Path: senator-bedfellow.mit.edu!dreaderd!not-for-mail Message-ID: Supersedes: Expires: 17 Mar 2003 10:19:33 GMT References: X-Last-Updated: 2002/08/14 From: lott@invest-faq.com (Christopher Lott) Newsgroups: misc.invest.misc,misc.invest.stocks,misc.invest.technical,misc.invest.options,misc.answers,news.answers Subject: The Investment FAQ (part 8 of 19) Followup-To: misc.invest.misc Reply-To: lott at invest-faq dot com Summary: Answers to frequently asked questions about investments. Should be read by anyone who wishes to post to misc.invest.* Organization: The Investment FAQ publicity department Keywords: invest, finance, stock, bond, fund, broker, exchange, money, FAQ URL: http://invest-faq.com/ Approved: news-answers-request@MIT.Edu Originator: faqserv@penguin-lust.MIT.EDU Date: 01 Feb 2003 10:23:40 GMT Lines: 1184 NNTP-Posting-Host: penguin-lust.mit.edu X-Trace: 1044095020 senator-bedfellow.mit.edu 3949 18.181.0.29 Xref: senator-bedfellow.mit.edu misc.invest.misc:38853 misc.invest.stocks:761215 misc.invest.technical:97007 misc.invest.options:48648 misc.answers:15585 news.answers:245653 Archive-name: investment-faq/general/part8 Version: $Id: part08,v 1.58 2002/08/14 10:20:04 lott Exp lott $ Compiler: Christopher Lott, lott at invest-faq dot com The Investment FAQ is a collection of frequently asked questions and answers about investments and personal finance. This is a plain-text version of The Investment FAQ, part 8 of 19. The web site always has the latest version, including in-line links. Please browse http://invest-faq.com/ Terms of Use The following terms and conditions apply to the plain-text version of The Investment FAQ that is posted regularly to various newsgroups. Different terms and conditions apply to documents on The Investment FAQ web site. The Investment FAQ is copyright 2001 by Christopher Lott, and is protected by copyright as a collective work and/or compilation, pursuant to U.S. copyright laws, international conventions, and other copyright laws. The contents of The Investment FAQ are intended for personal use, not for sale or other commercial redistribution. The plain-text version of The Investment FAQ may be copied, stored, made available on web sites, or distributed on electronic media provided the following conditions are met: + The URL of The Investment FAQ home page is displayed prominently. + No fees or compensation are charged for this information, excluding charges for the media used to distribute it. + No advertisements appear on the same web page as this material. + Proper attribution is given to the authors of individual articles. + This copyright notice is included intact. Disclaimers Neither the compiler of nor contributors to The Investment FAQ make any express or implied warranties (including, without limitation, any warranty of merchantability or fitness for a particular purpose or use) regarding the information supplied. The Investment FAQ is provided to the user "as is". Neither the compiler nor contributors warrant that The Investment FAQ will be error free. Neither the compiler nor contributors will be liable to any user or anyone else for any inaccuracy, error or omission, regardless of cause, in The Investment FAQ or for any damages (whether direct or indirect, consequential, punitive or exemplary) resulting therefrom. Rules, regulations, laws, conditions, rates, and such information discussed in this FAQ all change quite rapidly. Information given here was current at the time of writing but is almost guaranteed to be out of date by the time you read it. Mention of a product does not constitute an endorsement. Answers to questions sometimes rely on information given in other answers. Readers outside the USA can reach US-800 telephone numbers, for a charge, using a service such as MCI's Call USA. All prices are listed in US dollars unless otherwise specified. Please send comments and new submissions to the compiler. --------------------Check http://invest-faq.com/ for updates------------------ Subject: Insurance - Variable Universal Life (VUL) Last-Revised: 26 Jun 2000 Contributed-By: Ed Zollars (ezollar at mindspring.com), Chris Lott ( contact me ), Dan Melson (dmelson at home.com) This article explains variable universal life (VUL) insurance, and discusses some of the situations where it is appropriate. Variable universal life is a form of life insurance, specifically it's a type of cash-value insurance policy. (The other types of cash value life insurance are whole, universal, and variable life.) Like any life insurance policy, there is a payout in case of death (also called the death benefit). Like whole-life insurance, the insurance policy has a cash value that enjoys tax-deferred growth over time, and allows you to borrow against it. Unlike either term or traditional whole-life insurance, VUL policies allow the insured to choose how the premiums are invested, usually from a universe of 10-25 funds. This means that the policy's cash value as well as the death benefit can fluctuate with the performance of the investments that the policy holder chose. Where does the name come from? To take the second part first, the "universal" component refers to the fact the premium is not a "set in stone" amount as would be true with traditional whole life, but rather can be varied within a range. As for the first part of the name, the "variable" portion refers to the fact that the policy owner can direct the investments him/herself from a pool of options given in the policy and thus the cash value will vary. So, for instance, you can decide the cash value should be invested in various types of equities (while it can be invested in nonequities, most interest in VUL policies comes from those that want to use equities). Obviously, you bear the risk of performance in the policy, and remember we have to keep enough available to fund the expenses each year. So bad performance could require increasing premiums to keep the policy in force. Conversely, you gain if you can invest and obtain a better return (at least you get more cash value). If a VUL policy holder was fortunate enough to choose investments that yield returns anything like what the NASDAQ saw in 1999, the policy's cash value could grow quite large indeed. The cash value component of the policy may be in addition to the death benefit should you die (you get face insurance value *plus* the benefit) *OR* serve to effectively reduce the death benefit (you get the face value, which means the cash value effectively goes to subsidize the death benefit). It all depends on the policy. A useful way to think about VUL is to think of buying pure term insurance and investing money in a mutual fund at the same time. This is essentially what the insurance company that sells you a VUL is doing for you. However, unlike your usual mutual fund that may pass on capital gains and other income-tax obligations annually, the investments in a VUL grow on a tax-deferred basis. Uncle Sam may get a taste eventually (if the policy is cashed in or ceases to remain in force), but not while the funds are growing and the policy is maintained. We can talk about the insurance component of a VUL and about the investment component. The insurance component obviously provides the death benefit in the early years of the policy if needed. The investment component serves as "bank" of sorts for the amounts left over after charges are applied against the premium paid, namely charges