how it has performed in the past. How big and prominent this section is will depend on how proud the managers are of past performance.

Past performance is no guarantee of future success. While this is true, looking at past performance can be helpful.

PROCEED WITH CAUTION Past performance may not point to future winners, but it will tag future losers. A poor performance history does not inspire future confidence.

Frequently, the fund will show its performance relative to the S&P 500, they are said to have "beat the market." Funds that fall below this mark will try desperately to put some kind of positive spin on their history.

When we discuss picking a mutual fund, we will go into detail about how to use this information in making your decision.

Management

Many analysts believe that the management of a mutual fund is the single most important consideration when picking a fund. The fund manager is responsible for making the buy and sell decisions for the fund.

JUST A MINUTE Avoid looking at short-term performance. Anyone can get lucky once. Look for consistent performance over a long period.

Their ability to do this with consistent success means they are well known in the business and handsomely rewarded. One of the markers analysts look for is how long the current management has been in place and what past success or failure occurred on their watch. A recent change in management may signal a performance change.

Investment Strategies

Mutual funds follow two basic investment strategies: active management and indexing.

This is an important part of the prospectus because it tells you what to expect in the way of portfolio turnover and potential tax liabilities.

Active Management

An active management strategy means the manager will buy and sell stocks and/or bonds in a proactive attempt to stay ahead of the market (i.e., the S&P 500). This strategy can result in spectacular gains or losses depending on the skill and luck of the manager. It can also generate extraordinary tax liabilities when profits are made.

Indexing

An index fund on the other hand, seeks to match the market's performance by mimicking the index. For example, an index fund focused on the S&P 500 will  hold a portfolio of stocks that the manager believes is a proxy for the underlying stocks of the index. The fund will then, theoretically, move in tandem with the index. There are index funds for many different indexes and they number in the hundreds.

Index funds tend to have lower costs and tax liabilities because there is less churning (buying and selling of the portfolio).

Sales Fees

The fund is charged a fee to cover administrative costs (salaries, record keeping, etc.) and marketing by the management company. Funds are divided into two groups according to their fee structure: load and no-load.

Loaded funds

Loaded funds have a sales fee or commission that is paid to the person who sold you the fund. Unless you owe your brother-in-law, the broker, a lot of money, there are not many good reasons to buy a loaded fund.

No-load

No-load funds have no sales fee or commission, but they are not free, either. You still have to pay for administrative and marketing expenses, but these should run about 1.5 percent or less of your assets.

*SOURCE: ALPHA TEACH YOURSELF INVESTING IN 24 HOURS, 2000, KEN LITTLE, PGS. 55-58*

END

JUST A MINUTE

Mutual funds often are named with an eye to marketing rather than being an accurate description of the fund. For example, ACME Mutual Funds might offer a fund called "American Stock Growth Fund." However, when you read the prospectus you discover that 40 percent of the fund is in bonds. Investing in bonds is not a growth strategy.

PROCEED WITH CAUTION

Past performance may not point to future winners, but it will tag future losers. A poor performance history does not inspire future confidence.

JUST A MINUTE

Avoid looking at short-term performance. Anyone can get lucky once. Look for consistent performance over a long period.