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Mutual Fund BasicsA mutual fund is an investment company that helps you meet your financial goals by investing in various products, e.g., stocks, bonds, options, precious metals, etc. The valuation of a fund is expressed in Net Asset Value (NAV) per share (total asset in securities in the fund divided by the total number of shares). Daily increases/decreases in NAV are listed in the financial pages of most newspapers.
Most often, your transactions with the fund will be in terms of dollar value rather than the number of shares. If you invest $500 and the NAV on that day is $18, then the fund will add 27.778 shares ($500 divided by $18) in your account. Funds, usually, maintain the number of shares with an accuracy of three decimal places. Similarly, if you withdraw $600 and the NAV is $26, then the fund will reduce the number of shares, in your account, by 23.077 shares ($600 divided by $26). However, if you want, you can state the exact number of shares you want to sell.
Mutual funds have become popular, because they offer huge advantages to small and large investors. An investor can have a portfolio containing hundreds of individual issues (stocks, bonds, etc.) across the market with as little as $2500. Moreover, the investor can indirectly buy and sell those issues without paying the transaction fees to a broker. Another advantage of mutual fund is that it allows low, periodic investment. Most funds accept monthly investments of $100.
An investor can also acquire the services of superb managers by pooling her funds with the funds of thousands of other investors like her.
Furthermore, mutual fund investing gives wonderful liquidity. Fund shares can be bought or sold at a fraction of the cost that is incurred in selling individual stocks and bonds. Buying shares is as simple as mailing a check. An investor can also switch investments among funds and thereby have remarkable flexibility in building well diversified portfolios.
Mutual fund investing gives you simplicity and convenience. You can call a 1-800 number and request a simple application form and prospectus by mail. You will have to enter your name, address, and social security number in the form. If you want, you can check a box, in the form, so that the dividend and capital gains in the fund are automatically re-invested. Withdrawal of cash from the fund usually requires only a phone call. You can set-up a monthly investment plan where an amount specified by you is automatically transferred to the fund from your bank account. The funds mail monthly/quarterly statements showing all the transactions and the balance. At the end of the year you will get easy to follow 1099-D and 1099-B forms for filing the income tax return.
A custodian is in charge of safekeeping the cash and the securities in a fund. A manager or a team of managers makes the investment decisions for the fund. Securities and Exchange Commission (SEC) monitors the functioning of mutual funds
Hedge funds are very similar to mutual funds with a few differences. Hedge funds are not regulated by SEC. The managers charge a percent of profit (around 20%) they make as a fee, instead of drawing a salary. Hedge funds accept direct investments in large chunks ($200,000 or more) from wealthy investors (with asset more than a million). Hedge funds are much smaller than mutual funds (asset size of $20 million to $50 million). Some managers use shareholders' money as collateral to get loans and invest the borrowed money.
Cost is an important factor to consider while choosing mutual funds. A brief outline of various costs are given below.
Management fees and the 12(b)-1 fee are included in the Expense Ratio. Expense ratio can vary between 0.25% to over 3%. Funds with larger asset generally have lower expense ratio. In the following Figure (data from Investor's Business Daily, January 11, 2001) , the average expense ratio is plotted against ranges of fund asset. Do not select a fund with expense ratio significantly larger than the average shown in this Figure. For example, if a fund's asset is $750 million (in the 501 - 1000 range), its expense ratio should not be a lot more than 1%.
The broad classification of mutual funds is as follows.
In many literature and fund prospectus, you will see other classifications, such as "growth and income", "equity income", etc. Such categorization is arbitrary and ambiguous. We will stick to the straightforward classification given above for one important reason - it is suggested by the famous fund ranking publication, Morningstar.
Tech funds led in 1998 and 1999, but the loss in those funds, this year (April 2000), puts them in the 6th place among the sector funds. Similarly, Healthcare was the leader in 1990-1991, but dropped to 7th place in 1992. Communications was leading in 1988-1989 and finished in the 5th place in 1990. Sector funds are short-distance sprinters but not marathon runners. When your investment time horizon is 20, 30, 40 years, you do not put hot-and-cold sector funds in your portfolio. You build your core around well diversified funds.
In our discussion, we will ignore the sector funds. An excellent sector investing strategy is to invest in the sector SPDR's. You will find a discussion on SPDR's in another section of this web-site.
Let us begin with four basic rules to prepare a short list of funds.