for mortality (to fund the payouts for those that die with amounts paid beyond the cash values), administrative fees (it costs money to run an insurance company (grin)) and sales compensation (the advisor has to earn a living). How this amount is invested is the principal difference between a VUL and other insurance policies. If you own a VUL policy, you can borrow against the cash value build-up inside the policy. Because monies borrowed from a VUL policy that is maintained through the insured's life are technically borrowed against the death benefit, they work out tax free. This means a VUL owner can borrow money during retirement against the cash value of the policy and never pay tax on that money. It sounds almost too good to be true, but it's true. A policy holder who choose to borrow against the death benefit must be extremely careful. A policy collapses when the cash value plus any continuing payments aren't enough to keep the basic insurance in force, and that causes the previously tax-free loans to be viewed as taxable income. Too much borrowing can trigger a collapse. Here's how it can happen. As the insured ages, Cost of Insurance (COI) per thousand dollars of insurance rises. With a term policy, it's no big deal - the owner can just cancel or let it lapse without tax consequences, they just have no more life insurance policy. But with a cash value policy such as VUL there is the problem of distributions that the owner may take. Say on a policy with a cash value of $100,000 I start taking $10,000 per year withdrawals/loans. Say I keep doing this for 30 years, and then the variability of the market bites the investment and the cash value gets exhausted. I may have put say 50,000 into the policy - that's my cost basis, and I took that much out as withdrawals. But the other $250,000 is technically a loan against the death benefit, and I don't have to pay taxes on it - until there's suddenly no death benefit because there's no policy. So here's $250,000 I suddenly have to pay taxes on. Once the policy is no longer in force, all the money borrowed suddenly counts as taxable income, and the policy holder either has taxable income with no cash to show for it, or a need to start paying premiums again. At the point of collapse, the owner could be (reasonably likely) destitute anyway, so there may be very little in the way of real consequences, but if there are still assets, like a home, other monies, etcetera, you see that there could be problems. Which is why cash value life insurance should be the *last* thing you take distributions from in most cases (The more tax-favored they are, the longer you put off distributions.) What all this means is that the cash surrender value of the VUL really isn't totally available at any point in time, since accessing it all will result in a tax liability. If you want to consider the real cash value, you need realistic projections of what can be safely borrowed from the policy. This seems like a good time to mention one other aspect of taxes and life insurance, namely FIFO (first-in first-out) treatment. In other words, if a policy holder withdraws money from a cash-value life insurance policy, the withdrawal is assumed to come from contributions first, not earnings. Withdrawals that come from contributions aren't taxable (unless it's qualified money, a rare occurence). After the contributions are exhausted, then withdrawals are assumed to come from earnings. Computing the future value of a VUL policy borders on the impossible. Any single line projection of the VUL is a) virtually certain to be wrong and b) without question overly simplistic. This is a rather complex beast that brings with it a wide range of potential outcomes. Remember that while we cannot predict the future, we know pretty much for sure that you won't get a nice even rate of return each year (though that's likely what all VUL examples will assume). The date when returns are earned can be far more important than the average return earned. To compare a VUL with other choices, you need to do a lot of "what ifs" including looking at the impacts of uneven returns, and understand all the items in the presentation that may vary (including your date of death (grin)). While I hate to give "rules of thumb" in these areas, the closest I will come is to say that VUL normally makes the most sense when you can heavily fund the policy and are looking at a very long term for the funds to stay invested. The idea is to limit the "drag" on return from the insurance component, but get the tax shelter. Another issue is that if you will have a taxable estate and helping to fund estate taxes is one of the needs you see for life insurance, the question of the ownership of the insurance policy will come into play. Note that this will complicate matters even further (and you probably already thought it was bad enough (grin)), because what you need to do to keep it out of your estate may conflict with other uses you had planned for the policy. Note that there are "survivor VULs", insuring two lives, which are almost always sold for either estate planning or retirement plan purposes (or both). The cost of insurance is typically less than an annuity's M&E charges until the younger person is in their fifties. A person who is considering purchasing a VUL policy needs to think clearly about his or her goals. Those goals will determine both whether a VUL is right tool and how it should be used. Potential goals include: * Providing a pool of money that will only be tapped at my death, but will be used by my spouse. * Providing a pool of money that will only be used at my death, but which we want to use to pay estate taxes. * Providing a pool of money that I plan to borrow from in old age to live on, and which will, in the interim, provide a death benefit for my spouse. Once the goals are clear, and you've then determined that a VUL would be something that could fulfill your goals, you then have to find the right VUL. --------------------Check http://invest-faq.com/ for updates------------------ Subject: Mutual Funds - Basics Last-Revised: 11 Aug 1998 Contributed-By: Chris Lott ( contact me ) This article offers a basic introduction to mutual funds. It can help you decide if a mutual fund might be a good choice for you as an investment. If you visit a big fund company's web site (e.g., www.vanguard.com), they'll tell you that a mutual fund is a pool of money from many investors that is used to pursue a specific objective. They'll also hasten to point out that the pool of money is managed by an investment professional. A prospectus (see below) for any fund should tell you that a mutual fund is a management investment company. But in a nutshell, a mutual fund is a way for the little guy to invest in, well, almost anything. The most common varieties of mutual funds invest in stocks or bonds of US companies. (Please see articles elsewhere in this FAQ for basic explanations of stocks and bonds.) First let's address the important issue: how little is our proverbial little guy or gal? Well, if you have $20 to save, you would probably be better advised to speak to your neighborhood bank about a savings account. Most mutual funds require an initial investment of at least $1,000. Exceptions to this rule generally require regular, monthly investments or buying the funds with IRA money. Next, let's clear up the matter of the prospectus, since that's about the first