10 Commandments of Mutual Fund Investing

How to separate the top finishers from the also-rans.
BY ROBERT R. THOMAS AND RICHARD C. MUSAR

ROBERT R. THOMAS, CFA, is vice-president and director of investment for the Aris Corp. of America in State College, Pennsylvania. His e-mail address is rthomas@ariscorporation. com . RICHARD C. MUSAR, CPA, is business development manager for the Aris Corp. of America. His e-mail address is rmusar@ariscorporation.com .

o pick the winning horse in thoroughbred racing involves research into the record of the horse, trainer and jockey as well as into how the horse performs under different weather and track conditions. Even then, there is no guarantee of choosing a winner. When a CPA firm that offers financial planning takes on the task of helping clients identify specific stock mutual funds that meet their stated goals and objectives, careful research also is required—and a surer outcome hoped for. Instead of trying to pick the winner in a field of 12 horses, CPAs have to advise clients which of the more than 5,000 domestic equity funds will parallel the results of today's high-flying stock market. Bonds (and by extension bond funds) are clearly rated by Moody's or Standard & Poors, but equity mutual funds (like horses) involve more of a gamble. CPAs need to know how to handicap the race, evaluating stock funds to find the winners and weed out the losers.

Fortunately, there are some proven methods CPAs can make use of to recognize high performers. By heeding the commandments that follow, CPAs can better judge which of the myriad funds available today will best meet a client's investment needs.

MEET THE CLIENT'S OBJECTIVES

When choosing stock mutual funds, it's important for CPAs to keep the client's investment goals in mind and customize the mix of funds to reflect them. For example, if the client is an aggressive investor focused on long-term growth and unconcerned about dividends, buying shares in a small cap fund may be a good choice. (See the mutual fund glossary on page 23.) On the other hand, if the client is retired, he or she may need the extra income dividends bring. In this case, CPAs should look into funds that specialize in large cap stocks or consider a fund that invests primarily in high-dividend utility stocks.

CPAs also must consider whether the funds they are evaluating include international stocks. If the client already has decided to allocate 10% of his or her assets to foreign investments, the CPA should not skew that decision by recommending funds that have significant international holdings. To avoid overallocating, CPAs should keep in mind that "international" funds are made up entirely of stocks from outside the United States while "world" funds comprise both domestic and foreign securities. For instance, Janus Worldwide has 30% of its assets in U.S. stocks even though it is commonly considered an international fund.

Fund managers can also trip up a client's asset allocation goals by changing directions. CPAs should be on the lookout for funds that are undergoing a style shift such as when the fund manager begins to invest differently, perhaps putting a chunk of the fund's assets into a different market sector. For example, because of the current success of large cap funds, some small cap fund managers have started to buy blue-chip stocks. However, the small cap manager may not understand the large cap market as well as someone who specializes in it. The situation is akin to having an orthopedic surgeon perform heart surgery—the manager is operating outside his or her area of expertise and this can cause the fund to underperform in different market cycles.

CORRECTLY EVALUATE FUND RETURNS

Many investors—and the CPAs who advise them—simply compare a fund's rate of return with the S&P 500 index. However, unless you have invested in a large cap fund that consists only of S&P stocks, this technique will not give you an accurate picture of how well the fund is performing. To compare apples with apples,

CPAs need to look at funds—or an index—with assets similar to the benchmark's. If the fund under consideration is a small cap fund, compare it with other small cap funds or with an index such as the Russell 2000. CPAs also must be careful when comparing large cap funds with each other. There are two different styles of large cap funds—large cap growth and large cap value (see glossary). For the first quarter of 1999, growth funds outperformed value funds, as shown in the exhibit on page 22. As tempting as it is to put all the money the client has designated for large cap funds only into growth funds, this strategy could land you in the buy highsell low trap. CPAs should protect their clients by diversifying and investing in both value funds and growth funds. After all, today's large cap market winners may be tomorrow's losers.

To hedge against a bear market, find out how a fund you are considering has done when prices are down. CPAs can research a fund's historical performance by subscribing to one of the three large databases—Morningstar, Weisenberger and Ibbotson— that track fund performance on the Internet. (See the list of Internet resources below for information on how to contact these companies.) How did the fund do when the market dropped in 1990 and again in 1994? What about during July and August of 1998? Don't choose a fund that performed significantly below the market average in tough times, even if it does well when markets are flush.  