Rule #1: Always Buy No-load Funds
Editor of "No-load Fund Investor", Sheldon Jacobs said,"Load funds, by whatever name, are more costly, and thus inferior to no-loads." Jeffrey Lederman, in a Business Week article recently concluded, "...eventually all funds will be no-load...Fund companies and investors would both benefit if that happened sooner than later." Dr. P.B. Farrell of CBS Marketwatch states, "Wall Street's old boys' club still has a lot of members who continue to sell load funds and make commissions. They are the dinosaurs who don't know any better. And fortunately for these old fogies, there are a lot of investors who also don't know any better."
Rule #2: Pick Funds with High Category Rating.
Morningstar's resident financial planner, Sue Stevens states, "Morningstar's star ratings may get a lot of press, but Morningstar's category ratings are more important in my book." We will select funds that have earned a category rating of 4 or 5.
Rule #3: Fund is a Proven Performer.
We will discard all funds that have been in existence for less than seven years.
Rule #4: Fund has Reasonable Expense Ratio .
We will discard all funds that have an expense ratio significantly larger than the average for its asset range (see Expense Ratio plot above).
Among the funds listed in "Morningstar Mutual Fund 500", 2000 edition, the number of funds that satisfy these rules are as follows:
| Fund Category | Number |
| Large-cap value | 11 |
| Large-cap Growth | 9 |
| Large-cap Balanced | 8 |
| Mid-cap Growth | 3 |
| Mid-cap Value | 8 |
| Mid-cap Balanced | 7 |
| Small-cap Growth | 4 |
| Small-cap Value | 8 |
| Small-cap Balanced | 2 |
| Municipal Bonds | 14 |
| Government Bonds | 7 |
| Corporate Bonds | 9 |
| Mortgage-backed | 4 |
| International Funds | 7 |
| Hybrid Funds | 6 |
| Total | 107 |
To fully understand the whittling process you may like to review the material in the "Yield and Risk" section of this web-site. For all the one-hundred-seven funds, I have collected the average yield, standard deviation, and expense ratio from Morningstar Mutual Fund 500, 2000 Edition. Then I calculated the "Accumulation Value" and "DQPY" for these funds.
(You can calculate the accumulation and DQPY for your fund choices by using the calculator in the "Yield and Risk" section of this web-site.)
Higher accumulation value signifies a higher growth potential for a fund. DQPY (Down Quarters Per Year) is a measure of risk. Selection of a mutual fund for your portfolio should be governed by four basic principles. (i) Among two funds with comparable accumulation, select the fund with smaller DQPY. (ii) Among two funds with comparable DQPY, select the fund with higher accumulation. (iii) If you demand higher accumulation, you should be ready to accept a higher DQPY. (iv) Among two funds with comparable accumulation and DQPY, pick the one with lower expense ratio.
By utilizing the principles stated above, I made the fund selections in three groups: (a) Aggressive Stock Funds, (b)Cautious Stock Funds, and (c) Bond Funds. These selections, together with their accumulation and DQPY are given in the Tables below.
| Category | Fund | Accumulation | DQPY |
| Large-cap Growth | Fidelity Aggressive Growth (FDEGX) | 1.448 | 0.41 |
| Mid-cap Growth | Janus Enterprise (JAENX) | 1.428 | 0.49 |
| Small-cap Growth | Henlopen (HENLX) | 1.272 | 0.71 |
| International | Janus Worldwide (JAWWX) | 1.332 | 0.32 |
| Category | Fund | Accumulation | DQPY |
| Large-cap Growth | Janus Growth and Income (JAGIX) | 1.373 | 0.29 |
| Large-cap Balanced | Fidelity (FFIDX) | 1.272 | 0.37 |
| Hybrid | Janus Balanced (JABAX) | 1.243 | 0.25 |
| International | Janus Worldwide (JAWWX) | 1.332 | 0.32 |
| Municipal Bonds | Vanguard Limited Term (VMLTX) | 1.04 | 0.02 |
| Mortgage Backed | Vanguard GNMA (VFIIX) | 1.06 | 0.07 |
| Government Bonds | Vanguard Short-term Federal (VSGBX) | 1.05 | 0.00 |
Five highest ranking funds - Janus 20, Janus Mercury, Vanguard Prime Cap, RS Emerging Growth, and Janus Venture are excluded from the whittled list, because, unfortunately, these funds are closed to new investors.
Before I get to the discussion on Optimized Portfolios, it is appropriate to suggest two portfolios for the beginner. Optimized Portfolios require four to six funds and thus a larger asset. For beginners, who are starting with a small asset, the strategy should be to get into the best one or two mutual funds.
If you plan to invest between $2500 to $7500, I would suggest the Fidelity Aggressive Growth Fund. Also, plan to set-up an automatic, monthly investment in the fund.
