An Eagle Eye on Your Mutual Funds

Question of the week:I was really burned by a couple of mutual funds that I owned over the last couple of years, but I think I'm ready now to give funds another try. What should I do to make sure I don't repeat my mistakes? --CSC

Dear CSC,

Like you, lots of people these days are putting their money back into mutual funds. According to the Investment Company Institute, the mutual fund industry's trade organization, stock funds had an inflow of over $16 billion in April.

And like you, people are still smarting from recent experience with the stock market in general and mutual funds in particular. When we asked Armchair Millionaire community members about their regrets investing in funds, we definitely heard a common theme. These two responses were typical:

Too much tech. "My biggest mistake was investing in a heavily weighted high tech fund just before it had a 100 percent yearly gain and then watching it plummet from $78 a share to $8 in two years." --EA

Too much tech, too. "My mistake was buying into a tech fund right at the peak of the market and then having to sell to avoid a huge taxable distribution on the fund, even though I was losing money left and right." --Steve

Mutual funds are designed to make it easy to invest, but that doesn't mean that you should buy them and then just forget them. Fortunately, it's not difficult to monitor your funds. Whenever you invest in a fund, you'll receive fund reports delivered to your mailbox at least twice a year. Not only will these reports tell you how your fund is doing, they'll help you know if the fund is still the right investment for you. My guide provides the questions you should ask as you're reading your mutual fund reports.

The Armchair Millionaire Guide to Keeping an Eye on Your Funds

• How is it doing? The report will tell you the fund's performance over the last six months or year. Compare this against the market benchmark that's appropriate for that fund. For example, you'd check large-cap funds against the S&P 500 Index and small-cap funds against the Russell 2000.
• Is it doing what it said it would? If you bought a fund because it was investing for value in small-cap companies, for example, make sure it's still following that style. In search of better investment opportunities, it's not uncommon for fund mangers to stray from the stated investment strategy of their fund.
• What is it investing in? Each report will have a list of the stocks, bonds and cash in its portfolio. Use this to see how diversified the fund's holdings really are.
• How much turnover does it have? The turnover rate tells you how frequently the fund manager buys and sells. A rate of 25 percent means that one-fourth of the value of the portfolio was sold. The higher the turnover rate, the more in trading commissions the fund is paying, which translates into higher expenses for you. Also, funds with higher turnovers tend to realize more capital gains, which you'll have to pay taxes on (as long as the fund isn't in a retirement account).
• Why is it performing the way it is? Each fund report has some commentary from the fund manager with their interpretation of the fund's performance and outlook for the future. If the fund did poorly, there should be an explanation of how they plan to improve it.

THE BOTTOM LINE: Don't let a bad past experience with mutual funds prevent you from investing in these investment workhorses. With some regular oversight on your part, you can ensure that your fund investments remaining on track.

The Mutual Funds We Love to Hate

Question of the week:I'm interested in an actively managed fund that has had decent returns recently and that I think will do well in the future. I know you advocate index funds, but I really want to take advantage of this opportunity. What do you think? --GT, Long Island

Dear GT,

I understand your temptation to chase performance, but I urge you to consider both sides of the coin when contemplating actively managed funds. To give you some perspective, we asked members of the Armchair Millionaire community for their opinions about actively managed funds. Here are some of the comments we heard:

"The law of averages and efficient market theories show that it is very difficult for an actively managed fund to beat an index fund over time. And when you add transaction costs, it's almost impossible." --Jamie

"Active fund managers charge higher fees and in turn, cannot even beat the index most of the time. I'll take the guarantee of keeping up with the index instead of paying fees to have a slim chance of beating it." --Pat L.

"In the end, three things determine your return: performance, taxes and fees. Index funds are totally comparable to actively managed funds on performance and kick butt on tax efficiency and fees. " --Polly T.

My guide describes what I see as of the major pitfalls of actively managed mutual funds.

The Armchair Millionaire Guide to the Drawbacks of Actively Managed Funds

• High expenses. Since fund management fees and expenses are subtracted from the fund's assets, you never really see what you're missing. This makes it easy to ignore the impact these fees have on your return, but it can be significant over time. While every mutual fund has expenses, actively managed funds on average have higher expenses than index funds-sometimes much higher. To find out exactly how expenses affect your return, check out the Security and Exchange Commission's fund cost calculator at www.sec.gov.

