mutual funds

5 Tips for Mutual Fund Investments

January 26, 2013 By Richard Cox

Many new investors fall into a common trap created during bull markets, as a percentage of your paycheck is automatically invested into the mutual funds tied to your 401(k) plan. This automated process leads many investors to rely on the relatively easy, cheap and low-risk approach to capitalize on the long term benefits of stock ownership. But even with this easy process, it is still possible to make costly mistakes that can diminish returns and put your wider portfolio in danger. Coolchecks.net customers and anyone who wants to maximize their investments need to be aware of some common pitfalls that investors should avoid.

1 – Know the Stocks You Own

Most investors believe their 401(k) plan is well-diversified. Let’s say that we invest half of a retirement savings account in a Tech fund and the other half in a fund that is tied to the S&P 500. Without looking at the actual stocks being purchased, it can be easy to miss the fact that as much as 30% of an S&P 500 fund might include tech stocks. Then, if we look at the total exposure to tech stocks, the percentages could potentially exceed 60% for a single industry.

Needless to say, this is how how a diversified portfolio operates, and excessive exposure to a single sector leaves investors vulnerable to price swings for that industry. If this hypothetical example was seen prior to the 1999 dotcom bubble, this investor would have unnecessarily encountered substantial losses. These problems could have been avoided by simply knowing the stocks that are part of your chosen fund.

2 – Don’t Chase a Fund’s Past Performance

Another common mistake can be seen when investors get caught up in the hype of the next “hot mutual fund.” It can be very tempting to act on advice from a friend or a persuasive commercial but basing an investment decision on a fund’s past performance is usually unwise. This is because markets are cyclical in nature and so a fund investing in a profitable niche now could easily underperform later on.

There are also many examples where a fund does well under one manager and then performs poorly if that manager leaves the firm. For this reason, it is important to know if the fund strategy was the creation of a single manager or is part of a larger, institutionalized investment process that will be repeated in the future.

3 – Be Aware of Fees

Investors tend to focus on macroeconomic factors (such as the state of the labor market or the national economy as a whole), and instead ignore the fees associated with a particular mutual fund. This potentially costly mistake can have a major impact on the returns investors are able to capture over time. For example, let’s say we invest $5,000 each year in an S&P index fund over a 30-year period. During this time, the investment would total over $400,000. But if the fund’s fees came to 1.5% each year, that total investment would fall to less than $300,000. This amazing difference is the result of compounding investment.

Fees can have a particularly strong impact on bond funds, which tend to produce lower yields on an historical basis. Investors should look at the fund prospectus (to see the associated expense ratio), and read Morningstar.com to compare the funds expenses to others in a similar investment category.

4 – Don’t Forget the Effect of Taxes

In many cases, investors will buy into a fund during the later part of the year, as the fund makes net capital gains distributions to clients. But if you wait until those payouts have completed, you can avoid tax obligations before you have made any real returns on your investments.

A common mistake is seen when investors fail to track the cost basis for the fund when choosing to reinvest their dividend payouts into additional share purchases. This creates problems as investors likely make mistakes reporting larger taxable gains when selling the fund – essentially, paying taxes twice (taxes on the dividend income and on the gains made selling the fund). Other mistakes are seen in funds that aggressively manage the stock portfolio as a means for maximizing returns. Problems here occur when the fund is not held in an account that is not tax-deferred, such as a 401(k).

5 – Keep Your Investment Focus

Many investors hold onto their positions longer than they should. This is because many think that outcomes that occurred in the past will happen again in the future (see Tip 2). A smarter way to monitor fund performance is to establish a target for your holdings position that is appropriate for the expectations in that specific sector. When your target limit is reached for that fund holding, sell some (or all) of your holdings and take your profits. Targets like these can take some of the emotion out of the investment process. This is important for making rational decisions that can ultimately protect your savings.

Conclusion: Do Your Homework and Watch the Performance of Your Fund

Since mutual fund investments are widely regarded as a simple (or even automatic), it is important for investors to maintain focus, watch the changes seen in portfolio allocation and to ask questions when gains performance is not meeting your expectations. Has something changed with the fund’s strategy? Have previously successful managers left the company and are no longer guiding strategy? These are important events that could mean it is time to look for other options.