thing you'll receive if you call a fund company to request information. A prospectus is a legal document required by the SEC that explains to you exactly what you're getting yourself into by sending money to a management investment company, also known as buying into a mutual fund. The information most useful to you immediately will be the list of fees, i.e., exactly what you will be charged for having your money managed by that mutual fund. The prospectus also discloses things like the strategy taken by that fund, risks that are associated with that strategy, etc. etc. Have a look at one, you'll quickly see that securities lawyers don't write prose that's any more comprehensible than other lawyers. The worth of an investment with an open-end mutual fund is quoted in terms of net asset value. Basically, this is the investment company's best assessment of the value of a share in their fund, and is what you see listed in the paper. They use the daily closing price of all securities held by the fund, subtract some amount for liabilities, divide the result by the number of outstanding shares and Poof! you have the NAV. The fund company will sell you shares at that price (don't forget about any sales charge, see below) or will buy back your shares at that price (possibly less some fee). Although boring, you really should understand the basics of fund structure before you buy into them, mostly because you're going to be charged various fees depending on that structure. All funds are either closed-end or open-end funds (explanation to follow). The open-end funds may be further categorized into load funds and no-load funds. Confusingly, an open-end fund may be described as "closed" but don't mistake that for closed-end. A closed-end fund looks much like a stock of a publically traded company: it's traded on some stock exchange, you buy or sell shares in the fund through a broker just like a stock (including paying a commission), the price fluctuates in response to the fund's performance and (very important) what people are willing to pay for it. Also like a publically traded company, only a fixed number of shares are available. An open-end fund is the most common variety of mutual fund. Both existing and new investors may add any amount of money they want to the fund. In other words, there is no limit to the number of shares in the fund. Investors buy and sell shares usually by dealing directly with the fund company, not with any exchange. The price fluctuates in response to the value of the investments made by the fund, but the fund company values the shares on its own; investor sentiment about the fund is not considered. An open-end fund may be a load fund or no-load fund. An open-end fund that charges a fee to purchase shares in the fund is called a load fund. The fee is called a sales load, hence the name. The sales load may be as low as 1% of the amount you're investing, or as high as 9%. An open-end fund that charges no fee to purchase shares in the fund is called a no-load fund. Which is better? The debate of load versus no-load has consumed ridiculous amounts of paper (not to mention net bandwidth), and I don't know the answer either. Look, the fund is going to charge you something to manage your money, so you should consider the sales load in the context of all fees charged by a fund over the long run, then make up your own mind. In general you will want to minimize your total expenses, because expenses will diminish any returns that the fund achieves. One wrinkle you may encounter is a "closed" open-end fund. An open-end fund (may be a load or a no-load fund, doesn't matter) may be referred to as "closed." This means that the investment company decided at some point in time to accept no new investors to that fund. However, all investors who owned shares before that point in time are permitted to add to their investments. (In a nutshell: if you were in before, you can get in deeper, but if you missed the cutoff date, it's too late.) While looking at various funds, you may encounter a statistic labeled the "turnover ratio." This is quite simply the percentage of the portfolio that is sold out completely and issues of new securities bought versus what is still held. In other words, what level of trading activity is initiated by the manager of the fund. This can affect the capital gains as well as the actual expenses the fund will incur. That's the end of this short introduction. You should learn about the different types of funds , and you might also want to get information about the various fees that funds can charge , just to mention two big issues. Check out the articles elsewhere in this FAQ to learn more. Here are a few resources on the 'net that may also help. * Bill Rini maintains the Mutual Funds FAQ. http://www.moneypages.com/syndicate/faq/index.html * Brill Editorial Services offers Mutual Funds Interactive, an independent source of information about mutual funds. http://www.fundsinteractive.com/ * FundSpot offers mutual fund investors the best information available for free. http://www.fundspot.com/ * The Mutual Fund Investor's Center, run by the Mutual Fund Education Alliance, offers profiles, performance data, links, etc. http://www.mfea.com/ --------------------Check http://invest-faq.com/ for updates------------------ Subject: Mutual Funds - Average Annual Return Last-Revised: 24 Jun 1997 Contributed-By: Jack Piazza (seninvest at aol.com) The average annual return for a mutual fund is stated after expenses. The expenses include fund management fees, 12b-1 fees (if applicable), etc., all of which are a part of the fund's expense ratio. Average annual returns are also factored for any reinvested dividend and capital gain distributions. To compute this number, the annual returns for a fixed number of years (e.g., 3, 5, life of fund) are added and divided by the number of years, hence the name "average" annual return. This specifically means that the average annual return is not a compounded rate of return. However, the average annual returns do not include sales commissions, unless explictly stated. Also, custodial fees which are applied to only certain accounts (e.g., $10 annual fee for IRA account under a stated amount, usually $5,000) are not factored in annual returns. --------------------Check http://invest-faq.com/ for updates------------------ Subject: Mutual Funds - Buying from Brokers versus Fund Companies Last-Revised: 28 Dec 1998 Contributed-By: Daniel Pettit (dalacap at dalacap.com), Jim Davidson (jdavidso at xenon.stanford.edu), Chris Lott ( contact me ), Michael Aves (michaelaves at hotmail.com) Many discount brokerage houses now offer their clients the option of purchasing shares in mutual funds directly from the brokerage house. Even better, most of these brokers don't charge any load or fees if a client buys a no-load fund. There are a few advantages and disadvantages of doing this. Here are a few of the advantages. 1. One phone call/Internet connection gets you access to hundreds of funds. 2. One consolidated statement at the end of the month. 3. Instant access to your money for changing funds and or families, and for getting your money in your hand via checks (2-5 days). 4. You can buy on margin, if you are so inclined. 5. Only one tax statement to (mis)file. 6. The minimum investment is sometimes lower. And the disadvantages: 1. Many discount brokerage supermarket programs do not even give access to whole sectors of the market, such as high-yield bond funds, or multi-sector (aka "Strategic Income") bond funds. 