• Tax hits. Every year, funds have to distribute capital gains they have realized on stocks they have sold that are not offset by capital losses. If you receive a capital gain, you have to pay taxes on it-even if the fund has had a negative return that year. The SEC has said that more than 2.5 percent of the average stock fund's total return is lost each year to taxes--even more than the amount typically lost to fees. Because index funds have very little turnover of their holdings, they realize few or no capital gains that must be passed on to you.

• Style drift. In search of better investment opportunities, it's not uncommon for fund mangers to stray from the stated investment strategy of their fund. A value fund manager, for example, might start investing in growth stocks when they're hot. Likewise, a small-cap fund might buy some mid- or even large-cap stocks. This can make it nearly impossible for you to achieve the asset allocation you really want. Since index funds are pegged to an index, they won't stray from their original intention.

• Lack of disclosure. You have to know exactly what an actively managed fund owns on any given day. This means that you could easily own the same stock in several different funds, and not know it. It also makes it tough to confirm that the fund is still buying the kinds of stocks it did when you originally invested. Since index funds own the stocks of a particular index, you always know what you own.

THE BOTTOM LINE: When you take everything into account, I believe there's less to love about actively managed funds over index funds. By their nature, index funds are the lowest cost, most tax efficient, most reliable tools for building a long-term portfolio.

Keep a Lid on Fund Costs

Question of the week:My financial advisor recommends that I buy a mutual fund with a 5.75 percent load. I'm reluctant to pay a load, but my advisor promises me that the fund is worth it. What's your take on fund loads? --James R.

Dear James,

A load is simply a charge for buying (or sometimes for selling) shares in a mutual fund. That chunk of money, which can go as high as 8.5 percent, will come straight out of your investment, with all or part of it going to the broker or advisor who sold you the fund.

We asked the Armchair Millionaire community for opinions on paying loads, and got a range of responses both pro and con:

"When I first began investing I needed advice and paid for it by buying funds with loads. It always took a while for a fund to make up for the cost of the load." --DSB

"I've bought both load and no load funds. The loads are well worth it for the advice I get because I cannot afford to pay an advisor an hourly fee." --Jennifer W.

"I have never bought a load fund because I want to keep 100 percent of my money working for me. The catch with no-load funds is that you have to do the work." --Forrest H.

Be sure you're clear about what you're actually paying for when you pay a load. It is not to get a fund with a superior return-there is no evidence that load funds perform any better than no-load funds. Rather, you're paying for assistance in selecting the fund. With thousands of no-load funds to choose from, I personally see no reason to ever pay a load for a fund, unless you absolutely must rely on a commission-based advisor.

It's important to understand that all funds carry some costs that lower your returns. Look at these very carefully because a fund with high costs has to perform better than a low-cost fund just to stay even. My quick guide will help you understand the range of fund fees.

The Armchair Millionaire Guide to Mutual Fund Costs

• Shareholder expenses are paid for directly by each investor in the fund. They can include sales charges (for load funds), redemption fees when you sell shares, exchange fees for transferring money from one fund to another, and annual account maintenance fees.

• Operating expenses are all the costs associated with running the funds and are deducted directly from the assets of the fund. They can include management fees to compensate the fund managers, a distribution fee (also called a 12b-1 fee) for marketing expenses, and other fees to cover shareholder services, such as mailings and the fund's toll-free phone service.

• The expense ratio is the total of all the operating expenses, expressed as a percentage of the fund's total assets. Low-cost index funds might have expense ratios as low as .2 percent, while a high-cost actively managed fund might have an expense ratio as high as 2.5 percent.

  At first glance, it may be easy to brush off a higher-than-average expense ratio, but don't underestimate the difference it can make. For example, let's say you invest $10,000 for ten years and get annual returns of nine percent before expenses. If this money is in a fund with an expense ratio of 1.8 percent, your money will grow to $19,741. If the money is in a fund with an expense ratio of just .4 percent, however, your investment will grow to about $3,000 more, or $22,744.

• To compare fees between different funds, read each fund's prospectus. All fund prospectuses are required to present a complete description of fees in standardized, easy-to-read tables. Also, the Securities and Exchange Commission has an excellent calculator that helps with expense comparisons on its Web site at www.sec.gov.

