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10 Things About Funds Investors Should Know About.

Posted on | July 11, 2008 |

10 Things About Funds Investors Should Know About.

Whether you invest in mutual funds, index funds or exchange-traded funds and whether those funds are held in your 401(k), IRA or 403(b) there are a lot of factors to consider when choosing the right fund.

Here is quick and dirty break down of 5 different types of funds that are common in retirement accounts, and 5 terms commonly associated with those funds and what they mean. Just because you stash away 10% or more of your income doesn’t mean you can ignore where it goes.

I. TYPES OF FUNDS.

1. Mutual Fund.

Mutual funds are the most common investment vehicle for the average person. If you have a 401(k) or a 401(b), chances are very high that you have mutual funds in your portfolio.

A mutual fund is a pool of money collected from institutions and individuals for the purpose of investing in individual securities like stocks, bonds and money market accounts. In an example of a 401(k), you have money taken out of your paycheck each period and sent to your 401(k) account. That money is then used by the 401(k) firm (Fidelity for example) to purchase shares of the mutual fund(s) in your portfolio. Mutual funds are operated by money mangers and it is the money manager that will decide how the money is to be invested.

The advantage of mutual funds is that they offer access to professional investment managers and diversification to small investors that might not have the financial assets to access otherwise. Also, many fund companies waive many of the account fees for investors who invest regularly through payroll deduction for example, so it doesn’t take as much money to start investing.

2. Index Fund.

An index fund is a type of mutual fund in which the money manager chooses the underlying investments to match a specific market index. The most common index fund is probably an S&P 500 index fund, which attempts to match the performance and diversification of the Standard and Poor’s 500 largest U.S. stocks. Beyond this objective, the implied goal of an index fund is to provide broad market exposure (i.e. diversification), average gains and low operating costs (see expense ratios below).

Index funds are cheaper to run than other mutual funds because they are passive investments, meaning that the money manager determines which stocks the fund will hold a few times per year based on the type of index the fund is tracking and buy and hold based on this predetermined mix. Essentially, it’s more like a “set it and forget it” approach than active investing (see below).

The argument for index investing is that some 75% or so actively managed mutual funds fail to beat the index average over the long term (10+ years), so most investors are better off sticking to the average. There are cases in which it is better to avoid the average and focus on fewer stocks, but these are typically viewed as exceptions to the rule. Warren Buffett is a prime example. His approach is the exact opposite of everything I and other sites advocate, but the point is you and I are not Warren Buffett. If we were, we wouldn’t be reading personal finance blogs - we’d be second wealthiest man in the world. :)

3. Life-Cycle Fund.

Life-Cycle funds have been called “the future of retirement planning.” These funds are a type of mutual fund in which the asset allocation is automatically balanced (or adjusted) based on the length of time from the present to the time horizon of the fund. This is based on the tenets of diversification and asset allocation as described by modern portfolio theory (MPT) .

For example, MPT says that as an investor nears retirement age, he should invest more in bonds and less in stocks. So if the investor plans on being at retirement age in 2030, he will pick a 2030 life-cycle fund. At the time at which he buys the fund, he is still many years from retirement age so the fund will have 90-100% invested in stocks. By the time 2030 rolls around his fund will have automatically adjusted to something closer to 60% stocks, 40% bonds. It may be 70/30, but the point is the investor didn’t have to think about it - it happened automatically for him. It is because of this age component that life-cycle funds are also referred to as “age-based funds”.

The power of these types of funds is that they are the ultimate in “set it and forget it!” These are funds that work well with the average, lazy investor. Someone who is more concerned with playing World of Warcraft, or keeping tabs on many sports teams for multiple sports in a given season than keeping tabs on their money will do better in this type of fund. This type of fund is not for the DIY investor or someone who wants to be more active in their retirement planning.

4. Load Fund.

A load fund is a mutual fund (or index or life-cycle fund) that carries a sales commission or purchase fee. This extra fee is the load which the fund must bear. It is important to view this load as a weight because it automatically sets the fund back in terms of what it must gain to remain competitive or beat an index fund. Many load funds attempt to beat the average or index of the market. If the fund carries a load of 2%, then the fund must beat the index by 2% to break even. Some funds are worth this, many are not.

