Introduction Mutual funds have become extremely popular over the last 20 years. Once which was just another obscure financial instrument is now a part of our daily lives. More than 80 million people, or one half of the households in America, invest in mutual funds. That means that, in the United States alone, trillions of dollars are invested in mutual funds. In fact, too many people, investing means buying mutual funds. After all, its common knowledge that investing in mutual funds is better than simply letting your cash waste away in a savings account, but, for most people, that's where the understanding of funds ends. It doesn't a help that mutual fund is salespeople understand. Originally, mutual funds were heralded as a way for the little guy to get a piece of the market. Instead of spending all your free time buried in the financial pages of the Wall Street Journal, all you had to do was buy a mutual fund and you'd be set on your way to financial freedom. As you might have guessed, it's
1
speak
strange
language
that
interspersed with jargon that many investors don't
not that easy. Mutual funds are an excellent idea in theory, but, in reality, they haven't always delivered. Not all mutual funds are created equal, and investing in mutual isn't as easy as throwing your money at the first salesperson who solicits your business. In this tutorial, we'll explain the basics of mutual funds and hopefully clear up some of the myths around them. You can then decide whether or not they are right for you. The Definition A mutual fund is nothing more than a collection of stocks and/or bonds. You can think of a mutual fund as a company that brings together a group of people and invests their money in stocks, bonds, and other securities. Each investor owns shares, which represent a portion of the holdings of the fund. A mutual fund is a company that pools money from many investors and invests the money in stocks, bonds, short-term money-market instruments, or other securities. Legally known as an "open-end company," a mutual fund is one of three basic types of Investment Company. The two other basic types
2
are closed-end funds and Unit Investment Trusts (UITs). You can make money from a mutual fund in three ways: 1) Income is earned from dividends on stocks and interest on bonds. A fund pays out nearly all of the income it receives over the year to fund owners in the form of a distribution. 2) If the fund sells securities that have increased in price, the fund has a capital gain. Most funds also pass on these gains to investors in a distribution. 3) If fund holdings increase in price but are not sold by the fund manager, the fund's shares increase in price. You can then sell your mutual fund shares for a profit. Funds will also usually give you a choice either to receive a check for distributions or to reinvest the earnings and get more shares.
Types of mutual funds 1. Open-end fund
3
The term mutual fund is the common name for an open-end investment company. Being open-ended means that, at the end of every day, the fund issues new shares to investors and buys back shares from investors wishing to leave the fund. Mutual funds may be legally structured as corporations or business trusts but in either instance are classed as open-end investment companies by the SEC. Other funds have a limited number of shares; these are either closed-end funds or unit investment trusts, neither of which a mutual fund is. 2. Exchange-traded funds A relatively recent innovation, the exchange traded fund (ETF), is often formulated as an open-end investment company. ETFs combine characteristics of both mutual funds and closed-end funds. An ETF usually tracks a stock index (see Index funds). Shares are issued or redeemed by institutional investors Investors in large blocks (typically shares of 50,000). in small typically purchase
quantities through brokers at a small premium or discount to the net asset value; this is how the
4
institutional investor makes its profit. Because the institutional investors handle the majority of trades, ETFs are more efficient than traditional mutual funds (which are continuously issuing new securities and redeeming old ones, keeping detailed records of such issuance and redemption transactions, and, to effect such transactions, continually buying and selling securities and maintaining liquidity position) and therefore tend to have lower expenses. ETFs are traded throughout the day on a stock exchange, just like closed-end funds. Exchange traded funds are also valuable for foreign investors who are often able to buy and sell securities traded on a stock market, but who, for regulatory reasons, are unable to participate in traditional US mutual fund. 3. Equity funds Equity funds, which consist mainly of stock investments, are the most common type of mutual fund. Equity funds hold 50 percent of all amounts invested in mutual funds in the United States. Often equity funds focus investments on particular strategies and certain types of issuers.
5
4. Capitalization Fund managers and other investment professionals have varying definitions of mid-cap and large-cap ranges. The following ranges are used by Russell Indexes Russell Micro cap Index - micro-cap ($54.8 - 539.5 million) Russell 2000 Index - small-cap ($182.6 million - 1.8 billion) Russell Midcap Index - mid-cap ($1.8 - 13.7 billion) Russell 1000 Index - large-cap ($1.8 - 386.9 billion) 5. Growth vs. value Another distinction is made between growth funds, which invest in stocks of companies that have the potential for large capital gains, and value funds, which concentrate on stocks that are undervalued. Value stocks have historically produced higher returns; however, financial theory states this is compensation for their greater risk. Growth funds tend not to pay regular dividends. Income funds tend to be more conservative investments, with a focus on stocks that pay dividends. A balanced fund may use a combination of strategies, typically including some
6
level
of
investment
in
bonds,
to
stay
more
conservative when it comes to risk, yet aim for some growth. [Citation needed] 6. Index funds versus active management Main articles: Index fund and active management An index fund maintains investments in companies that are part of major stock (or bond) indices, such as the S&P 500, while an actively managed fund attempts to outperform a relevant index through superior stock-picking techniques. The assets of an index fund are managed to closely approximate the performance of a particular published index. Since the composition of an index changes infrequently, an index fund manager makes fewer trades, on average, than does an active fund manager. For this reason, index funds generally have lower trading expenses than actively managed funds, and typically incur fewer short-term capital gains which must be passed on to shareholders. Additionally, index funds do not incur expenses to pay for selection of individual stocks (proprietary selection techniques, research, etc.) and deciding when to buy, hold or sell individual holdings. Instead, a fairly simple computer
7
model can identify whatever changes are needed to bring the fund back into agreement with its target index. The performance of an actively managed fund largely depends on the investment decisions of its manager. Statistically, the for every there investor is one end who who up outperforms index before market,
underperforms. Among those who outperform their expenses, fund though, should many have underperforming after expenses. Before expenses, a well-run index average performance. By minimizing the impact of expenses, index funds should be able to perform better than average. Certain empirical evidence seems to illustrate that mutual funds do not beat the market and actively managed mutual funds under-perform other broadbased portfolios with similar characteristics. One study found that nearly 1,500 U.S. mutual funds under-performed the market in approximately half of the years between 1962 and 1992. Moreover, funds that performed well in the past are not able to beat
8
the market again in the future (shown by Jensen, 1968; Grimblatt and Sheridan Titman, 1989. 7. Bond funds Bond funds account for 18% of mutual fund assets. Types of bond funds include term funds, which have a fixed set of time (short-, medium-, or long-term) before they mature. Municipal bond funds generally have lower returns, but have tax advantages and lower risk. High-yield bond funds invest in corporate bonds, including high-yield or junk bonds. With the potential for high yield, these bonds also come with greater risk.