2. Most discount brokers also will not allow clients to do an exchange between funds of different families during the same day (one trade must clear fist, and the the trade can be done the next day). 3. Many will not honor requests to exchange out of funds if you call after 2pm. EST. (which of course is 11am in California). This is a serious restriction, since most fund families will honor an exchange or redemption request so long as you have a rep on the phone by 3:59pm. 4. You pay transaction fees on some no-load funds. 5. The minimum investment is sometimes higher. Of course the last item in each list contradict each other, and deserve comment. I've seen a number of descriptions of funds that had high initial minimums if bought directly (in the $10,000+ range), but were available through Schwab for something like $2500. I think the same is true of Fidelity. Your mileage may vary. --------------------Check http://invest-faq.com/ for updates------------------ Subject: Mutual Funds - Distributions and Tax Implications Last-Revised: 27 Jan 1998 Contributed-By: Chris Lott ( contact me ), S. Jaguiar, Art Kamlet (artkamlet at aol.com), R. Kalia This article gives a brief summary of the issues surrounding distributions made by mutual funds, the tax liability of shareholders who recieve these distributions, and the consequences of buying or selling shares of a mutual fund shortly before or after such a distribution. Investment management companies (i.e., mutual funds) periodically distribute money to their shareholders that they made by trading in the shares they hold. These are called dividends or distributions, and the shareholder must pay taxes on these payments. Why do they distribute the gains instead of reinvesting them? Well, a mutual fund, under The Investment Company Act of 1940, is allowed to make the decision to distribute substantially all earnings to shareholders at least annually and thereby avoid paying taxes on those earenings. Of course, they do. In general, equity funds distribute dividends quarterly, and distribute capital gains annually or semi-annually. In general, bond funds distribute dividends monthly, and distribute capital gains annually or semi-annually. When a distribution is made, the net asset value (NAV) goes down by the same amount. Suppose the NAV is $8 when you bought and has grown to $10 by some date, we'll pick Dec. 21. On paper you have a profit of $2. Then, a $1 distribution is made on Dec. 21. As a result of this distribution, the NAV goes down to $9 on Dec. 22 (ignoring any other market activity that might happen). Since you received a $1 payment and your shares are still worth $9, you still have the $10. However, you also have a tax liability for that $1 payment. Mutual funds commonly make distributions late in the year. Because of this, many advise mutual fund investors to be wary of buying into a mutual fund very late in the year (i.e., shortly before a distribution). Essentially what happens to a person who buys shortly before a distribution is that a portion of the investment is immediately returned to the investor along with a tax bill. In the short term it essentially means a loss for the investor. If the investor had bought in January (for example), and had seen the NAV rise nicely over the year, then receiving the distribution and tax bill would not be so bad. But when a person essentially increases their tax bill with a fund purchase, it is like seeing the value of the fund drop by the amount owed to the tax man. This is the main reason for checking with a mutual fund for planned distributions when making an investment, especially late in the year. But let's look at the issue a different way. The decision of buying shortly before a distribution all comes down to whether or not you feel that the fund is going to go up more in value than the total taxable event will be to you. For instance let's say that a fund is going to distribute 6% in income at the end of December. You will have to pay tax on that 6% gain, even though your account value won't go up by 6% (that's the law). Assuming that you are in a 33% tax bracket, a third of that gain (2% of your account value) will be paid in taxes. So it comes down to asking yourself the question of whether or not you feel that the fund will appreciate by 2% or more between now and the time that the income will be distributed. If the fund went up in value by 10% between the time of purchase and the distribution, then in the above example you would miss out on a 8% after-tax gain by not investing. If the fund didn't go up in value by at least 2% then you would take a loss and would have been better off waiting. So how clear is your crystal ball? For someone to make the claim that it is always patently better to wait until the end of the year to invest so as to avoid capital gains tax is ridiculous. Sometimes it is and sometimes it isn't. Investing is a most empirical process and every new situation should be looked at objectively. And it's important not to lose sight of the big picture. For a mutual fund investor who saw the value of their investment appreciate nicely between the time of purchase and the distribution, a distribution just means more taxes this year but less tax when the shares are sold. Of course it is better to postpone paying taxes, but it's not as though the profits would be tax-free if no distribution were made. For those who move their investments around every few months or years, the whole issue is irrelevant. In my view, people spend too much time trying to beat the tax man instead of trying to make more money. This is made worse by ratings that measure 'tax efficiency' on the basis of current tax liability (distributions) while ignoring future tax liability (unrealized capital gains that may not be paid out each year but they are still taxed when you sell). So what are the tax implications based on the timing of any sale? Actually, for most people there are none. If you sell your shares on Dec. 21, you have $2 in taxable capital gains ($1 from the distribution and $1 from the growth from 8 to 9). If you sell on Dec. 22, you have $1 in taxable capital gains and $1 in taxable distributions. This can make a small difference in some tax brackets, but no difference at all in others. --------------------Check http://invest-faq.com/ for updates------------------ Subject: Mutual Funds - Fees and Expenses Last-Revised: 28 Jun 1997 Contributed-By: Chris Lott ( contact me ) Investors who put money into a mutual fund gain the benefits of a professional investment management company. Like any professional, using an investment manager results in some costs. These costs are recovered from a mutual fund's investors either through sales charges or operation expenses . Sales charges for an open-end mutual fund include front-end loads and back-end loads (redemption fees). A front-end load is a fee paid by an investor when purchasing shares in the mutual fund, and is expressed as a percentage of the amount to be invested. These loads may be 0% (for a no-load fund), around 2% (for a so-called low-load fund), or as high as 8% (ouch). A back-end load (or redemption fee) is paid by an investor when selling shares in the mutual fund. Unlike front-end loads, a back-end load may be a flat fee, or it may be expressed as a sliding scale. A