Internet Resources
Here are just a few of the Web sites that will help CPAs select and track mutual funds.
www.findafund.com > Access to in-depth mutual fund profiles and portfolio updates by e-mail.
www.fundsinteractive.com > News, research and links as well as a mutual fund message board and online polls.
www.ibbotson.com > A wealth of information on mutual fund performance from a veteran provider of investment data.
www.mfcafe.com > The Mutual Fund Caf provides news, analysis and other fund information.
www.morningstar.net/ > Basic service, including information on more than 7,500 mutual funds, is free. Premium service, offered for a monthly fee, provides advanced fund screening and full access to this company's mutual fund news.
www.mutualfundresearch.com > Customized research reports by e-mail as well as other information to help investors and advisers monitor their portfolio.
www.tradingday.com/mf/html > Mutual fund research, news and commentary.
www.weisenberger.com > A variety of resources including customized data services, software and information on nearly 10,000 mutual funds.

Fund Facts
  • Assets in mutual funds increased 24% in 1998 to $5.5 trillion. This was the fourth consecutive year of more than 20% growth. Investment performance—appreciation plus reinvested dividends—accounted for about half the increase.
  • Assets in equity mutual funds increased 26% in 1998 to $2.98 trillion. Large cap U.S. funds captured the majority of new money, followed by small cap and international funds.
  • An estimated 77.3 million individuals in 44.4 million U.S. households own the majority—78%—of mutual funds. Banks, trustees and other institutional investors own the remaining 22%.
  • Mutual funds distributed an estimated $161 billion in long-term capital gains to shareholders in 1998, down from a record $184 billion in 1997. Investors reinvested almost 90% of these gains.

Source: Investment Company Institute, Mutual Fund Fact Book, 1999 edition. www.ici.org .

EVALUATE THE FUND'S MANAGERS

Never accept a fund's track record at face value. Look more deeply to find the source of its success—or failure. The best way to predict a fund's performance is to analyze its manager. How long has he or she been on the job? How experienced are the research analysts the manager works with? Remember, the fund doesn't pick stocks; the manager does. If a fund has an excellent five-year track record, but the current manager has been on the job for only six months, the fund's future based on its five-year performance is moot. The Web sites listed in the Internet Resources sidebar at right also will be helpful in providing this information.

Many investors make the mistake of assuming a fund will continue its strong performance even when the manager changes. This often is not the case. To decide whether to advise a client to buy or sell in such circumstances, CPAs should do some research on the new fund manager. Has he or she managed a similar fund in the past? For example, in one fund family our firm deals with, a strong manager left one of the company's small cap growth funds. Although the new manager had an excellent track record, he had no small cap experience. We advised our clients to sell out of the fund. Within the year, the fund—which had been a five-star performer—was performing below average. In another instance, when a well-known fund manager left his job (see the box on page 25 for one way to track manager changes), many investors were skittish about keeping money in the fund. The new manager had an excellent track record following the same style of investing, and the fund remained successful.  

DON'T DISMISS POORLY PERFORMING OR NEW FUNDS

While this commandment may sound odd, even a fund that has been operating for only six months probably will do well if it is managed by someone with a solid track record for the same kind of fund. By the same token, funds that have performed poorly can turn around quickly if a new manager with strong expertise managing a similar fund comes on board. As noted above, the fund manager is key to the fund's profitability.

CPAs also should not avoid a fund that has fallen on hard times because it is in a sector that is out of favor or because the fund's manager has an underperforming investment style. If a CPA shuns such funds, clients can lose out in two ways: They miss an opportunity to further diversify their portfolios and the chance to profit when these funds regain their market share. For example, this past April both value funds and small cap funds experienced resurgence. Patient investors who had never sold out of these funds reaped the benefits.

Large Cap Fund Performance*
  First Quarter 1999 Last 12 Months Last 3 Years Last 5 Years
Large cap value funds .95% 2.16% 17.91% 18.81%
Large cap growth funds 7.87% 17.45% 26.32% 23.20%
*Information provided by Morningstar, Inc. as of March 31, 1999.

KEEP TAXES LOW

Helping a client avoid an unnecessarily heavy tax burden is an integral part of any good investment plan. To further this, CPAs should recommend that the client invest money held outside of qualified retirement plans or IRAs in mutual funds with low distribution yields. (Most mutual funds distribute dividends and capital gains to shareholders monthly, quarterly or annually.) The shareholder is required to pay taxes on these distributions even if they are reinvested in additional shares.