Here, we looked at 5 simple tips for new investors to follow when managing their savings investments. It is always important to read the materials that are provided by the fund, do your own research (on sites like Morningstar.com), and to consider selling your shares when unexpected changes are made within the fund. At least once each year, you should check to see that the same management team is in place and look at the changes that are being made in the underlying stock selections.

Becoming Tax Efficient with Fund Investments

January 18, 2013 By Richard Cox

For our Coolchecks.net customers, Richard Cox brings us advice about keeping more of our money.

One of the most often-discussed aspects of mutual funds is the fact that they tend to produce poor performances relative to the S&P 500 when things are judged on a pre-tax basis. And, in many cases, these comparisons become even less favorable when looking at mutual funds on an after-tax basis. Money managers tend to under-perform relative to Index funds because Index funds will hold investments for the long term. This becomes important when investors are looking to minimize the expenses that are created when stock investments are bought and then sold on a short-term basis.

When we look at the capital gains distributions in Index funds and compare these to those generated by money managers, significant lessons can be learned. These lessons essentially tell us that low turnover rates (a small number of trade transactions) and minimal cash balances (in funds that remain almost fully invested) can help investors to capture enhanced returns relative to other investment options.

Advantages of Index Funds

To be sure, index fund managers have an advantage that is not possessed by money managers. The S&P 500 500 index is constructed by the Standard & Poor’s editorial board, so all these fund managers need to do is look at the stock weightings in the S&P 500 and distribute the managed money according to those weightings. Selling stock holdings is an even easier process, as these index managers only need to sell shares when the makeup of the index is updated. Typically, the S&P 500 will see 10 to 15 stock changes each year, and these tend to come from bankruptcies, mergers, acquisitions, or heavy corporate distress. When we compare these changes to the number of “buys and sells” conducted yearly in the average mutual fund, 10 to 15 is a very small number.

If capital distributions that can be found in the Vanguard Index Trust 500 show 15 cents in short-term capital gains over a given year, 40 cents in long-term capital gains, and the Vanguard Index Trust 500 closes that year with a net asset value (NAV) of $90 per share, it becomes easy to see that the relatively low taxes (likely around 55 cents) do little to diminish the returns in either of these funds. It should also be remembered, however, that an investor would take on additional tax consequences if shares of the fund were sold.

Lowering Your Tax Liabilities by Keeping Your Money Invested

Most new investors, however, are looking to create wealth over larger time horizons and to use the benefits of compounding returns to their highest advantage. Looking at things on an after-tax basis, investors can create more value in their investments when keeping money invested (i.e. not cashing-in your shares). So, while paying high fees can diminish your returns, handing over money in taxes (for fund shares that didn’t need to be sold) can have the same negative effect.

As another example, assume that Vanguard’s Windsor fund creates short-term gain distributions of 85 cents and a long-term distribution equal to $2. If the fund possesses a NAV equal to $17 at the end of the year, Windsor will generate 6.5 times the tax burden (per share) while showing a NAV that is 81% lower. If Windsor creates returns of 20% for the year (and the S&P 500 generates returns of 30% for the same period), most of Windsor’s returns will be taxed as capital gains distributions. This can reduce those returns by as much as 15% to 35%. (Here the exact reduction will depend on the tax bracket of the investor.)

The troubling reality is that a majority of mutual fund providers choose not to highlight after-tax returns. They say that this is because individual tax situations are different, but if after-tax returns were highlighted, the performance differences between your typical mutual fund and in the S&P 500 would become much larger and more difficult to ignore. Another benefit gained when using a predetermined investment plan (which includes less frequent share sales) is that this reduces the amount of money you have stored in low yield cash holdings. It is possible for index funds to have more than 98% of its cash invested in market assets, but mutual funds will typically have much larger amounts of cash on hand (i.e. not actively invested). So if your money is in a mutual fund, and only 90% or your cash is invested, it becomes more difficult to beat the returns posted by the index fund because of the smaller amounts of money actively invested.