8. Money market funds Money market funds hold 26% of mutual fund assets in the United States. Money market funds entail the least risk, as well as lower rates of return. Unlike certificates of deposit (CDs), money market shares are liquid and redeemable at any time. The interest
9
rate quoted by money market funds is known as the 7 Day SEC Yield. 9. Funds of funds Funds of funds (FoF) are mutual funds which invest in other underlying mutual funds (i.e., they are funds comprised of other funds). The funds at the underlying level are typically funds which an investor can invest in individually. A fund of funds will typically charge a management fee which is smaller than that of a normal fund because it is considered a fee charged for asset allocation services. The fees charged at the underlying fund level do not pass through the statement of operations, but are usually disclosed in the fund's annual report, prospectus, or statement of additional information. The fund should be evaluated on the combination of the fund-level expenses and underlying fund expenses, as these both reduce the return to the investor. Most FoFs invest in affiliated funds (i.e., mutual funds managed by the same advisor), although some invest in funds managed by other (unaffiliated) advisors. The cost associated with investing in an unaffiliated underlying fund is most often higher than
10
investing in an affiliated underlying because of the investment management research involved in investing in fund advised by a different advisor. Recently, FoFs have been classified into those that are actively managed (in which the investment advisor reallocates frequently among the underlying funds in order to adjust to changing market conditions) and those that are passively managed (the investment advisor allocates assets on the basis of on an allocation model which is rebalanced on a regular basis). The design of FoFs is structured in such a way as to provide a ready mix of mutual funds for investors who are unable to or unwilling to determine their own asset allocation model. Fund companies such as TIAA-CREF, Vanguard, and Fidelity have also entered this market to provide investors with these options and take the "guess work" out of selecting funds. The allocation mixes usually vary by the time the investor would like to retire: 2020, 2030, 2050, etc. The more distant 10. the target retirement date, the more aggressive the asset mix. Hedge funds
11
Hedge funds in the United States are pooled investment funds with loose SEC regulation and should not be confused with mutual funds. Some hedge fund managers are required to register with SEC as investment advisers under the Investment Advisers Act. The Act does not require an adviser to follow or avoid any particular investment strategies, nor does it require or prohibit specific investments. Hedge funds typically charge a management fee of 1% or more, plus a “performance fee” of 20% of the hedge fund’s profit. There may be a "lock-up" period, during which an investor cannot cash in shares. A variation of the hedge strategy is the 130-30 fund for individual investors. 11. Mutual funds vs. other investments
Mutual funds offer several advantages over investing in individual stocks. For example, the transaction costs are divided among all the mutual fund shareholders, who also benefit by having a third, party (professional fund managers), apply expertise and dedicate time options. to manage However,
12
and
research the
investment
despite
professional management, mutual funds are not immune to risks. They share the same risks associated with the investments made. If the fund invests primarily in stocks, it is usually subject to the same ups and downs and risks as the stock market. Advantages of Mutual Funds: • Professional Management The primary advantage of funds (at least theoretically) is the professional management of your money. Investors purchase funds because they do not have the time or the expertise to manage their own portfolios. A mutual fund is a relatively inexpensive way for a small investor to get a full-time manager to make and monitor investments. • Diversification - By owning shares in a mutual fund instead of owning individual stocks or bonds, your risk is spread out. The idea behind diversification is to invest in a large number of assets so that a loss in any particular investment is minimized by gains in others. In other words, the more stocks and bonds you own, the less any one of them can hurt you (think about Enron). Large mutual funds typically own hundreds of different stocks in
13
many different industries. It wouldn't be possible for an investor to build this kind of a portfolio with a small amount of money. • Economies of Scale - Because a mutual fund buys and sells large amounts of securities at a time, its transaction costs are lower than what an individual would pay for securities transactions. • Liquidity - Just like an individual stock, a mutual fund allows you to request that your shares be converted into cash at any time. • Simplicity - Buying a mutual fund is easy! Pretty well any bank has its own line of mutual funds, and the minimum investment is small. Most companies also have automatic purchase plans whereby as little as $100 can be invested on a monthly basis. Year after year, key players in the Forex market make a killing by picking the right currencies – now it’s your turn. Access industry gurus Boris and Kathy’s exclusive FREE report, The Five Things That Move the Currency Market – And How to Profit from Them, right now! Disadvantages of Mutual Funds:
14
• Professional Management - Did you notice how we qualified the advantage or of not professional the so-called management with the word "theoretically"? Many investors debate whether professionals are any better than you or I at picking stocks. Management is by no means infallible, and, even if the fund loses money, the manager still takes his/her cut. We'll talk about this in detail in a later section. • Costs - Mutual funds don't exist solely to make your life easier - all funds are in it for a profit. The mutual fund industry is masterful at burying costs under layers of jargon. These costs are so complicated that in this tutorial we have devoted an entire section to the subject. • Dilution It's possible to have too much diversification. Because funds have small holdings in so many different companies, high returns from a few investments often don't make much difference on the overall return. Dilution is also the result of a successful fund getting too big. When money pours into funds that have had strong success, the
15
manager often has trouble finding a good investment for all the new money. • Taxes - When making decisions about your money, fund managers don't consider your personal tax situation. For example, when a fund manager sells a security, a capital-gains tax is triggered, which affects how profitable the individual is from the sale. It might have been more advantageous for the individual to defer the capital gains liability. Different Types of Funds No matter what type of investor you are, there is bound to be a mutual fund that fits your style. According to the last count there are more than 10,000 mutual funds in North America! That means there are more mutual funds than stocks. It's important to understand that each mutual fund has different risks and rewards. In general, the higher the potential return, the higher the risk of loss. Although some funds are less risky than others, all funds have some level of risk - it's never possible to diversify away all risk. This is a fact for all investments.