sliding-scale means that the redemption fee is high if the investor sells shares within the first year of buying them, but declines to little or nothing after 3, 4, or 5 years. A sliding-scale fee is usually implemented to discourage investors from switching rapidly among funds. Loads are used to pay the sales force. The only good thing about sales charges is that investors only pay them once. A closed-end mutual fund is traded like a common stock, so investors must pay commissions to purchase shares in the fund. An article elsewhere in this FAQ about discount brokers offers information about minimizing commissions. To keep the dollars rolling in over the years, investment management companies may impose fees for operating expenses. The total fee load charged annually is usually reported as the expense ratio . All annual fees are charged against the net value of an investment. Operating expenses include the fund manager's salary and bonuses (management fees), keeping the books and mailing statements every month (accounting fees), legal fees, etc. The total expense ratio ranges from 0% to as much as 2% annually. Of course, 0% is a fiction; the investment company is simply trying to make their returns look especially good by charging no fees for some period of time. According to SEC rules, operating expenses may also include marketing expenses. Fees charged to investors that cover marketing expenses are called "12b-1 Plan fees." Obviously an investor pays fees to cover operating expenses for as long as he or she owns shares in the fund. Operating fees are usually calculated and accrued on a daily basis, and will be deducted from the account on a regular basis, probably monthly. Other expenses that may apply to an investment in a mutual fund include account maintenance fees, exchange (switching) fees, and transaction fees. An investor who has a small amount in a mutual fund, maybe under $2500, may be forced to pay an annual account maintenance fee. An exchange or switching fee refers to any fee paid by an investor when switching money within one investment management company from one of the company's mutual funds to another mutual fund with that company. Finally, a transaction fee is a lot like a sales charge, but it goes to the fund rather than to the sales force (as if that made paying this fee any less painful). The best available way to compare fees for different funds, or different classes of shares within the same fund, is to look at the prospectus of a fund. Near the front, there is a chart comparing expenses for each class assuming a 5% return on a $1,000 investment. The prospectus for Franklin Mutual Shares, for example, shows that B investors (they call it "Class II") pay less in expenses with a holding period of less than 5 years, but A investors ("Class I") come out ahead if they hold for longer than 5 years. In closing, investors and prospective investors should examine the fee structure of mutual funds closely. These fees will diminish returns over time. Also, it's important to note that the traditional price/quality curve doesn't seem to hold quite as well for mutual funds as it does for consumer goods. I mean, if you're in the market for a good suit, you know about what you have to pay to get something that meets your expectations. But when investing in a mutual fund, you could pay a huge sales charge and stiff operating expenses, and in return be rewarded with negative returns. Of course, you could also get lucky and buy the next hot fund right before it explodes. Caveat emptor. --------------------Check http://invest-faq.com/ for updates------------------ Subject: Mutual Funds - Index Funds and Beating the Market Last-Revised: 26 May 1999 Contributed-By: Chris Lott ( contact me ) This article discusses index funds and modern portfolio theory (MPT) as espoused by Burton Malkiel, but first makes a digression into the topic of "beating the market." Investors and prospective investors regularly encounter the phrase "beating the market" or sometimes "beating the S&P 500." What does this mean? Somehow I'm reminded of the way Garrison Keillor used to start his show on Minnesota Public Radio, "Greetings from Lake Woebegon, where all the women are beautiful and all the children are above average" .. but I digress. To answer the second question first: The S&P 500 is a broad market index. Saying that you "beat the S&P" means that for some period of time, the returns on your investments were greater than the returns on the S&P index (although you have to ask careful questions about whether dividends paid out were counted, or only the capital appreciation measured by the rise in stock prices). Now, the harder question: Is this always the best indicator? This is slightly more involved. Everyone, most especially a mutual fund manager, wants to beat "the market". The problem lies in deciding how "the market" did. Let's limit things to the universe of stocks traded on U.S. exchanges.. even that market is enormous . So how does an aspiring mutual fund manager measure his or her performance? By comparing the fund's returns to some measure of the market. And now the $64,000 question: What market is the most appropriate comparison? Of course there are many answers. How about the large-cap market, for which one widely known (but dubious value) index is the DJIA? What about the market of large and mid-cap shares, for which one widely known index is the S&P 500? And maybe you should use the small-cap market, for which Wilshire maintains various indexes? And what about technology stocks, which the NASDAQ composite index tracks somewhat? As you can see, choosing the benchmark against which you will compare yourself is not exactly simple. That said, an awful lot of funds compare themselves against the S&P. The finance people say that the S&P has some nice properties in the way it is computed. Most market people would say that because so much of the market's capitalization is tracked by the S&P, it's an appropriate benchmark. You be the judge. The importance of indexes like the S&P500 is the debate between passive investing and active investing. There are funds called index funds that follow a passive investment style. They just hold the stocks in the index. That way you do as well as the overall market. It's a no-brainer. The person who runs the index fund doesn't go around buying and selling based on his or her staff's stock picks. If the overall market is good, you do well; if it is not so good, you don't do well. The main benefit is low overhead costs. Although the fund manager must buy and sell stocks when the index changes or to react to new investments and redemptions, otherwise the manager has little to do. And of course there is no need to pay for some hotshot group of stock pickers. However, even more important is the "efficient market theory" taught in academia that says stock prices follow a random walk. Translated into English, this means that stock prices are essentially random and don't have trends or patterns in the price movements. This argument pretty much attacks technical analysis head-on. The theory also says that prices react almost instantaneously to any information - making fundamental analysis fairly useless too. Therefore, a passive investing approach like investing in an index fund is supposedly the best idea. John Bogle of the Vanguard fund is one of the main proponents of a low-cost index fund. The people against