Clients can minimize taxable distributions by not investing in a fund just before its "ex-date"—the date the fund pays distributions. For example, assume a client buys shares in a fund for $8.50 per share just three days before the fund pays its quarterly dividend. If the fund makes a distribution of 50 cents per share, the client now has that much of his or her investment back. The problem—in addition to the fact that the value of the client's investment has declined by the amount of the distribution—is that the distribution is taxable. The client has essentially purchased 50 cents per share of taxable income. Clients always should make a purchase after the ex-date. Another good strategy for avoiding tax headaches is to pay attention to a fund's turnover ratio. This figure provides a quick, accurate gauge of how often the fund manager trades stock in the fund's portfolio. A 50% turnover ratio means the manager changes half of the portfolio annually. A fund manager who holds—rather than sells—securities will not distribute too many capital gains to investors.  

SCRUTINIZE FUND EXPENSES

In addition to the investment management fee a CPA firm may charge, clients also incur other mutual fund expenses. These include the fund's internal expense ratio, an upfront or deferred sales charge or "load" and 12(b)-1 fees. The 12(b)-1 fee is included in the fund's internal expense ratio although it is sometimes shown separately in the fund prospectus. Clients also may be charged transaction costs, an additional fee the custodian charges to buy and sell fund shares. The fund also will incur trading fees—commissions it pays to trade stocks—that are not included in the internal expense ratio. These fees increase as a fund's turnover ratio increases.

Remember that any fee a client pays lowers returns, so it is important for CPAs to carefully evaluate the expenses associated with a recommended fund. A good first step is to compare the fund's expense ratio with that of other funds with the same management style. For example, according to Morningstar, the average internal expense ratio for technology funds was 1.75%. For health care funds, the average was 1.66%. (For more information on evaluating mutual fund fees, see the sidebar on page 24.)  

Mutual Fund Terms
Alpha factor. Measures the difference between a fund's actual and expected returns.
Beta factor. Measures a fund's sensitivity to market movements.
Distribution yield. A measure of a fund's income distributions. A fund's monthly yield is calculated by dividing its annualized dividend plus short-term capital gains, if any, by the average 30-day offering price.
Internal expense ratio. The percentage of its assets that a fund pays for operating expenses, management, 12(b)-1 and administrative fees.
Large cap fund. A mutual fund that specializes in the stocks of large companies—those with a market capitalization over $8.3 billion as defined by Morningstar, Inc.
  • Large cap growth stock. Equity securities of large cap companies that have high forecasted sales growth, high return on equity and low dividend payout.
  • Large cap value stock. Equity securities of large cap companies that have low forecasted priceearnings ratios, low pricebook ratios and high dividend yields.
Median market capitalization. A measure of the size of the companies in which a fund invests—small cap, mid cap and large cap.
Mid cap fund. A fund that specializes in the stocks of midsize companies—those with a market capitalization between $1.2 billion and $8.3 billion, as defined by Morningstar, Inc.
Pricebook ratio. The latest closing price of a stock divided by the revenues per share.
Priceearnings ratio. The current market price of a stock divided by some measure of earnings per share.
S&P 500 index. A capitalization-weighted index made up of 500 stocks traded on the New York and American stock exchanges and over the counter. Stocks are selected based on market size, liquidity and industry group representation.
Sector fund. A fund that focuses on one particular economic segment such as health care, natural resources, financial services or technology. Sector funds are an ideal way to invest in a specific industry without sacrificing diversity.
Small cap fund. A fund that specializes in the stock of smaller companies—those with a market capitalization under $1.2 billion, as defined by Morningstar, Inc.
Standard deviation. A depiction of how widely a fund's returns have varied over time.
Turnover ratio. A representation of how frequently a manager trades a fund's portfolio. A ratio of 100% suggests that a manager changes the entire portfolio annually.
12(b)-1 fee. Named for the SEC rule that permits it, this is a yearly fee charged for a fund's promotion, marketing and distribution expenses.

DIVERSIFY THE CLIENT'S PORTFOLIO

Diversification is important to the success of any investment portfolio. A client should both invest in several different mutual funds and make sure the funds themselves are invested in different industries. To ensure the portfolio is well diversified, a CPA can start by examining what industries a fund invests in. If the client has decided to risk a certain percentage of his or her mutual fund portfolio in technology sector funds, it is not a good idea to increase that risk by buying a general equity fund that also invests heavily in technology stocks. Should the technology industry take a tumble, the general equity fund, which is supposed to hedge the risk the client is taking in the sector fund, will also fall.