16
Each fund has a predetermined investment objective that tailors the fund's assets, regions of investments and investment strategies. At the fundamental level, there are three varieties of mutual funds: 1) Equity funds (stocks) 2) Fixed-income funds (bonds) 3) Money market funds All mutual funds are variations of these three asset classes. For example, while equity funds that invest in fast-growing companies are known as growth funds, equity funds that invest only in companies of the same sector or region are known as specialty funds. Let's go over the many different flavors of funds. We'll start with the safest and then work through to the more risky. • Money Market Funds The money market consists of short-term debt instruments, mostly Treasury bills. This is a safe place to park your money. You won't get great returns, but you won't have to worry about losing your principal. A typical return is twice the amount you would earn in a regular
17
checking/savings
account and a little less than the average certificate of deposit (CD). • Bond/Income Funds Income funds are named appropriately: their purpose is to provide current income on a steady basis. When referring to mutual funds, the terms "fixed-income," "bond," and "income" are synonymous. These terms denote funds that invest primarily in government and corporate debt. While fund holdings may appreciate in value, the primary objective of these funds is to provide a steady cash flow to investors. As such, the audience for these funds consists of conservative investors and retirees. Bond funds are likely to pay higher returns than certificates of deposit and money market investments, but bond funds aren't without risk. Because there are many different types of bonds, bond funds can vary dramatically depending on where they invest. For example, a fund specializing in high-yield junk bonds is much more risky than a fund that invests in government securities. Furthermore, nearly all bond funds are subject to
18
interest rate risk, which means that if rates go up the value of the fund goes down. • Balanced Funds The objective of these funds is to provide a balanced mixture of safety, income and capital appreciation. The strategy of balanced funds is to invest in a combination of fixed income and equities. A typical balanced fund might have a weighting of 60% equity and 40% fixed income. The weighting might also be restricted to a specified maximum or minimum for each asset class. A similar type of fund is known as an asset allocation fund. Objectives are similar to those of a balanced fund, but these kinds of funds typically do not have to hold a specified percentage of any asset class. The portfolio manager is therefore given freedom to switch the ratio of asset classes as the economy moves through the business cycle. • Equity Funds Funds that invest in stocks represent the largest category of mutual funds. Generally, the investment objective of this class of funds is long-term capital growth with some income. There are, however, many
19
different types of equity funds because there are many different types of equities. A great way to understand the universe of equity funds is to use a style box, an example of which is below. The idea is to classify funds based on both the size of the companies invested in and the investment style of the manager. The term value refers to a style of investing that looks for high quality companies that are out of favor with the market. These companies are characterized by low P/E and price-to-book ratios and high dividend yields. The opposite of value is growth, which refers to companies that have had (and are expected to continue to have) strong growth in earnings, sales and cash flow. A compromise between value and growth is blend, which simply refers to companies that are neither value nor growth stocks and are classified as being somewhere in the middle. For e.g.:- a mutual fund that invests in large-cap companies that are in strong financial shape but have recently seen their share prices fall would be placed in the upper left quadrant of the style box (large and value). The opposite of this would be a
20
fund that invests in startup technology companies with excellent growth prospects. Such a mutual fund would reside in the bottom right quadrant (small and growth). • Global/International Funds An international fund (or foreign fund) invests only outside your home country. Global funds invest anywhere around the world, including your home country. It's tough to classify these funds as either riskier or safer than domestic investments. They do tend to be more volatile and have unique country and/or political risks. But, on the flip side, they can, as part of a well-balanced portfolio, actually reduce risk by increasing likely that diversification. another Although the world's is economies are becoming more inter-related, it is economy somewhere outperforming the economy of your home country. • Specialty Funds This classification of mutual funds is more of an allencompassing category that consists of funds that have proved to be popular but don't necessarily belong to the categories we've described so far. This
21
type of mutual fund forgoes broad diversification to concentrate on a certain segment of the economy. Sector funds are targeted at specific sectors of the economy such as financial, technology, health, etc. Sector funds are extremely volatile. There is a greater possibility of big gains, but you have to accept that your sector may tank. Regional funds make it easier to focus on a specific area of the world. This may mean focusing on a region (say Latin America) or an individual country (for example, only Brazil). An advantage of these funds is that they make it easier to buy stock in foreign countries, which is otherwise difficult and expensive. Just like for sector funds, you have to accept the high risk of loss, which occurs if the region goes into a bad recession. Socially-responsible funds (or ethical funds) invest only in companies that meet the criteria of certain guidelines or beliefs. Most socially responsible funds don't invest in industries such as tobacco, alcoholic beverages, weapons or nuclear power. The idea is to get a competitive performance while still maintaining a healthy conscience.
22
• Index Funds The last but certainly not the least important are index funds. This type of mutual fund replicates the performance of a broad market index such as the S&P 500 or Dow Jones Industrial Average (DJIA). An investor in an index fund figures that most managers can't beat the market. An index fund merely replicates the market return and benefits investors in the form of low fees. The Costs Costs are the biggest problem with mutual funds. These costs eat into your return, and they are the main reason why the majority of funds end up with sub-par performance. What's even more disturbing is the way the fund industry hides costs through a layer of financial complexity and jargon. Some critics of the industry say that mutual fund companies get away with the fees they charge only because the average investor does not understand what he/she is paying for. Fees can be broken down into two categories:
23
1. Ongoing yearly fees to keep you invested in the fund. 2. Transaction fees paid when you buy or sell shares in a fund (loads).
The Expense Ratio The ongoing expenses of a mutual fund are represented by the expense ratio. This is sometimes also referred to as the management expense ratio (MER). The expense ratio is composed of the following: • The cost of hiring the fund manager(s) - Also known as the management fee, this cost is between 0.5% and 1% of assets on average. While it sounds small, this fee ensures that mutual fund managers remain in the country's top echelon of earners. Think about it for a second: 1% of 250 million (a small mutual fund) is $2.5 million - fund managers are definitely not going hungry! It's true that paying managers is a necessary fee, but don't think that a high fee assures superior performance.