If you plan to invest between $7500 to $25,000, I would suggest two-thirds of the asset invested in Fidelity Aggressive Growth Fund and one-third of the asset invested in Janus Worldwide Fund. Your automatic, monthly investment should also be invested in the funds in the same proportion (two-thirds in Fidelity and one-third in Janus).
If your investment is more than $25,000, then move to the following section.
The building of an optimized portfolio requires two things: the materials and a plan.
The materials depend on the goal of the investor. The goal is usually specified in terms of the period of investment or the time horizon. Time horizon is a date in the future when you will need to use your savings. I have classified the time horizon into four levels: (i)More than 8 years, (ii) between 5 and 8 years, (iii) between 2 and 5 years, and (iv) less than 2 years. Based on this classification, I will construct four portfolios. Depending on the time horizon, the ingredients in the portfolio are chosen from the aggressive and cautious stock funds and the bond funds, listed above.
If you are saving for children's education, you have a specific time horizon based on your children's age. If you are saving for buying a home, you know when you will need the cash. If you are saving for retirement, subtract your age from sixty-five to obtain your time horizon.
The plan is a mathematical technique to determine an appropriate combination of the ingredients. This mathematical technique is described in detail in the section on "Diversification and Asset Allocation" of this web-site. The goal is to minimize the variance (risk) for a specified, desired yield. Such minimization provides a set of operating points on the "efficient frontier". An investor can then chose her operating point based on her comfort level in regards to her risk tolerance.
This portfolio consists of the Aggressive Stock Funds. Four operating points on the efficient frontier are shown in the Table below. For each operating point, the asset allocation in each fund, the accumulation value, and the DQPY are shown.
| FDEGX | JAENX | HENLX | JAWWX | Accumulation | DQPY |
|---|---|---|---|---|---|
| 18% | 10% | 10% | 62% | 1.271 | 0.37 |
| 33% | 10% | 10% | 47% | 1.277 | 0.42 |
| 49% | 10% | 10% | 31% | 1.282 | 0.48 |
| 64% | 10% | 10% | 16% | 1.286 | 0.54 |
This portfolio consists of four cautious stock funds. Five operating points on the efficient frontier are shown in the Table below. For each operating point, the asset allocation in each fund, the accumulation value, and the DQPY are shown.
| JAGIX | FFIDX | JABAX | JAWWX | Accumulation | DQPY |
|---|---|---|---|---|---|
| 10% | 18% | 62% | 10% | 1.205 | 0.10 |
| 10% | 40% | 40% | 10% | 1.215 | 0.08 |
| 10% | 58% | 19% | 13% | 1.225 | 0.06 |
| 10% | 54% | 10% | 26% | 1.235 | 0.06 |
| 10% | 31% | 10% | 49% | 1.243 | 0.10 |
This portfolio consists of four cautious stock funds and three bond funds. The risk minimization in this portfolio was performed with an additional constraint - 30% of the asset are invested in the bond funds. The efficient frontier consists of eight operating points. The allocations, accumulation, and the DQPY for the best operating point on the efficient frontier is given in the Table below. An additional quantity that is also shown in this Table is the "income" from this portfolio.
| JAGIX | FFIDX | JABAX | JAWWX | VFIIX | Accumulation | DQPY | Income |
|---|---|---|---|---|---|---|---|
| 10% | 10% | 10% | 40% | 30% | 1.192 | 0.1 | 3.14% |
This portfolio is very similar to Portfolio IV. The only difference being that 70% of the asset are invested in the bond funds. The efficient frontier consists of four operating points. The allocations, accumulation, DQPY, and income for the best operating point on the efficient frontier are given in the Table below.
| FFIDX | JAWWX | VMLTX | VFIIX | VSGBX | Accumulation | DQPY | Income |
|---|---|---|---|---|---|---|---|
| 7% | 23% | 10% | 44% | 16% | 1.119 | 0.02 | 4.79% |
| Fidelity | 1-800-544-8888 |
| Henlopen | 1-800-922-0224 |
| Janus | 1-800-525-8983 |
| Vanguard | 1-800-662-7447 |
What is "dollar cost averaging"? It is a system in which the mutual fund company automatically takes an amount, specified by you, out of your bank account and buys shares of the fund. This transfer usually takes place at the beginning of each month. You can easily set this system up by checking a box in the application form and mailing a voided check or deposit slip together with your application. If you had not done so when you opened the fund account, do it ASAP by writing a letter to your fund manager.