THE BOTTOM LINE: Historically, load funds have no advantages over no-load funds when it comes to investment performance. However, load charges may be a necessary evil when dealing with a financial advisor because that advisor deserves to be paid for his or her time and expertise.

The Balancing Act of Growth and Value

Question of the week:I've always invested in growth mutual funds because they seemed to do so well. But the last year or so, the value funds are performing much better than growth funds. I'm thinking of switching all my money to value. What do you think about that? --Wobbling Dear Wobbling, It seems that the upswing in value funds has caught the attention of other investors, too, and that quite a few of them have the same idea you do. According to the Financial Research Corporation, a consulting firm that tracks these things, value-style funds brought in far more in new investments in the first quarter of this year than did growth funds. When we asked the Armchair Millionaire community how they are reacting to the upswing in value and drop in growth, we got a range of responses: Ignore the swings. "Have a diverse portfolio and stick with it. Ride out the highs and lows of the market and over time you will make money." --Joe G. Move a little with the swings. "I have shifted somewhat more into value funds. I do think it's worthwhile to adjust your portfolio mix depending on the market." --Mike F. Leverage swings to the fullest. "I've looked at the market swings as opportunity to invest in stocks that are undervalued with an expectation for growth. --Linda I'd caution you against falling into the classic trap of making drastic changes in your portfolio in order to chase performance. After all, who's to say that as soon as you switch to the value funds that we won't see an upswing again in growth? My quick guide will help you understand what growth and value investing is all about and how to wisely balance the two. The Armchair Millionaire Guide to Understanding Growth and Value What is value investing? Value investors are the bargain shoppers of the stock market, on the lookout for stocks that, for one reason or another, look inexpensive. It could be that the company is in an industry that has fallen on hard times or it may have recently had disappointing earnings reports. The trick to value investing is in determining which companies are fundamentally strong but has gone unrecognized by the stock market. Once they are discovered (or often re-discovered), the value investor is set to profit. What is growth investing? In contrast to thrifty value investors, growth managers are happy to pay full price (or even a premium) for stocks that have shown good growth in earnings in the recent past and that they believe will continue to show strong growth in the future. Typically, these companies offer much-in-demand products or services, a solid business plan and management team, and an overall healthy financial picture. What works when? Because the two styles are so different, it's unusual that they both work well at the same time. When the economy is growing, growth usually reaps the highest rewards. But during times of economic slowdown, investing in stocks that are still a real value can pay off nicely. What are the risks? Both styles carry their own kind of risk. Simply because they have further to fall, the prices of growth stocks can take a bigger hit during bear markets than value stocks. On the other hand, the risk in value stocks is that they simply may never achieve their hoped-for value. Which is right for you? If you're looking to build a well-rounded, long-term portfolio, the answer is "Both." By investing in at least one fund managed for growth, and one managed for value (or a single index fund, which will cover both), you'll be positioned to capture the advantages of each, regardless of what the economy may bring. At the same time, the diversification you'll achieve will help reduce the risks of each. THE BOTTOM LINE: There's always some part of the market in vogue, and another part in the doghouse. But since you can't accurately predict the next darling of Wall Street, stick with a diverse portfolio that covers all of the market.

What's So Great About Index Funds?

Question of the week:I've been hearing a lot lately about the benefits of index funds and they sound interesting, but I hesitate to invest in them because they will never beat the market. Why should I settle for just average returns?
--Douglas R.

Dear Douglas,

You've asked a great question that often comes up for people considering index funds. First, let's define exactly what we're talking about.

An index is simply a list of stocks. A well-known example is the S&P 500, made up of 500 of the largest companies in the U.S. An index fund seeks to do nothing more than match the performance of its index, which it does by either owning every stock in the index, or a representative sampling of it. By its very makeup, an index fund will never outperform its index. In contrast, actively managed funds seek to beat the performance of the market by selecting stocks that their managers believe will have above-average returns.

So why would anyone settle for average? It's because the "average" of index funds is actually better than the performance of most actively managed funds. According to The Vanguard Group, a leading provider of index mutual funds, the S&P 500 index outperformed 72 percent of large-cap, actively managed funds in 2001. And looking back over a longer time frame at the ten years ending December 31, 2000, the average low-cost index fund beat out the average stock fund by a half a percentage point each year.