24
• Administrative costs - These include necessities such as postage, record keeping, customer service, cappuccino machines, etc. Some funds are excellent at minimizing these costs while others (the ones with the cappuccino machines in the office) are not. • The last part of the ongoing fee :-( in the United States anyway) is known as the 12B-1 fee. This expense goes toward paying brokerage commissions and toward advertising and promoting the fund. That's right, if you invest in a fund with a 12B-1 fee, you are paying for the fund to run commercials and sell itself! On the whole, expense ratios range from as low as 0.2% (usually for index funds) to as high as 2%. The average equity mutual fund charges around 1.3%1.5%. You'll generally pay more for specialty or international funds, which require more expertise from managers. Are high fees worth it? You get what you pay for, right? Wrong. Just about every study ever done has shown no correlation between high expense ratios and high
25
returns. This is a fact. If you want more evidence, consider this quote from the Securities and Exchange Commission's website: "Higher expense funds do not, on average, perform better than lower expense funds." How to Invest in Mutual Funds Looking for a mutual fund to invest in, but not sure how to choose the right one for you? Check out this handy guide to get you started. If you're too busy to pick your own stocks but still want to get into the investment game, buy a mutual fund. Think of a mutual fund as a giant investment club with a few million members who have all hired a fund manager and a staff to pick and choose when to buy and sell their stocks. Here's the challenge. There are more than 9,000 mutual funds out there. So, unless you're a professional analyst, you probably don't have the time, knowledge or know-how to look at more than four or five before you get totally confused and turned off. The 10 mutual fund families to the right
26
have been around for several decades and have excellent track records for management and profitability. Each of them is a "no-load" fund, which means no sales charge or commission is taken out of your investment. Most brokers and financial planners will not suggest these fund families for that reason. But have no fear. No-load fund companies have excellent customer service representatives who will answer all of your questions, helping you understand which funds fit your needs. Take advantage of all the free literature and information they offer to learn how to start building wealth assets. Most of the fund families test to offer judge investor your education of pages, which a include a glossary, chat groups, a multiple-choice knowledge investing, complete list of all their funds (including prospectus, annual report and application forms to download), and an advisor who will respond to your questions by e-mail. Each of these funds allows you to open an account for $1,000, or to waive that minimum, start an automatic monthly payment arrangement with $50 or $100 deducted from your bank account, the same
27
way that you pay life insurance or make mortgage payments. This is how you put yourself on your own payroll. Treat yourself like a creditor who has to be paid each month. Would you miss the mortgage or Visa payment and not feel upset or guilty? Then treat your retirement money the same way. Mutual fund companies like Strong (800-368-1030), American Century (800-343- 2021) and Invesco (8002-INVESCO) allow you to start automatic investment plans with as little as $50 a month. Only one African American mutual fund has beaten the S & P 500 Index, with a 32% return. The Profit Value Fund managed by Eugene Profit (888-744-2337), www.profitfunds.com, also allows new investors to open an account with $1,000 or do $50 a month automatic investing. Net asset value The net asset value, or NAV, is the current market value of a fund's holdings, less the fund's liabilities, usually expressed as a per-share amount. For most funds, the NAV is determined daily, after the close of trading on some specified financial exchange, but
28
some funds update their NAV multiple times during the trading day. The public offering price, or POP, is the NAV plus a sales charge. Open-end funds sell shares at the POP and redeem shares at the NAV, and so a process order only after the NAV is determined. Closed-end funds (the shares of which are traded by investors) may trade at a higher or lower price than their NAV; this is known as a premium or discount, respectively. If a fund is divided into multiple classes of shares, each class will typically have its own NAV, reflecting differences in fees and expenses paid by the different classes. You know what I'm saying... Some mutual funds own securities which are not regularly traded on any formal exchange. These may be shares in very small or bankrupt companies; they may be derivatives; or they may be private Investments in unregistered financial instruments (such as stock in a non-public company). In the absence of a public market for these securities, it is the responsibility of the fund manager to form an estimate of their value when computing the NAV.
29
How much of a fund's assets may be invested in such securities is stated in the fund's prospectus. Turnover Turnover is a measure of the fund's securities transactions, usually calculated over a year's time, and usually expressed as a percentage of net asset value. This value is usually calculated as the value of all transactions (buying, selling) divided by 2 divided by the fund's total holdings; i.e., the fund counts one security sold and another one bought as one "turnover". Thus turnover measures the replacement of holdings. In Canada, under NI 81-106 (required disclosure for investment funds) turnover ratio is calculated based on the lesser of purchases or sales divided by the average size of the portfolio (including cash). Turnover generally has tax consequences for a fund, which are passed through to investors. In particular, when selling an investment from its portfolio, a fund may realize a capital gain, which will ultimately be distributed to investors as taxable income. The process of buying and selling securities also has its
30
own costs, such as brokerage commissions, which are borne by the fund's shareholders. Expenses and TER'S Mutual funds bear expenses similar to other companies. The fee structure of a mutual fund can be divided into two or three main components: management fee, no management expense, and 12b-1/non-12b-1 fees. All expenses are expressed as a percentage of the average daily net assets of the fund. Management Fees The management with fee the for the fund is usually synonymous contractual investment
advisory fee charged for the management of a fund's investments. However, as many fund companies include administrative fees in the advisory fee component, when attempting to compare the total management expenses of different funds, it is helpful to define management advisory fee + as equal the to the contractual comparing fee contractual
administrator fee. This "levels the playing field" when management fee components across multiple funds.
31
Contractual advisory fees may be structured as "flatrate" fees, i.e., a single fee charged to the fund, regardless of the asset size of the fund. However, many funds have contractual fees which include breakpoints, so that as the value of a fund's assets increases, the advisory fee paid decreases. Another way in which the advisory fees remain competitive is by structuring the fee so that it is based on the value of all of the assets of a group or a complex of funds rather than those of a single fund. Non-management Expenses Apart from the management fee, there are certain non-management expenses which most funds must pay. Some of the more significant (in terms of amount) non-management expenses are: transfer agent expenses (this is usually the person you get on the other end of the phone line when you want to purchase/sell shares of a fund), custodian expense (the fund's assets are kept in custody by a bank which charges a custody fee), legal/audit expense, fund accounting expense, registration expense (the SEC charges a registration fee when funds file registration statements
32
with
it),
board
of
directors/trustees
expense
(the
disinterested
members of the board who oversee the fund are usually paid a fee for their time spent at meetings), and printing and postage expense (incurred when printing and delivering shareholder reports). 12b-1/Non-12b-1 Service Fees 12b-1 service fees/shareholder servicing fees are contractual fees which a fund may charge to cover the marketing expenses of the fund. Non-12b-1 service fees are marketing/shareholder servicing fees which do not fall under SEC rule 12b-1. While funds do not have to charge the full contractual 12b-1 fee, they often do. When investing in a front-end load or no-load fund, the 12b-1 fees for the fund are usually . 250% (or 25 basis points). The 12b-1 fees for backend and level-load share classes are usually between 50 and 75 basis points but may be as much as 100 basis points. While funds are often marketed as "noload" funds, this does not mean they do not charge a distribution expense through a different mechanism. It is expected that a fund listed on an online brokerage site will be paying for the "shelf-space" in
33
a different manner even if not directly through a 12b1 fee.
Fees and Expenses by the Investor (not the Fund) Fees and expenses borne by the investor vary based on the arrangement made with the investor's broker. Sales loads (or contingent deferred sales loads (CDSL)) are not included in the fund's total expense ratio (TER) because they do not pass through the statement of operations for the fund. Additionally, funds may charge early redemption fees to discourage investors from swapping money into and out of the fund quickly, which may force the fund to make bad trades to obtain the necessary liquidity. For example, Fidelity Diversified International Fund (FDIVX) charges a 1 percent fee on money removed from the fund in less than 30 days. Brokerage Commissions An additional expense which does not pass through the statement of operations and cannot be controlled
34
by the investor is brokerage commissions. Brokerage commissions are incorporated into the price of the fund and are reported usually 3 months after the fund's annual report in the statement of additional information. Brokerage commissions are directly related to portfolio turnover (portfolio turnover refers to the number of times the fund's assets are bought and sold over the course of a year). Usually the higher the rate of the portfolio turnover, the higher the brokerage commissions. The advisors of mutual fund companies are required to achieve "best execution" through brokerage arrangements so that the commissions charged to the fund will not be excessive.