Dollar cost averaging achieves three things for you. Firstly, the money leaves your account, so you cannot spend the money that you don't have, on the t-shirt, or jewelry, or the half-gallon-milk-shake that you do not need. Secondly, dollar cost averaging makes good investment sense. Consider a regular, monthly investment of $100. When the fund price is $25, your $100 will buy 4 shares. When the fund share price is $50, your $100 will buy 2 shares. Thus, you are buying more shares when the price is low. This is consistent with the "mantra" of investing - "buy-low-sell-high". Finally, the good habit of regular savings is the key to comfortable future. Use the Brick by Brick calculator to see how regular, small investments accumulate, compound, and grow to substantial wealth.
Monkeys are restless, always jumping from branch to branch, looking for a more attractive location. Restless mutual fund investors, in a similar fashion, jump from fund to fund, looking for a more attractive return.
Founder of The vanguard Group of Investment Companies, J.C. Bogle analyzed these "restless" moves in his book titled "Bogle on Mutual Funds". He says, "Let's suppose you read the (Forbes) Honor Roll listing each year and purchase (or hold) an equal amount in each fund on the list, eliminating funds as they were dropped from the list" (Bogle, page 91). If you had adopted this strategy from 1974-92, your annualized return would be 11.2%. Whereas, over this period, annualized return from the average equity fund was 12.5% and the return from the Wilshire 5000 Index was 13.1%. Your actively managed Honor Roll portfolio performed well below an unmanaged market index.
What went wrong? If, on 2 January 2001, you buy the highest flyer fund of 2000, then there is a high probability that you will be disappointed in the year 2001. Very few funds are repeat performers. Bogle makes this point very nicely in his book (Bogle, page 90). He followed 176 mutual funds from 1977-92. Out of the 44 funds that belonged in the 1st quartile based on overall growth during the period 1977-87, only 14 re-appeared in the first quartile during the period 1987-92.
In summary, what should your strategy be? Don't jump from high flyer to high flyer. Construct a portfolio of funds selected for their superior performance over a long period of time. Once a year, adjust the allocations in these funds so that you always operate on the efficient frontier.
To evaluate the performance of your portfolio, calculate accumulation and DQPY, use the calculator provided in the Chapter on Asset Allocation.
You probably own mutual funds in two possible segments of your portfolio - (i) Within an IRA, (ii) outside IRA. The strategies for re-allocation and hence fund transfer for these two segments are quite different.
For the funds within your IRA, at the beginning of a year, you should compare the existing balances in your funds with the required, optimized balances. In case of a mismatch, you may need to take an amount of cash from some mutual funds and re-distribute it among the others. For funds within an IRA, such cash withdrawal from a fund is not a taxable event. Within the tax sheltered IRA, the cash transfer makes no difference to what you would owe to the IRS at the end of the year.
However, for funds outside IRA, cash withdrawal for the purpose of re-allocation may have serious consequences on the amount of tax you owe. Most investors shy away from asset allocation because of huge capitals gains that they have accumulated in some of their funds. Any major re-allocation requires significant amount of cash transfer, among mutual funds, which is a taxable event. As a consequence, many investors remain shackled to a grossly imbalanced portfolio in an effort to avoid a large income-tax payment. Fortunately, there is a very easy way out of this situation.
All mutual funds pay dividends and capital gains either on a quarterly or annual basis. These payments are called the distribution. Receiving this distribution is a taxable event and you are required to report it to the IRS. Most investors opt for automatic re-investment of this distribution in the same fund that paid the distribution. Instead of automatic re-investment, you can ask your fund manager to send you a check for the amount of the distribution. Receiving a check or re-investing in the same fund makes no difference as far as taxation goes, because both of these events are equally taxable. However, receiving the check gives you a chance to re-allocate. You may re-invest the distribution in the same fund or another fund of your choice. Thereby, you can use this distribution to reallocate and redistribute cash among funds. As you receive the distribution checks from all your mutual funds, you will have to re-invest the cash according to your asset allocation plan. You have to be willing to go through this process in a disciplined fashion, at the end of each quarter.
In the diagram below, the effect of taking the distribution from Janus Fund and investing in Janus Twenty is shown. Some of the data for this diagram are taken from Investor's Business Daily of August 22, 2000.
At the end of 1994 (beginning of 1995), Janus Fund pays a dividend of $800. A new Janus 20 account is started with this distribution and an additional $2000. At the end of each subsequent year, the distribution from Janus Fund is received as cash and invested in Janus 20. The growth of investment over a five-year period (from the beginning of 1995 to the end of 1999) is shown in the Figure.
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