the idea of the efficient market (including of course all the stock brokers who want to make a commission, etc.) subscribe to one of two camps - outright snake oil (weird stock picking methods, bogus claims, etc.) or research in some camps that point out that the market isn't totally efficient. Of course academia is aware of various anomalies like the January effect, etc. Also "The Economist" magazine did a cover story on the "new technology" a few years ago - things like using Chaos Theory, Neural Nets, Genetic Algorithms, etc. etc. - a resurgence in the idea that the market was beatable using new technology - and proclaimed that the efficient market theory was on the ropes. However, many say that's an exaggeration. If you look at the records, there are very, very few funds and investors who consistently beat the averages (the market - approximated by the S&P 500 which as I said is a "no brainer investment approach"). What you see is that the majority of the funds, etc. don't even match the no-brainer approach to investing. Of the small amount who do (the winners), they tend to change from one period to another. One period or a couple of periods they are on top, then they do much worse than the market. The ones who stay on top for years and years and years - like a Peter Lynch - are a very rare breed. That's why efficient market types say it's consistent with the random nature of the market. Remember, index funds that track the S&P 500 are just taking advantage of the concept of diversification. The only risk they are left with (depending on the fund) is whether the entire market goes up and down. People who pick and choose individual companies or a sector in the market are taking on added risk since they are less diversified. This is completely consistent with the more risk = possibility of more return and possibility of more loss principle. It's just like taking longer odds at the race track. So when you choose a non-passive investment approach you are either doing two things: 1. Just gambling. You realize the odds are against you just like they are at the tracks where you take longer odds, but you are willing to take that risk for the slim chance of beating the market. 2. You really believe in your own or a hired gun's stock picking talent to take on stocks that are classified as a higher risk with the possibility of greater return because you know something that nobody else knows that really makes the stock a low risk investment (secret method, inside information, etc.) Of course everyone thinks they belong in this camp even though they are really in the former camp, sometimes they win big, most of times they lose, with a few out of the zillion investors winning big over a fairly long period. It's consistent with the notion that it's gambling. So you get this picture of active fund managers expending a lot of energy on a tread mill running like crazy and staying in the same spot. Actually it's not even the same spot since most don't even match the S&P 500 due to the added risk they've taken on in their picks or the transaction costs of buying and selling. That's why market indexes like the S&P 500 are the benchmark. When you pick stocks on your own or pay someone to manage your money in an active investment fund, you are paying them to do better or hoping you will do better than doing the no-brainer passive investment index fund approach that is a reasonable expectation. Just think of paying some guy who does worse than if he just sat on his butt doing nothing! The following list of resources will help you learn much, much more about index mutual funds. * An accessible book that covers investing approaches and academic theories on the market, especially modern portfolio theory (MPT) and the efficient market hypothesis, is this one (the link points to Amazon): Burton Malkiel A Random Walk Down Wall Street This book was written by a former Princeton Prof. who also invested hands-on in the market. It's a bestseller, written for the public and available in paperback. * IndexFunds.com offers much information about index mutual funds. The site is edited by Will McClatchy and published by IndexFunds, Inc., of Austin, Texas. http://www.indexfunds.com * The list of frequently asked questions about index mutual funds, which is maintained by Dale C. Maley. http://www.geocities.com/Heartland/Prairie/3524/faqperm5.html --------------------Check http://invest-faq.com/ for updates------------------ Subject: Mutual Funds - Money-Market Funds Last-Revised: 16 Aug 1998 Contributed-By: Chris Lott ( contact me ), Rich Carreiro (rlcarr at animato.arlington.ma.us) A money-market fund (MMF) is a mutual fund, although a very special type of one. The goal of a money-market fund is to preserve principal while yielding a modest return. These funds try very, very, very hard to maintain a net asset value (NAV) of exactly $1.00. Basically, the companies try to make these feel like a high-yield bank account, although one should never forget that the money-market fund has no insurance against loss. The NAV stays at $1 for (at least) three reasons: 1. The underlying securities in a MMF are very short-term money market instruments. Usually maturing in 60 days or less, but always less than 180 days. They suffer very little price fluctuation. 2. To the extent that they do fluctuate, the fund plays some (legal) accounting games (which are available because the securities are so close to maturity and because they fluctuate fairly little) with how the securities are valued, making it easier to maintain the NAV at $1. 3. MMFs declare dividends daily, though they are only paid out monthly. If you totally cash in your MMF in the middle of the month, you'll receive the cumulative declared dividends from the 1st of the month to when you sold out. If you only partially redeem, the dividends declared on the sold shares will simply be part of what you see at the end of the month. This is part of why the fund's interest income doesn't raise the NAV. MMFs remaining at a $1 NAV is not advantageous in the sense that it reduces your taxes (in fact, it's the opposite), it's advantageous in the sense that it saves you from having to track your basis and compute and report your gain/loss every single time you redeem MMF shares, which would be a huge pain, since many (most?) people use MMFs as checking accounts of a sort. The $1 NAV has nothing to do with being able to redeem shares quickly. The shareholders of an MMF could deposit money and never touch it again, and it would have no effect on the ability of the MMF to maintain a $1 NAV. Like any other mutual fund, a money-market fund has professional management, has some expenses, etc. The return is usually slightly more than banks pay on demand deposits, and perhaps a bit less than a bank will pay on a 6-month CD. Money-market funds invest in short-term (e.g., 30-day) securities from companies or governments that are highly liquid and low risk. If you have a cash balance with a brokerage house, it's most likely stashed in a money-market fund. --------------------Check http://invest-faq.com/ for updates------------------ Subject: Mutual Funds - Reading a Prospectus Last-Revised: 9 Aug 1999 Contributed-By: Chris Stallman (chris at teenanalyst.com) Ok, so you just went to a mutual fund family's (e.g., Fidelity) web site and requested your first prospectus. As you anxiously wait for it to arrive in the mail, you start to wonder what