All of these factors create some combined negatives, because money managers must outperform the index so that they can make up for increased expenses and because they are never fully invested with all available cash resources. So, if money managers do beat the market (or simply break even) on a pre-tax basis, any value gains made for individual investors might be depleted with capital gains distributions which make a large percentage of these gains taxable.

Lessons for Individual Investors

So, when individual investors want to make their own financial decisions, the lessons here should be very clear: The best approach for generating larger, long-term returns is through maximizing money that is actively invested in the market and in adhering to the rules of tax efficiency. When the effects of taxation are calculated, outperformance margins that many short-term investors believe they have captured are significantly diminished.

Typically, the argument of these short term investors is that you will have to sell your shares at some point. But the reality shows us that when money compounds over longer time frames (as gains are reinvested, rather than cashed out), the lower tax rates for long-term shareholders create after-tax benefits that can be substantial. This does not even factor-in the possibility of owning stocks with dividend yields, which allow you to capture a rising income – gained through simple stock ownership. In some cases, it will be possible to live on your dividend income and leave your invested equity untouched (and without additional tax liabilities).

These are the reasons why S&P 500 Index investments are tough competition when compared to managed money accounts. When we understand why the S&P 500 index fund is often a preferable investment vehicle, it is possible to understand how to invest and keep expenses low. When investors minimize tax burdens and maximize the amount of money that is actively invested in the market, returns for the typical S&P 500 index fund far surpass those generated by professionally managed money. As an investor, your goal is to replicate this approach as closely as possible, as this will generate strong returns on an after-tax basis that are above and beyond what is typically seen in the market averages.

Measuring the Relative Performance of a Mutual Fund

January 4, 2013 By Richard Cox

Do you know how to measure your mutual fund performance? Are your personal finances allowing you to start using your savings as another way to earn money?

To most, assessing the true performance seems like a complicated task. Many advertisements tout certain funds as having 5-star ratings or as being the “best choice” for American investors. But how exactly are these performance ratings determined? Can these ratings be trusted? What exactly do we mean when we say a mutual fund generated a return of 20% and does this give us the true picture of a fund’s performance?

It can be very easy to get caught up in the hype of the media advertisements attached to many mutual funds, so making the best choice in a mutual fund investment requires a solid understanding of how performance should be measured. Here, we will look at how to measure the relative performances of mutual funds so that we can properly assess the claims made in their advertisements.

Using the Morningstar Style Box

The first step in accurately assessing a fund’s past performance is to look at the Morningstar Style box, which divides mutual funds by market capitalization (small, medium and large) and by its investment objective (value, growth, and blend). The box has 9 sections and can be seen in the graphic below:

This configuration allows you to place your chosen fund its correct category (one box on the “tic tac toe” spectrum). This is helpful because it will allow you to compare total performance (rates of return) with funds of a similar size and investment approach. Typically, investors make these comparisons over 3, 5, and 10 year time horizons (allowing you to smooth out short term fluctuations in the market). Of course, performance comparisons can also be made relative to a benchmark index like the S&P 500, but the more specific performance comparisons (to those funds in a similar Morningstar category) tend to be more useful.

Separating Your Fund from the Market as a Whole

When looking to make an assessment of the market as a whole, the S&P 500 can be a useful benchmark for determining broad economic performance. But in order to have a meaningful idea of your fund’s true merits, it must be compared to its peers those within the same style box category.

For example, roughly 90% of the available mutual funds underperformed the S&P 500 in 1998. Index funds tied to the S&P 500 fall into the “blend” and “large cap” fund categories (which suggests that the S&P 500 has limited exposure to value and growth stocks). In this year, as most mutual funds offered weaker returns than investments in the S&P 500, a majority of the similarly categorized “large cap” and “growth” funds actually beat the S&P 500 index. From this, should we surmise that the managers of these funds put forward an exceptional performance? Not exactly.

In 1998, growth funds with large market caps generated average returns of about 35% (which was about 8% better than what was seen in the S&P 500). But some funds (such as the Vanguard Growth Index fund) generated returns above 42% for the year. So, when some funds advertise the performance as “market leading” because they beat the S&P 500 benchmark, the first question to ask is whether or not the fund falls into the “large cap” and “growth” categories. If this is true, you should not be as impressed by these results as you would be if the fund fell into one other categories (which would be a more impressive feat). This is because the assets in that fund should have had no problem beating the S&P that year.