Keep in mind that fund managers may have different philosophies. CPAs can further diversify and customize a client's portfolio by selecting funds run by managers with differing management styles. For example, there are three different types of large cap value funds. Some value managers are disciples of GARP—growth at a reasonable price. They will purchase growth stocks that are for some reason "on sale." Other managers are contrarians and will pick stocks from the bottom of the barrel, following the old buy lowsell high strategy. Still others take what is called an equity income approach. These funds generally invest at least half of their assets in stocks with above-average dividends, and they are often a good choice for investors seeking income.  

Fund Expenses Really Do Matter

Mutual fund costs take a big chunk out of investor returns. That's why it's important for CPAs today to know what costs an investor is paying and which cost structure is best. Many investors have made a great deal of money by investing in mutual funds. Although much of this success is attributable to a booming stock market, economies of scale also contribute. Since mutual funds buy and sell securities in large blocks, they have lower trading and transaction costs than a single investor could possibly get when buying and selling individual securities. Funds also can make more cost-effective arrangements for securities custody, recordkeeping and tax accounting and reporting than individuals can.

INVESTOR BEWARE

Annual mutual fund charges (expense ratios) vary widely, from a high of 3% to as low as 0.07%. Expense ratios include custodial fees, shareholder servicing fees, administrative expenses (postage, printing, overhead, accounting and legal), money management fees and, in some cases, 12(b)-1 fees. Some funds also charge front-end, annual or exit fees called "loads." Loads can be a substantial disincentive to move in and out of a fund, making it difficult to prudently manage a portfolio. Today there are many excellent no-load mutual funds available. Information about these mutual funds is easily accessible.

Don Phillips, president and CEO of Morningstar, says the mutual fund industry "still offers terrific value, great convenience and services that help a lot of investors." In a 1998 speech, Barry Barbash, former head of the SEC Division of Investment Management, told mutual fund industry insiders that "investors pay for investment advice, whether it comes in the form of a mutual fund, a wrap fee program or a broker. How much an individual pays appears to be somewhat less of a concern today, when people may do more comparison shopping for a VCR than for a mutual fund."

Most investors, Barbash said, are "blissfully unaware" of how much they pay for the privilege of owning a mutual fund. He cited a 1996 report by the Office of the Controller of the Currency and the SEC, Survey of Mutual Fund Investors, which concluded that "less than one American in five knows how much his or her funds charge. It seems that when economic times are good, investors think they can afford to be oblivious to these costs." Barbash also cautioned that "investor attitudes toward fees are likely to change, however, should mutual fund performance decline."

Mutual Fund Fees: Impact of a 1% Fee Difference
    Number of Years Investment Is Held/Investment Value
  Expense Rate 5 years 10 years 15 years 20 years 25 years
  .75% $16,000 $24,000 $38,000 $59,000 $91,000
  1.75% $15,000 $22,000 $33,000 $49,000 $73,000
Source: Jonathan Pond.

CALCULATE THE DIFFERENCE

Jonathan Pond, a CPA and well-known financial planner, calculated how much difference investment expenses can make over time. The exhibit above shows that investment expenses make a sizable difference in how well an investment performs. The table illustrates how much a small difference in mutual fund expenses can mean to an investment nest egg. It compares a $10,000 investment in two different funds, both of which produce 10% annual returns, before expenses. After 25 years, a 1% difference in expenses can mean nearly $20,000 less in an investor's pockets.

In April 1999, the SEC introduced a mutual fund cost calculator, an interactive Internet-based tool that promises to "take the mystery and math out of the cost equation." The calculator will help investors estimate and compare the costs of owning mutual funds (including sales charges and annual operating expenses) and assess the long-term impact on investment returns. The calculator can help investors find quick answers to questions such as "which is better, a no-load fund with yearly expenses of 1.75% or a fund with a 3.5% front-end sales charge and yearly expenses of 0.90%?" CPAs and their clients can assess the SEC financial facts tool-kit—which includes the mutual fund cost calculator—at www.sec.gov/ consumer/toolkit.htm .