information will be in it and how you'll manage to understand it. Understanding a prospectus is crucial to investing in a mutual fund once you know a few key points. When you request information on a mutual fund, they usually send you a letter mentioning how great the fund is, the necessary forms you will have to fill out to invest in the fund, and a prospectus. You can usually just throw away the letter because it is often more of an advertisement than anything else. But you should definitely read the prospectus because it has all the information you need about the mutual fund. The prospectus is usually broken up into different sections so we'll go over what each section's purpose is and what you should look for in it. Objective Statement Usually near the front of a prospectus is a small summary or statement that explains the mutual fund. This short section tells what the goals of the mutual fund are and how it plans to reach these goals. The objective statement is really important in choosing your fund. When you choose a fund, it is important to choose one based on your investment objective and risk tolerance. The objective statement should agree with how you want your money managed because, after all, it is your money. For example, if you wanted to reduce your exposure to risk and invest for the long-term, you wouldn't want to put your money in a fund that invests in technology stocks or other risky stocks. Performance The performance section usually gives you information on how the mutual fund has performed. There is often a table that gives you the fund's performance over the last year, three years, five years, and sometimes ten years. The fund's performance usually helps you see how the fund might perform but you should not use this to decide if you are going to invest in it or not. Funds that do well one year don't always do well the next. It's often wise to compare the fund's performance with that of the index. If a fund consistently under performs the index by 5% or more, it may not be a fund that you want to invest in for the long-term because that difference can mean the difference of retiring with $200,000 and retiring with $1.5 million. Usually in the performance section, there is a small part where they show how a $10,000 investment would perform over time. This helps give you an idea of how your money would do if you invested in it but this number generally doesn't include taxes and inflation so your portfolio would probably not return as much as the prospectus says. Fees and Expenses Like most things in life, a mutual fund doesn't operate for free. It costs a mutual fund family a lot of money to manage everyone's money so they put in some little fees that the investors pay in order to make up for the fund's expenses. One fee that you will come across is a management fee, which all funds charge. Mutual funds charge this fee so that the fund can be run. The money collected from the shareholders from this fee is used to pay for the expenses incurred from buying and selling large amounts of shares in stocks. This fee usually ranges from about 0.5% up to over 2%. Another fee that you're likely to encounter is a 12b-1 fee. The money collected from charging this fee is usually used for marketing and advertising the fund. This fee usually ranges between 0.25-0.75%. However, not all funds charge a 12b-1 fee. One fee that is a little less common but still exists in many funds is a deferred sales load. Frequent buying and selling of shares in a mutual fund costs the mutual fund money so they created a deferred sales charge to discourage this activity. This fee sometimes disappears after a certain period and can range from 0.5% up to 5%. When you are looking through a prospectus, be sure that you look over these fees because even if a mutual fund performs well, its growth may be limited by high expenses. How to Purchase and Redeem Shares This section provides information on how you can get your money into the mutual fund and how you can sell shares when you need the money out of the fund. These methods are usually the same in every fund. The most common method to invest in a fund once you are in it is to simply fill out investment forms and write a check to the mutual fund family. This is probably the easiest but it often takes a few days or even a week to have the funds credited to your account. Another method that is common is automatic withdrawals. These allow you to have a certain amount which you choose to be deducted from your bank account each month. These are excellent for getting into the habit of investing on a regular basis. Wire transfers are also possible if you want to have your money invested quickly. However, most funds charge you a small fee for doing this and some do not allow you to wire any funds if you do not meet their minimum amount. The fund will also provide information on how you can redeem your shares. One common way is to request a redemption by filling out a form or writing a letter to the mutual fund family. This is the most common method but it isn't the only one. You can also request to redeem your shares by calling the mutual fund itself. This option saves you a few days but you have to make sure the fund has this option open to the shareholders. You can also request to have your investment wired into your bank account. This is a very fast method for redeeming shares but you usually have to pay a fee for doing this. And like redeeming shares over the phone, you have to make sure the mutual fund offers this option. Now that you understand the basics of a prospectus, you're one step closer to getting started in mutual funds. So when you finally receive the information you requested on a mutual fund, look it over carefully and make an educated decision if it is right for you. For more insights from Chris Stallman, visit http://www.teenanalyst.com --------------------Check http://invest-faq.com/ for updates------------------ Subject: Mutual Funds - Redemptions Last-Revised: 5 May 1997 Contributed-By: A. Chowdhury On the stock markets, every time someone sells a share, someone buys it, or in other words, equal numbers of opposing bets on the future are placed each day. However, in the case of open-end mutual funds, every dollar redeemed in a day isn't necessarily replaced by an invested dollar, and every dollar invested in a day doesn't go to someone redeeming shares. Still, although mutual fund shares are not sold directly by one investor to another investor, the underlying situation is the same as stocks. If a mutual fund has no cash, any redemption requires the fund manager to sell an appropriate amount of shares to cover the redemption; i.e., someone would have to be found to buy those shares. Similarly, any new investment would require the manager to find someone to sell shares so the new investment can be put to work. So the manager acts somewhat like the fund investor's representative in buying/selling shares. A typical mutual fund has some cash to use as a buffer, which confuses the issue but doesn't fundamentally change it. Some money comes in, and some flows out, much of it cancels each other out. If there is a small imbalance, it can be covered from the fund's cash position, but not if there is a big imbalance. If the manager covers your sale from the fund's cash, he/she is reducing the fund's cash and so increasing the fund's stock exposure (%), in other words he/she is betting on the