Matching Comparable Funds

There are some names that are well known in the fund community (such as Vanguard) that aim to provide access to index funds which fall into many of the Morningstar style boxes (Vanguard funds fall into 7 of these 9 categories). So, when looking for funds to use as a measured standard of performance, these funds provide a good starting point.

Morningstar.com allows you to search for your fund using its name or ticker symbol. You will then see a wide selection of informational articles related to the fund. This will include its style box categories, yearly performance relative to the S&P 500 (for assessment against the broader market), and performance comparisons to funds that are more directly related to your fund of choice. A quick internet search of this type can allow investors to assess the relative performance for mutual funds before making any share purchases.

SmartMoney’s Comparison Tools

Other sites, like SmartMoney.com, will allow you to compare funds through time periods of 1, 3, or 5 years. These types of sites allow you to monitor how the funds in your 401(k) plan are performing when compared with a similarly positioned index fund. The Vanguard funds make these comparisons particularly convenient and the following list shows which funds are comparable for each style box category. You can use the ticker search at SmartMoney.com to look for these match-ups:

Small Cap Funds: Vanguard Small Cap Index Inv (NAESX) compares to the Russell 2000 Index
Mid Cap Funds: Shelton S&P Midcap Index (SPMIX) compares to the S&P Mid Cap 400 Index
Large Cap Funds (Value): Vanguard Value Index (VIVAX) compares to the BARRA/S&P Value Index
Large Cap Funds (Growth): Vanguard Growth Index (VIGRX) compares with the BARRA/S&P Growth Index
Large Cap Funds (Blend): Vanguard 500 Index (VFINX) compares to the S&P 500 Index

In addition to this, Vanguard has addressed other style box categories with a value fund in the small cap category (VISVX), as well as a mid cap index fund (VIMSX). But since these are recent additions to the market, there is not enough of a historical record to allow for a meaningful analysis. Instead, when looking at mid cap funds, other options include the California Investment Trust S&P Midcap Fund (SPMIX). When looking at small cap funds in the growth or value category, investors can compare the chosen fund with those in the blend index funds with small market capitalization. One example is the Vanguard’s Small Cap Index Fund (NAESX).

Conclusion: Market Returns and Performance Ratings are Only Meaningful When Compared to Their Peers

Making a comparison of the annual returns generated by your chosen fund to those generated by a similarly positioned index or index fund will allow you to accurately assess the track record and measure its performance on a relative basis. In many cases, these performances are less than impressive, despite what the fund’s marketing team might suggest in advertisements. In other cases, a fund will outperform its peers (and its associated index), so an investor’s main task is to identify a fund that consistently outperforms relative to its competition.

Characteristics of the Main Types of Mutual Funds

December 26, 2012 By Richard Cox

When reviewing your personal finances, be sure to let your saved money work for you and increase your assets. Follow along with Richard Cox’s investment guides.

For new investors looking at mutual funds, it is important to know that not all of these funds are exposed to the same markets or the same asset types. Typically, a mutual fund will fall into one of three categories – Bond funds, Money Market funds, or Stock funds. In order to increase diversification exposure, many investors will split their resources and buy into a portion of all three. Here, we look at the characteristics of each of these Mutual Fund types.

Stock Funds

The most volatile of these funds is the Stock fund, which is sometimes called an Equity fund. In these cases, the value of the fund might fluctuate sharply in small periods of time. On the positive side, stocks perform better on a historical basis when compared to other asset classes. This is generally due to the expectation that companies will later command a greater market share and improve on revenues and profit outlooks. These factors tend to create increases in stock value for shareholders.