35
36
37
doc_843920161.doc
1
speak
strange
language
that
interspersed with jargon that many investors don't
not that easy. Mutual funds are an excellent idea in theory, but, in reality, they haven't always delivered. Not all mutual funds are created equal, and investing in mutual isn't as easy as throwing your money at the first salesperson who solicits your business. In this tutorial, we'll explain the basics of mutual funds and hopefully clear up some of the myths around them. You can then decide whether or not they are right for you. The Definition A mutual fund is nothing more than a collection of stocks and/or bonds. You can think of a mutual fund as a company that brings together a group of people and invests their money in stocks, bonds, and other securities. Each investor owns shares, which represent a portion of the holdings of the fund. A mutual fund is a company that pools money from many investors and invests the money in stocks, bonds, short-term money-market instruments, or other securities. Legally known as an "open-end company," a mutual fund is one of three basic types of Investment Company. The two other basic types
2
are closed-end funds and Unit Investment Trusts (UITs). You can make money from a mutual fund in three ways: 1) Income is earned from dividends on stocks and interest on bonds. A fund pays out nearly all of the income it receives over the year to fund owners in the form of a distribution. 2) If the fund sells securities that have increased in price, the fund has a capital gain. Most funds also pass on these gains to investors in a distribution. 3) If fund holdings increase in price but are not sold by the fund manager, the fund's shares increase in price. You can then sell your mutual fund shares for a profit. Funds will also usually give you a choice either to receive a check for distributions or to reinvest the earnings and get more shares.
Types of mutual funds 1. Open-end fund
3
The term mutual fund is the common name for an open-end investment company. Being open-ended means that, at the end of every day, the fund issues new shares to investors and buys back shares from investors wishing to leave the fund. Mutual funds may be legally structured as corporations or business trusts but in either instance are classed as open-end investment companies by the SEC. Other funds have a limited number of shares; these are either closed-end funds or unit investment trusts, neither of which a mutual fund is. 2. Exchange-traded funds A relatively recent innovation, the exchange traded fund (ETF), is often formulated as an open-end investment company. ETFs combine characteristics of both mutual funds and closed-end funds. An ETF usually tracks a stock index (see Index funds). Shares are issued or redeemed by institutional investors Investors in large blocks (typically shares of 50,000). in small typically purchase
quantities through brokers at a small premium or discount to the net asset value; this is how the
4
institutional investor makes its profit. Because the institutional investors handle the majority of trades, ETFs are more efficient than traditional mutual funds (which are continuously issuing new securities and redeeming old ones, keeping detailed records of such issuance and redemption transactions, and, to effect such transactions, continually buying and selling securities and maintaining liquidity position) and therefore tend to have lower expenses. ETFs are traded throughout the day on a stock exchange, just like closed-end funds. Exchange traded funds are also valuable for foreign investors who are often able to buy and sell securities traded on a stock market, but who, for regulatory reasons, are unable to participate in traditional US mutual fund. 3. Equity funds Equity funds, which consist mainly of stock investments, are the most common type of mutual fund. Equity funds hold 50 percent of all amounts invested in mutual funds in the United States. Often equity funds focus investments on particular strategies and certain types of issuers.
5
4. Capitalization Fund managers and other investment professionals have varying definitions of mid-cap and large-cap ranges. The following ranges are used by Russell Indexes Russell Micro cap Index - micro-cap ($54.8 - 539.5 million) Russell 2000 Index - small-cap ($182.6 million - 1.8 billion) Russell Midcap Index - mid-cap ($1.8 - 13.7 billion) Russell 1000 Index - large-cap ($1.8 - 386.9 billion) 5. Growth vs. value Another distinction is made between growth funds, which invest in stocks of companies that have the potential for large capital gains, and value funds, which concentrate on stocks that are undervalued. Value stocks have historically produced higher returns; however, financial theory states this is compensation for their greater risk. Growth funds tend not to pay regular dividends. Income funds tend to be more conservative investments, with a focus on stocks that pay dividends. A balanced fund may use a combination of strategies, typically including some
6
level
of
investment
in
bonds,
to
stay
more
conservative when it comes to risk, yet aim for some growth. [Citation needed] 6. Index funds versus active management Main articles: Index fund and active management An index fund maintains investments in companies that are part of major stock (or bond) indices, such as the S&P 500, while an actively managed fund attempts to outperform a relevant index through superior stock-picking techniques. The assets of an index fund are managed to closely approximate the performance of a particular published index. Since the composition of an index changes infrequently, an index fund manager makes fewer trades, on average, than does an active fund manager. For this reason, index funds generally have lower trading expenses than actively managed funds, and typically incur fewer short-term capital gains which must be passed on to shareholders. Additionally, index funds do not incur expenses to pay for selection of individual stocks (proprietary selection techniques, research, etc.) and deciding when to buy, hold or sell individual holdings. Instead, a fairly simple computer
7
model can identify whatever changes are needed to bring the fund back into agreement with its target index. The performance of an actively managed fund largely depends on the investment decisions of its manager. Statistically, the for every there investor is one end who who up outperforms index before market,
underperforms. Among those who outperform their expenses, fund though, should many have underperforming after expenses. Before expenses, a well-run index average performance. By minimizing the impact of expenses, index funds should be able to perform better than average. Certain empirical evidence seems to illustrate that mutual funds do not beat the market and actively managed mutual funds under-perform other broadbased portfolios with similar characteristics. One study found that nearly 1,500 U.S. mutual funds under-performed the market in approximately half of the years between 1962 and 1992. Moreover, funds that performed well in the past are not able to beat
8
the market again in the future (shown by Jensen, 1968; Grimblatt and Sheridan Titman, 1989. 7. Bond funds Bond funds account for 18% of mutual fund assets. Types of bond funds include term funds, which have a fixed set of time (short-, medium-, or long-term) before they mature. Municipal bond funds generally have lower returns, but have tax advantages and lower risk. High-yield bond funds invest in corporate bonds, including high-yield or junk bonds. With the potential for high yield, these bonds also come with greater risk.