market at the same time as you are betting against it. Of course if there is a large imbalance between money coming in and out, exceeding the cash on hand, then the manager has to go to the stock market to buy/sell. And so forth. --------------------Check http://invest-faq.com/ for updates------------------ Subject: Mutual Funds - Types of Funds Last-Revised: 12 Aug 1999 Contributed-By: Chris Lott ( contact me ) This article lists the most common investment fund types. A type of fund is typically characterized by its investment strategy (i.e., its goals). For example, a fund manager might set a goal of generating income, or growing the capital, or just about anything. (Of course they don't usually set a goal of losing money, even though that might be one of the easist goals to achieve :-). If you understand the types of funds, you will have a decent grasp on how funds invest their money. When choosing a fund, it's important to make sure that the fund's goals align well with your own. Your selection will depend on your investment strategy, tax situation, and many other factors. Money-market funds Goal: preserve principal while yielding a modest return. These funds are a very special sort of mutual fund. They invest in short-term securities that pay a modest rate of interest and are very safe. See the article on money-market funds elsewhere in this FAQ for an explanation of the $1.00 share price, etc. Balanced Funds Goal: grow the principal and generate income. These funds buy both stocks and bonds. Because the investments are highly diversified, investors reduce their market risk (see the article on risk elsewhere in this FAQ). Index funds Goal: match the performance of the markets. An index fund essentially sinks its money into the market in a way determined by some market index and does almost no further trading. This might be a bond or a stock index. For example, a stock index fund based on the Dow Jones Industrial Average would buy shares in the 30 stocks that make up the Dow, only buying or selling shares as needed to invest new money or to cash out investors. The advantage of an index fund is the very low expenses. After all, it doesn't cost much to run one. See the article on index funds elsewhere in this FAQ. Pure bond funds Bond funds buy bonds issued by many different types of companies. A few varieties are listed here, but please note that the boundaries are rarely as cut-and-dried as I've listed here. Bond (or "Income") funds Goal: generate income while preserving principal as much as possible. These funds invest in medium- to long-term bonds issued by corporations and governments. Variations on this type of fund include corporate bond funds and government bond funds. See the article on bond basics elsewhere in this FAQ. Holding long-term bonds opens the owner to the risk that interest rates may increase, dropping the value of the bond. Tax-free Bond Funds (aka Tax-Free Income or Municipal Bond Funds) Goal: generate tax-free income while preserving principal as much as possible. These funds buy bonds issued by municipalities. Income from these securities are not subject to US federal income tax. Junk (or "High-yield") bond funds Goal: generate as much income as possible. These funds buy bonds with ratings that are quite a bit lower than high-quality corporate and government bonds, hence the common name "junk." Because the risk of default on junk bonds is high when compared to high-quality bonds, these funds have an added degree of volatility and risk. Pure stock funds Stock funds buy shares in many different types of companies. A few varieties are listed here, but please note that the boundaries are rarely as cut-and-dried as I've listed here. Aggressive growth funds Goal: capital growth; dividend income is neglected. These funds buy shares in companies that have the potential for explosive growth (these companies never pay dividends). Of course such shares also have the potential to go bankrupt suddenly, so these funds tend to have high price volatility. For example, an actively managed aggressive-growth stock fund might seek to buy the initial offerings of small companies, possibly selling them again very quickly for big profits. Growth funds Goal: capital growth, but consider some dividend income. These funds buy shares in companies that are growing rapidly but are probably not going to go out of business too quickly. Growth and Income funds Goal: Grow the principal and generate some income. These funds buy shares in companies that have modest prospect for growth and pay nice dividend yields. The canonical example of a company that pays a fat dividend without growing much was a utility company, but with the onset of deregulation and competition, I'm not sure of a good example anymore. Sector funds Goal: Invest in a specific industry (e.g., telecommunications). These funds allow the small investor to invest in a highly select industry. The funds usually aim for growth. Another way of categorizing stock funds is by the size of the companies they invest in, as measured by the market capitalization, usually abbreviated as market cap. (Also see the article in the FAQ about market caps .) The three main categories: Small cap stock funds These funds buy shares of small companies. Think new IPOs. The stock prices for these companies tend to be highly volatile, and the companies never (ever) pay a dividend. You may also find funds called micro cap, which invest in the smallest of publically traded companies. Mid cap stock funds These funds buy shares of medium-size companies. The stock prices for these companies are less volatile than the small cap companies, but more volatile (and with greater potential for growth) than the large cap companies. Large cap stock funds These funds buy shares of big companies. Think IBM. The stock prices for these companies tend to be relatively stable, and the companies may pay a decent dividend. International Funds Goal: Invest in stocks or bonds of companies located outside the investor's home country. There are many variations here. As a rule of thumb, a fund labeled "international" will buy only foreign securities. A "global" fund will likely spread its investments across domestic and foreign securities. A "regional" fund will concentrate on markets in one part of the world. And you might see "emerging" funds, which focus on developing countries and the securities listed on exchanges in those countries. In the discussion above, we pretty much assumed that the funds would be investing in securities issued by U.S. companies. Of course any of the strategies and goals mentioned above might be pursued in any market. A risk in these funds that's absent from domestic investments is currency risk. The exchange rate of the domestic currency to the foreign currency will fluctuate at the same time as the investment, which can easily increase -- or reverse -- substantial gains abroad. Another important distinction for stock and bond funds is the difference between actively managed funds and index funds. An actively managed fund is run by an investment manager who seeks to "beat the market" by making trades during the course of the year. The debate over manged versus index funds is every bit the equal of the debate over load versus no-load funds. YOU decide for yourself. --------------------Check http://invest-faq.com/ for updates------------------ Compilation Copyright (c) 2002 by Christopher Lott. .