In addition to superior long-term performance, index funds have other important advantages. Armchair Millionaire community members weigh in with some of them:

Low expenses. "Investing in index funds is the most effective tool for maximizing returns while maintaining very low expenses." --Reuben

Minimized taxes. "There's nothing more tax efficient than an index fund. Since indexes don't change that often, funds don't sell that often, which minimizes capital gains." --Polly T.

Simplicity. "I've switched mostly to index funds because of their simplicity. Now I can concentrate on my real work and just rebalance my portfolio quarterly." --Harry SW

Use my checklist to construct a solid, common sense portfolio with index funds.

The Armchair Millionaire's Checklist for an Index Fund Portfolio

• Cover the market. Use index funds to invest in every part of the stock market. An S&P 500 index fund will cover the large companies, a Russell 2000 index fund will cover the small companies, and an EAFE index fund will cover the major international stocks. I invest one-third of my own portfolio in each of these indexes.

• Explore the niches. Once you have the base of your portfolio established with funds of the major indexes, consider spicing it up a bit with one or two index funds that specialize in one sector or industry.

• Invest regularly. Most fund families will allow you to make automatic monthly or quarterly investments drawn directly from your bank account. Doing so will make investing easy and give you the benefits of dollar cost averaging--take advantage of it.

• Rebalance periodically. Since each index will have a different rate of return, keep your eye on your target asset allocation (the percentage of your portfolio that each index represents) and rebalance your portfolio as necessary.

THE BOTTOM LINE: In any given year, some actively managed funds will outperform their index. But the chances of the same fund beating the market year after year are extremely small. Use index funds to achieve market returns, with low fees and low taxes.

Choosing the Best Mutual Funds

Question of the week: I've just come into a small inheritance and I want to sock it away for the future. Everyone tells me that I should be looking into stock mutual funds. If you were to believe all the mutual fund advertising, you'd think that every fund is a winner. How do I really know which fund is any good? --Joel

Dear Joel,

For people who don't have the time and expertise to research and track individual stocks--which includes most of us--mutual funds are one of the best possible ways to invest. And a lot of other investors agree--the Investment Company Institute, the trade group for the mutual fund industry, says that Americans have nearly $7 trillion stashed away in mutual funds.

But there are thousands of fund choices, so it's very important to sort out the weak from the chaff. We recently asked the Armchair Millionaire community for its advice on what to look for when shopping for a fund. They offered us this battle-tested wisdom:

Check out the management. "I look for long-term management. I want my fund managers to have been in their jobs for a long time--at least seven years." --Cole

Consider fees. "I look at the fees first. Just because a fund charges higher fees doesn't mean that it is well managed. If a fund has above-average fees, I skip it." --ACF

Compare returns to a benchmark. "The past performance of a fund alone is meaningless. You have to compare it to how the market overall has done. I always compare large cap funds to the S&P 500 index and small cap funds to the Russell 2000." --James49

Watch the tax impact. "I want my money managed for the least taxable exposure. I expect my fund managers to be able to manage the fund for maximum tax efficiency." --Presto

It's also important to know what not to do when choosing a fund. Use my checklist to avoid the most common mutual fund mistakes.

The Armchair Millionaire's Checklist of Mutual Fund No-Nos

• Don't pay a load. Loads, or sales fees, come straight out of your investment. There's no evidence that load funds perform any better than no-load funds, so keep your money and stick with the no-loads.

• Don't overlap. Funds are themselves a diversified investment, but don't think that owning a lot of funds means that you'll be even more diversified. Instead, you may end up with many funds that own the same stocks. You should be able to achieve adequate diversification with as few as two or three funds that target different areas of the overall stock market.

• Don't chase performance. Last year's hot fund can be this year's laggard. Making your fund choices based on recent performance has historically been a losing proposition. Look for long term histories through a variety of market conditions such as bull markets, bear markets, recessions and periods of economic growth.

• Don't trade in and out of funds. Trying to time your investment and switching frequently between funds is pointless. You invest in funds to leave the trading up to a professional, so leave your money in your funds long enough for the portfolio managers to do their jobs.

THE BOTTOM LINE: All mutual funds are not created equal. When you choose a mutual fund, you're really choosing a person or a team to manage your money. Use common sense and make sure to get objective advice before you make a purchase.