8. Money market funds Money market funds hold 26% of mutual fund assets in the United States. Money market funds entail the least risk, as well as lower rates of return. Unlike certificates of deposit (CDs), money market shares are liquid and redeemable at any time. The interest
9
rate quoted by money market funds is known as the 7 Day SEC Yield. 9. Funds of funds Funds of funds (FoF) are mutual funds which invest in other underlying mutual funds (i.e., they are funds comprised of other funds). The funds at the underlying level are typically funds which an investor can invest in individually. A fund of funds will typically charge a management fee which is smaller than that of a normal fund because it is considered a fee charged for asset allocation services. The fees charged at the underlying fund level do not pass through the statement of operations, but are usually disclosed in the fund's annual report, prospectus, or statement of additional information. The fund should be evaluated on the combination of the fund-level expenses and underlying fund expenses, as these both reduce the return to the investor. Most FoFs invest in affiliated funds (i.e., mutual funds managed by the same advisor), although some invest in funds managed by other (unaffiliated) advisors. The cost associated with investing in an unaffiliated underlying fund is most often higher than
10
investing in an affiliated underlying because of the investment management research involved in investing in fund advised by a different advisor. Recently, FoFs have been classified into those that are actively managed (in which the investment advisor reallocates frequently among the underlying funds in order to adjust to changing market conditions) and those that are passively managed (the investment advisor allocates assets on the basis of on an allocation model which is rebalanced on a regular basis). The design of FoFs is structured in such a way as to provide a ready mix of mutual funds for investors who are unable to or unwilling to determine their own asset allocation model. Fund companies such as TIAA-CREF, Vanguard, and Fidelity have also entered this market to provide investors with these options and take the "guess work" out of selecting funds. The allocation mixes usually vary by the time the investor would like to retire: 2020, 2030, 2050, etc. The more distant 10. the target retirement date, the more aggressive the asset mix. Hedge funds
11
Hedge funds in the United States are pooled investment funds with loose SEC regulation and should not be confused with mutual funds. Some hedge fund managers are required to register with SEC as investment advisers under the Investment Advisers Act. The Act does not require an adviser to follow or avoid any particular investment strategies, nor does it require or prohibit specific investments. Hedge funds typically charge a management fee of 1% or more, plus a “performance fee” of 20% of the hedge fund’s profit. There may be a "lock-up" period, during which an investor cannot cash in shares. A variation of the hedge strategy is the 130-30 fund for individual investors. 11. Mutual funds vs. other investments
Mutual funds offer several advantages over investing in individual stocks. For example, the transaction costs are divided among all the mutual fund shareholders, who also benefit by having a third, party (professional fund managers), apply expertise and dedicate time options. to manage However,
12
and
research the
investment
despite
professional management, mutual funds are not immune to risks. They share the same risks associated with the investments made. If the fund invests primarily in stocks, it is usually subject to the same ups and downs and risks as the stock market. Advantages of Mutual Funds: • Professional Management The primary advantage of funds (at least theoretically) is the professional management of your money. Investors purchase funds because they do not have the time or the expertise to manage their own portfolios. A mutual fund is a relatively inexpensive way for a small investor to get a full-time manager to make and monitor investments. • Diversification - By owning shares in a mutual fund instead of owning individual stocks or bonds, your risk is spread out. The idea behind diversification is to invest in a large number of assets so that a loss in any particular investment is minimized by gains in others. In other words, the more stocks and bonds you own, the less any one of them can hurt you (think about Enron). Large mutual funds typically own hundreds of different stocks in
13
many different industries. It wouldn't be possible for an investor to build this kind of a portfolio with a small amount of money. • Economies of Scale - Because a mutual fund buys and sells large amounts of securities at a time, its transaction costs are lower than what an individual would pay for securities transactions. • Liquidity - Just like an individual stock, a mutual fund allows you to request that your shares be converted into cash at any time. • Simplicity - Buying a mutual fund is easy! Pretty well any bank has its own line of mutual funds, and the minimum investment is small. Most companies also have automatic purchase plans whereby as little as $100 can be invested on a monthly basis. Year after year, key players in the Forex market make a killing by picking the right currencies – now it’s your turn. Access industry gurus Boris and Kathy’s exclusive FREE report, The Five Things That Move the Currency Market – And How to Profit from Them, right now! Disadvantages of Mutual Funds:
14
• Professional Management - Did you notice how we qualified the advantage or of not professional the so-called management with the word "theoretically"? Many investors debate whether professionals are any better than you or I at picking stocks. Management is by no means infallible, and, even if the fund loses money, the manager still takes his/her cut. We'll talk about this in detail in a later section. • Costs - Mutual funds don't exist solely to make your life easier - all funds are in it for a profit. The mutual fund industry is masterful at burying costs under layers of jargon. These costs are so complicated that in this tutorial we have devoted an entire section to the subject. • Dilution It's possible to have too much diversification. Because funds have small holdings in so many different companies, high returns from a few investments often don't make much difference on the overall return. Dilution is also the result of a successful fund getting too big. When money pours into funds that have had strong success, the
15
manager often has trouble finding a good investment for all the new money. • Taxes - When making decisions about your money, fund managers don't consider your personal tax situation. For example, when a fund manager sells a security, a capital-gains tax is triggered, which affects how profitable the individual is from the sale. It might have been more advantageous for the individual to defer the capital gains liability. Different Types of Funds No matter what type of investor you are, there is bound to be a mutual fund that fits your style. According to the last count there are more than 10,000 mutual funds in North America! That means there are more mutual funds than stocks. It's important to understand that each mutual fund has different risks and rewards. In general, the higher the potential return, the higher the risk of loss. Although some funds are less risky than others, all funds have some level of risk - it's never possible to diversify away all risk. This is a fact for all investments.