If the load is paid at the time of purchase, it is a front-end load. If the load is paid upon sale of the shares, then it is a back-end load. Some funds charge a load for the entire time the fund is held. This type of load is called a level-load.

IMPORTANT NOTE: If a fund limits its level load to no more that 0.25% (the maximum is 1%), it can call itself a “no-load” fund in its marketing literature.

5. Open-End Fund.

Open-end funds are mutual funds that do not have a restriction on the number of shares that can be sold. Open-end funds are required to buy back shares when investors wish to sell. If a fund’s management determines that the assets of the fund (i.e. the money taken into the fund) have grown too much and they are unable to provide the performance they wish, then they can close the fund. Closed-end funds are funds that do not issue more shares and are not required to buy them back. Closed-end fund shares are little bit more like stocks in this regard because if you can’t find a buyer, then you’re stuck with the shares. However, this often leads to higher share value since it creates more demand for the outstanding shares.

II. FUND TERMS.

1. Family Of Funds.

When an investment company, such as Fidelity or Vanguard, offers a mutual fund, that fund is said to be part of that company’s family of funds. This is also called a  “mutual fund family” or a “fund family.” Larger investment firms typically offer a larger family of funds and a wider selection of categories to invest in.

2. Diversification.

Diversification is a simple concept of portfolio management. The basis is rooted in the belief that different sectors of the market, or the economy, perform better than other sectors at different times. To put it another way, the stock market as a whole does not always go up. We’re watching this play out now with oil and financial’s. Bank stocks have tanked since the housing bust and subprime loan problems, while oil stocks have boomed with increased demand and speculation.

A properly diversified portfolio, so the theory goes, will hold both financial stocks and oil stocks, thus limiting the damage done by the loss in financial stocks but also limiting the gains made by the oil stocks. Proper diversification yields higher than average return for lower than average risk. Diversification attempts to eliminate one of the biggest sources of lost money in investing: performance chasing. Picking the right stock or sector just before it booms is a great way to build wealth, but it’s also a great way to lose your shirt if not done properly.

Critics of diversification often cite examples like Warren Buffett to show how focusing (the opposite of diversifying) can lead to mind blowing returns and wealth building. While this is true, it often requires a level of investing and business acumen that the average person does not have or is not interested in having. For this reason, diversification is often recommended for most investors.

3. Net Asset Value (NAV).

A fund’s NAV is its share price. The NAV is derived by taking the total value of all the assets held by the fund (subtracting any liabilities) and dividing it by the number of shares outstanding. A mutual fund’s (or index fund or ETF’s) NAV is like a stock’s book value.

A mutual fund’s NAV is calculated once every day and is based on closing market price of the underlying assets held by the fund. Since most mutual funds pay the share holder virtually all of their income and capital gains, the NAV is not considered the best performance gauge.

Conversely, Closed-end funds and ETFs (exchange-traded funds) trade at market value like stocks, so their share price may be at a premium or discount to their NAV.

4. Active Management.

Active managed funds have a manager, or team of managers that actively track the market and determine which assets to buy for a given fund’s portfolio. The managers of these funds use analytical research, market and economic forecasts as well as their own judgement and experience to determine whether to buy, sell or hold an investment.

Actively managed funds are at the opposite philosophical spectrum from index, or passive investments. Proponents say that actively managed funds can out perform the market in general because their managers can take advantage of trends and the mistakes of others. Critics say that actively managed funds are why 75% of all mutual funds fail to beat the index.

5. Expense Ratio.

The expense ratio tells you how expensive a fund is to own. This is sometimes known as the “management expense ratio” (MER), because it is determined by calculating the fund’s operating expenses for the year, and dividing that by the average dollar value of its assets under management. Since operating expenses are subtracted from a fund’s assets, they lower the overall return of the fund. Expense ratio is the single biggest influencer of return that the individual investor can control. You may not be able to pick the sector that will out perform the market over the next 12 months, but you can pick the amount of return you want to fork over to the management of the fund.

Still, it is important to note that operating expenses vary widely from one type of fund to another. But the expense ratio of two similar funds should be considered on an even plain. So, if large cap growth fund A has an expense ratio twice that of large cap growth fund B, then fund A should out perform fund B by at least the difference, or it is not worth its expense.

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