IN SEARCH OF LOWER COSTS

The most important consideration in selecting a mutual fund is its potential to perform well. Even so, CPAs need to keep an eye on sales charges and expenses, which can seriously erode client returns. As the exhibit shows, a slight difference in expenses can make a big difference in the amount that accumulates long-term. Lower cost funds put more money to work. That's why CPAs should study mutual fund expenses carefully and find the most cost-effective funds to recommend to their clients.

—Phyllis Bernstein, CPA/PFS, director of the AICPA personal financial planning division.

BE CAUTIOUS ABOUT INVESTING IN OVERSIZE FUNDS

If a fund has become bloated and simply has too much money to spend, the fund manager will have a harder time reacting quickly to changes in the market. (After all, it's a lot easier to turn a speedboat than an aircraft carrier.) The larger a fund becomes, the more difficulty the manager will have finding stocks that meet the fund's goals and philosophy.

These factors are one reason why a fund will close to new investors once it reaches a certain size; management wants to maintain its investment agility. Since the danger of becoming sluggish is greater for small cap funds, due to liquidity issues, many such funds close their doors when they are managing assets of $1 billion or less.

Conversely, CPAs also need to beware funds that have only a small number of holdings—those that have invested in only a few choice stocks. If a fund has 30 or fewer holdings, it is not fully diversified. Although the fund may be profitable, you'll have to monitor it more closely than other funds. And unless the client is a risk taker, a portfolio concentrated in only a few stocks may not be appropriate.

Tracking Manager Changes

One way CPAs can track changes in mutual fund managers is through FundAlarm, a free, noncommercial Web site ( www.fundalarm.com/ ) that helps investors "know when to hold 'em, know when to fold 'em...." The site tracks 2,606 stock and balanced mutual funds and includes a page of recent manager changes. Updated monthly, the page tracks manager changes, hirings and firings for 12 months, with an archive of prior changes available. The site also includes a wealth of other helpful information on the tracked funds; for example, funds are compared with one of six benchmarks.

MINIMIZE RISK

When selecting a fund, CPAs can use several techniques to determine the fund's stability. CPAs should consider these risk factors in the fund's prospectus:

Beta factor. A standard beta—indicating the norm—is 1.00. If a fund has a beta of 1.10, it should perform at 10% better than the index it is benchmarked against during an up market and 10% worse during a down market. A low beta, below 0.80, signifies that the fund's market-related risk is low. CPAs should check a fund's beta to make sure the risk matches the client's objectives and risk tolerance.

Alpha factor. A positive alpha indicates that a fund has performed well, given its beta factor. CPAs can use alpha to see if a fund manager has added value to a fund's return given the level of risk taken. For example, if a fund has a beta of 1.2 and the market index returns 10%, the fund should return 12% since it took on 20% more risk. If the fund actually performs 13%, the fund has a positive alpha of 1%.

Standard deviation. When a fund follows a normal standard deviation, this means roughly 68% of the time the fund's returns will fall within one standard deviation of the mean return of the fund. Approximately 95% of the time it will fall within two standard deviations of the mean. If a fund has a mean annual return of 15% and a standard deviation of 13%, the return will be between 2% and 28% about 68% of the time. It will be between 211% and 41% about 95% of the time. Economic conditions. CPAs also can determine risk by looking at how a fund manager reacted to bull and bear markets, periods of high and low inflation or high and low interest rates. CPAs should look carefully at the current economic environment and select a manager whose track record is suited to the circumstances. For example, now would not be a good time to invest with a manager who does well only in times of high inflation. So what should a CPA look for? Generally, the best bet is a fund with a beta of 1.1 or less, a positive alpha and a standard deviation not more than 10% higher than that of the fund's peers.

MONITOR, MONITOR, MONITOR

This last commandment is perhaps the most important to heed. Besides evaluating a fund before recommending it to a client, a CPA must continue to keep an eye on how the fund is doing so he or she can advise clients when to buy, sell or hold. CPAs have to check on the funds they have selected at least monthly and do a thorough analysis every three months. Virtually all of the major fund families have Internet Web sites that provide up-to-the-minute information. With investment markets constantly changing, the great fund the CPA picked a few short months ago may turn sour—and violate some of these commandments. The fund's manager could change, the fund itself could undergo a style shift, the manager could begin investing in riskier stocks or the fund could become too large. CPAs who recommend mutual funds to their clients would be well advised to keep their ears to the ground, their noses in the Wall Street Journal and their Web browsers pointed at one of the many sites that provide mutual fund research information.

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