16
Each fund has a predetermined investment objective that tailors the fund's assets, regions of investments and investment strategies. At the fundamental level, there are three varieties of mutual funds: 1) Equity funds (stocks) 2) Fixed-income funds (bonds) 3) Money market funds All mutual funds are variations of these three asset classes. For example, while equity funds that invest in fast-growing companies are known as growth funds, equity funds that invest only in companies of the same sector or region are known as specialty funds. Let's go over the many different flavors of funds. We'll start with the safest and then work through to the more risky. • Money Market Funds The money market consists of short-term debt instruments, mostly Treasury bills. This is a safe place to park your money. You won't get great returns, but you won't have to worry about losing your principal. A typical return is twice the amount you would earn in a regular
17
checking/savings
account and a little less than the average certificate of deposit (CD). • Bond/Income Funds Income funds are named appropriately: their purpose is to provide current income on a steady basis. When referring to mutual funds, the terms "fixed-income," "bond," and "income" are synonymous. These terms denote funds that invest primarily in government and corporate debt. While fund holdings may appreciate in value, the primary objective of these funds is to provide a steady cash flow to investors. As such, the audience for these funds consists of conservative investors and retirees. Bond funds are likely to pay higher returns than certificates of deposit and money market investments, but bond funds aren't without risk. Because there are many different types of bonds, bond funds can vary dramatically depending on where they invest. For example, a fund specializing in high-yield junk bonds is much more risky than a fund that invests in government securities. Furthermore, nearly all bond funds are subject to
18
interest rate risk, which means that if rates go up the value of the fund goes down. • Balanced Funds The objective of these funds is to provide a balanced mixture of safety, income and capital appreciation. The strategy of balanced funds is to invest in a combination of fixed income and equities. A typical balanced fund might have a weighting of 60% equity and 40% fixed income. The weighting might also be restricted to a specified maximum or minimum for each asset class. A similar type of fund is known as an asset allocation fund. Objectives are similar to those of a balanced fund, but these kinds of funds typically do not have to hold a specified percentage of any asset class. The portfolio manager is therefore given freedom to switch the ratio of asset classes as the economy moves through the business cycle. • Equity Funds Funds that invest in stocks represent the largest category of mutual funds. Generally, the investment objective of this class of funds is long-term capital growth with some income. There are, however, many
19
different types of equity funds because there are many different types of equities. A great way to understand the universe of equity funds is to use a style box, an example of which is below. The idea is to classify funds based on both the size of the companies invested in and the investment style of the manager. The term value refers to a style of investing that looks for high quality companies that are out of favor with the market. These companies are characterized by low P/E and price-to-book ratios and high dividend yields. The opposite of value is growth, which refers to companies that have had (and are expected to continue to have) strong growth in earnings, sales and cash flow. A compromise between value and growth is blend, which simply refers to companies that are neither value nor growth stocks and are classified as being somewhere in the middle. For e.g.:- a mutual fund that invests in large-cap companies that are in strong financial shape but have recently seen their share prices fall would be placed in the upper left quadrant of the style box (large and value). The opposite of this would be a
20
fund that invests in startup technology companies with excellent growth prospects. Such a mutual fund would reside in the bottom right quadrant (small and growth). • Global/International Funds An international fund (or foreign fund) invests only outside your home country. Global funds invest anywhere around the world, including your home country. It's tough to classify these funds as either riskier or safer than domestic investments. They do tend to be more volatile and have unique country and/or political risks. But, on the flip side, they can, as part of a well-balanced portfolio, actually reduce risk by increasing likely that diversification. another Although the world's is economies are becoming more inter-related, it is economy somewhere outperforming the economy of your home country. • Specialty Funds This classification of mutual funds is more of an allencompassing category that consists of funds that have proved to be popular but don't necessarily belong to the categories we've described so far. This
21
type of mutual fund forgoes broad diversification to concentrate on a certain segment of the economy. Sector funds are targeted at specific sectors of the economy such as financial, technology, health, etc. Sector funds are extremely volatile. There is a greater possibility of big gains, but you have to accept that your sector may tank. Regional funds make it easier to focus on a specific area of the world. This may mean focusing on a region (say Latin America) or an individual country (for example, only Brazil). An advantage of these funds is that they make it easier to buy stock in foreign countries, which is otherwise difficult and expensive. Just like for sector funds, you have to accept the high risk of loss, which occurs if the region goes into a bad recession. Socially-responsible funds (or ethical funds) invest only in companies that meet the criteria of certain guidelines or beliefs. Most socially responsible funds don't invest in industries such as tobacco, alcoholic beverages, weapons or nuclear power. The idea is to get a competitive performance while still maintaining a healthy conscience.
22
• Index Funds The last but certainly not the least important are index funds. This type of mutual fund replicates the performance of a broad market index such as the S&P 500 or Dow Jones Industrial Average (DJIA). An investor in an index fund figures that most managers can't beat the market. An index fund merely replicates the market return and benefits investors in the form of low fees. The Costs Costs are the biggest problem with mutual funds. These costs eat into your return, and they are the main reason why the majority of funds end up with sub-par performance. What's even more disturbing is the way the fund industry hides costs through a layer of financial complexity and jargon. Some critics of the industry say that mutual fund companies get away with the fees they charge only because the average investor does not understand what he/she is paying for. Fees can be broken down into two categories:
23
1. Ongoing yearly fees to keep you invested in the fund. 2. Transaction fees paid when you buy or sell shares in a fund (loads).
The Expense Ratio The ongoing expenses of a mutual fund are represented by the expense ratio. This is sometimes also referred to as the management expense ratio (MER). The expense ratio is composed of the following: • The cost of hiring the fund manager(s) - Also known as the management fee, this cost is between 0.5% and 1% of assets on average. While it sounds small, this fee ensures that mutual fund managers remain in the country's top echelon of earners. Think about it for a second: 1% of 250 million (a small mutual fund) is $2.5 million - fund managers are definitely not going hungry! It's true that paying managers is a necessary fee, but don't think that a high fee assures superior performance.