When gauging potential stock performance, it is important to consider the changing economic conditions which might affect corporate earnings, or risks such as upcoming lawsuits or possible restrictions in future product releases. Stock funds have sub-divisions as well, which feature different types of assets:

Income Funds: Focus on stocks with high dividend yields
Index Funds: Attempt to match the performance of a major stock index (such as the Dow or S&P 500)
Sector Funds: Specialize in industry sectors (such as technology, finance or healthcare)
Growth Funds: Attempt to create substantial capital appreciation (but are less likely to pay dividends regularly)

Bond Funds

Bond funds will generally buy government or corporate debt, and are sometimes referred to as Fixed Income funds. This is because Bond funds look to provide consistent investment income with regular dividend payments. These funds are included in many investment portfolios because they tend to perform well when stock markets are losing value. This helps to provide balance and risk protection for investors.

Bond funds are organized by sector (just like Stock Funds), and can vary in terms of potential risk. Low risk funds invest in stable assets like US Treasury Bonds, while riskier funds invest in very high-yield bonds or those associated with corporations with low credit ratings. Risk for bond funds can come from these areas:

Instances where bond issuers (either a government or a company) is unable to repay its debts
The bond is paid off prematurely, preventing a bond fund manager from re-investing profits in a higher return asset
Interest rates rise, bringing value declines to the purchased bonds

Money Market Funds

Money Market funds are typically associated with lower risk, relative to many other fund types and asset classes. These funds have legal requirements which limit their investments to selected high quality investments over short time periods. These assets are issued by the federal government, local municipalities, or stable US companies. In exchange for this security, historical returns tend to be lower (when compared to stock or bond funds), and these lower rates of return make these funds vulnerable to value declines in periods of high inflation.

Choosing Your Mutual Fund

When choosing your mutual fund investments, it is important to keep all of these factors in mind. Different fund types will perform better in certain economic environments and the total level of risk associated with each fund type will differ from investor to investor.

Reducing Fees in Mutual Fund Investments

December 15, 2012 By Richard Cox

Investing money is one way that Coolchecks.net recommends you use to enhance your personal finance strategies. Here is a short guide to mutual funds.

Mutual Fund Investment Guide

Selecting a winning mutual fund can seem like a daunting task, so whether you are looking to invest in a managed fund based on your own interest or if you are forced to do this because index funds are not provided by your 401(k), it pays to have an understanding of the basic workings of these instruments and the ways mutual funds tend to behave in relation to the broader market. First, it is important to understand that many mutual funds underperform the many benchmark stock indices because of the fees that are associated with these investments.

As client investors, our primary task is to ensure that these fee charges are low, as this gives us a better chance to achieve returns that beat the rest of the market. To do this, we will summarize the major terms that you will inevitably encounter when buying into a mutual fund and then give a short checklist that should be followed before any real investments are made.

Expense Ratios

Expense ratios are created by the annual fees that are charged by all mutual funds. These fees combine administrative costs, distribution fees, management fees, and operating costs. These costs are combined and calculated as a percentage to total assets. Actively managed mutual funds usually have expense ratios in the neighborhood of 1.5% per year. Ideally, look for expense ratios of 1% or less, but this might take some work since average fees have been rising in recent years.

Understanding Turnover

The next essential element to understand is “turnover,” which measures the length of time a mutual hold will hold a stock. Funds incur expenses whenever a fund is bought or sold, so if a fund holds onto a stock for a longer period of time, there will be fewer trading expenses. Additionally, capital gains taxes will also be lower when turnover rates are correctly managed.

If, for example, a fund has a turnover rate of 100%, that fund will buy an entirely new collection of stocks each year. Mutual funds average turnover rates of 80% but it is possible to find funds with substantially lower rates (sometimes even as low as 5%). The lower the rate, the lower the charges that will be later transferred to the investor.

A Checklist for Mutual Fund Investors

A summary checklist to use when looking for winning mutual funds should look like this:

1. No sales charges for clients (this includes level loads, front loads, and sales loads that are contingent deferred)
2. An expense ratio that is lower than its peers (usually below 1%)
3. Low turnover relative to the competition, (generally lower than 50% a year, a number closer to 20% is preferred).
4. Fund policy that remains fully invested. (Cash reserves of something close to 0%.)

Understanding these aspects of mutual fund investing can be important in ensuring we achieve returns that beat the wider market. In short, we are looking to keep our fees low and to choose low turnover funds, as these tend to give us the best chance enhancing returns.