24
• Administrative costs - These include necessities such as postage, record keeping, customer service, cappuccino machines, etc. Some funds are excellent at minimizing these costs while others (the ones with the cappuccino machines in the office) are not. • The last part of the ongoing fee :-( in the United States anyway) is known as the 12B-1 fee. This expense goes toward paying brokerage commissions and toward advertising and promoting the fund. That's right, if you invest in a fund with a 12B-1 fee, you are paying for the fund to run commercials and sell itself! On the whole, expense ratios range from as low as 0.2% (usually for index funds) to as high as 2%. The average equity mutual fund charges around 1.3%1.5%. You'll generally pay more for specialty or international funds, which require more expertise from managers. Are high fees worth it? You get what you pay for, right? Wrong. Just about every study ever done has shown no correlation between high expense ratios and high
25
returns. This is a fact. If you want more evidence, consider this quote from the Securities and Exchange Commission's website: "Higher expense funds do not, on average, perform better than lower expense funds." How to Invest in Mutual Funds Looking for a mutual fund to invest in, but not sure how to choose the right one for you? Check out this handy guide to get you started. If you're too busy to pick your own stocks but still want to get into the investment game, buy a mutual fund. Think of a mutual fund as a giant investment club with a few million members who have all hired a fund manager and a staff to pick and choose when to buy and sell their stocks. Here's the challenge. There are more than 9,000 mutual funds out there. So, unless you're a professional analyst, you probably don't have the time, knowledge or know-how to look at more than four or five before you get totally confused and turned off. The 10 mutual fund families to the right
26
have been around for several decades and have excellent track records for management and profitability. Each of them is a "no-load" fund, which means no sales charge or commission is taken out of your investment. Most brokers and financial planners will not suggest these fund families for that reason. But have no fear. No-load fund companies have excellent customer service representatives who will answer all of your questions, helping you understand which funds fit your needs. Take advantage of all the free literature and information they offer to learn how to start building wealth assets. Most of the fund families test to offer judge investor your education of pages, which a include a glossary, chat groups, a multiple-choice knowledge investing, complete list of all their funds (including prospectus, annual report and application forms to download), and an advisor who will respond to your questions by e-mail. Each of these funds allows you to open an account for $1,000, or to waive that minimum, start an automatic monthly payment arrangement with $50 or $100 deducted from your bank account, the same
27
way that you pay life insurance or make mortgage payments. This is how you put yourself on your own payroll. Treat yourself like a creditor who has to be paid each month. Would you miss the mortgage or Visa payment and not feel upset or guilty? Then treat your retirement money the same way. Mutual fund companies like Strong (800-368-1030), American Century (800-343- 2021) and Invesco (8002-INVESCO) allow you to start automatic investment plans with as little as $50 a month. Only one African American mutual fund has beaten the S & P 500 Index, with a 32% return. The Profit Value Fund managed by Eugene Profit (888-744-2337), www.profitfunds.com, also allows new investors to open an account with $1,000 or do $50 a month automatic investing. Net asset value The net asset value, or NAV, is the current market value of a fund's holdings, less the fund's liabilities, usually expressed as a per-share amount. For most funds, the NAV is determined daily, after the close of trading on some specified financial exchange, but
28
some funds update their NAV multiple times during the trading day. The public offering price, or POP, is the NAV plus a sales charge. Open-end funds sell shares at the POP and redeem shares at the NAV, and so a process order only after the NAV is determined. Closed-end funds (the shares of which are traded by investors) may trade at a higher or lower price than their NAV; this is known as a premium or discount, respectively. If a fund is divided into multiple classes of shares, each class will typically have its own NAV, reflecting differences in fees and expenses paid by the different classes. You know what I'm saying... Some mutual funds own securities which are not regularly traded on any formal exchange. These may be shares in very small or bankrupt companies; they may be derivatives; or they may be private Investments in unregistered financial instruments (such as stock in a non-public company). In the absence of a public market for these securities, it is the responsibility of the fund manager to form an estimate of their value when computing the NAV.
29
How much of a fund's assets may be invested in such securities is stated in the fund's prospectus. Turnover Turnover is a measure of the fund's securities transactions, usually calculated over a year's time, and usually expressed as a percentage of net asset value. This value is usually calculated as the value of all transactions (buying, selling) divided by 2 divided by the fund's total holdings; i.e., the fund counts one security sold and another one bought as one "turnover". Thus turnover measures the replacement of holdings. In Canada, under NI 81-106 (required disclosure for investment funds) turnover ratio is calculated based on the lesser of purchases or sales divided by the average size of the portfolio (including cash). Turnover generally has tax consequences for a fund, which are passed through to investors. In particular, when selling an investment from its portfolio, a fund may realize a capital gain, which will ultimately be distributed to investors as taxable income. The process of buying and selling securities also has its
30
own costs, such as brokerage commissions, which are borne by the fund's shareholders. Expenses and TER'S Mutual funds bear expenses similar to other companies. The fee structure of a mutual fund can be divided into two or three main components: management fee, no management expense, and 12b-1/non-12b-1 fees. All expenses are expressed as a percentage of the average daily net assets of the fund. Management Fees The management with fee the for the fund is usually synonymous contractual investment
advisory fee charged for the management of a fund's investments. However, as many fund companies include administrative fees in the advisory fee component, when attempting to compare the total management expenses of different funds, it is helpful to define management advisory fee + as equal the to the contractual comparing fee contractual
administrator fee. This "levels the playing field" when management fee components across multiple funds.
31
Contractual advisory fees may be structured as "flatrate" fees, i.e., a single fee charged to the fund, regardless of the asset size of the fund. However, many funds have contractual fees which include breakpoints, so that as the value of a fund's assets increases, the advisory fee paid decreases. Another way in which the advisory fees remain competitive is by structuring the fee so that it is based on the value of all of the assets of a group or a complex of funds rather than those of a single fund. Non-management Expenses Apart from the management fee, there are certain non-management expenses which most funds must pay. Some of the more significant (in terms of amount) non-management expenses are: transfer agent expenses (this is usually the person you get on the other end of the phone line when you want to purchase/sell shares of a fund), custodian expense (the fund's assets are kept in custody by a bank which charges a custody fee), legal/audit expense, fund accounting expense, registration expense (the SEC charges a registration fee when funds file registration statements
32
with
it),
board
of
directors/trustees
expense
(the
disinterested
members of the board who oversee the fund are usually paid a fee for their time spent at meetings), and printing and postage expense (incurred when printing and delivering shareholder reports). 12b-1/Non-12b-1 Service Fees 12b-1 service fees/shareholder servicing fees are contractual fees which a fund may charge to cover the marketing expenses of the fund. Non-12b-1 service fees are marketing/shareholder servicing fees which do not fall under SEC rule 12b-1. While funds do not have to charge the full contractual 12b-1 fee, they often do. When investing in a front-end load or no-load fund, the 12b-1 fees for the fund are usually . 250% (or 25 basis points). The 12b-1 fees for backend and level-load share classes are usually between 50 and 75 basis points but may be as much as 100 basis points. While funds are often marketed as "noload" funds, this does not mean they do not charge a distribution expense through a different mechanism. It is expected that a fund listed on an online brokerage site will be paying for the "shelf-space" in
33
a different manner even if not directly through a 12b1 fee.
Fees and Expenses by the Investor (not the Fund) Fees and expenses borne by the investor vary based on the arrangement made with the investor's broker. Sales loads (or contingent deferred sales loads (CDSL)) are not included in the fund's total expense ratio (TER) because they do not pass through the statement of operations for the fund. Additionally, funds may charge early redemption fees to discourage investors from swapping money into and out of the fund quickly, which may force the fund to make bad trades to obtain the necessary liquidity. For example, Fidelity Diversified International Fund (FDIVX) charges a 1 percent fee on money removed from the fund in less than 30 days. Brokerage Commissions An additional expense which does not pass through the statement of operations and cannot be controlled
34
by the investor is brokerage commissions. Brokerage commissions are incorporated into the price of the fund and are reported usually 3 months after the fund's annual report in the statement of additional information. Brokerage commissions are directly related to portfolio turnover (portfolio turnover refers to the number of times the fund's assets are bought and sold over the course of a year). Usually the higher the rate of the portfolio turnover, the higher the brokerage commissions. The advisors of mutual fund companies are required to achieve "best execution" through brokerage arrangements so that the commissions charged to the fund will not be excessive.
35
36
37
doc_843920161.doc