Preparing for retirement is better done the sooner you start. For many people mutual funds are a cost effective way to gain access to professional money management.
Fund Objectives
A fund’s objective is described in its prospectus. An objective lays out what type securities it will buy what mix it will have, what distributions it will pay and so forth. Mutual fund management teams usually stay invested regardless of market conditions. It is up to you or your adviser to determine if you should be in the market.
The following definitions are but a few examples and come from the Investment Company Institute. Capital appreciation funds seek growth of capital; dividends are not a primary consideration, Growth funds invest primarily in common stock of growth companies, which are those that exhibit signs of above-average growth, even if the share price is high relative to earnings/intrinsic value, Investment Grade Bond funds seek current income by investing primarily in investment grade debt securities.
Your portfolio should have a reasonable mix of funds with different objectives to create diversified asset allocation. Over-weighting in funds with similar objectives like Capital Appreciation, Growth and Domestic Equity would not be considered diversified because all three are similar. A better example of diversification would be Growth Stock, Value Stock and Government Bond. Growth and Value stocks have a history of negative correlation, meaning that when one goes up the other goes down. Stocks and bonds have the same negative correlation history.
With a well-diversified portfolio, the hope is that whatever market condition, business event or political news that causes one part of the portfolio to go down will cause another to go up thereby creating balance and smoothing out volatility.
Sales loads
The sales Charge is sometimes the most confusing thing about mutual funds. Many companies do not charge an upfront sales charge but still charge fees of course. For companies that do assess a sales charge there is an alphabet soup of share classes from which to choose. This sales charge is compensation to the salesman offering the advice on what you should buy. Only you can decide if you need to pay for this service.
Let’s examine these share classes first. Each one has a different sales charge structure. The most common share classes are A, B and C shares. Class A shares have an upfront charge or a “load.” It is included in the price the investor pays for the shares known as the Public Offering Price or POP. For example, a global growth fund Class A has a load of 5.75%. If its POP is $28.72 per share then its NAV, Net Asset Value would be $27.07. That’s the value of each share in your account immediately after the transaction.
Other common share classes are B and C which have no load but instead charge a CDSC, Contingent Deferred Sales Charge starting as high as 5% for Class B shares but decreasing per year until it reaches 0%. B shares are becoming less and less available since C shares have come available. Class C usually charges a CDSC starting at 1%.
In addition to the sales load of Class A shares many funds also assesses a 12B-1 fee, named for the Investment Company Act of 1940 section covering it. This fund example charges 25 bps (basis points) per year or 0.25% which is deducted from the fund to cover its marketing expenses. This of course, reduces the NAV by 0.25%. Both B and C shares usually charge a 12B-1 fee of 1% which can really put a drag on return over the years. Many fund companies offer various other share classes for specific situations like Class I Shares or Institutional Shares which are common in wrap accounts and R Shares in 401(k) plans. These share classes have lower loads or CDSCs if any.
If you require the advice of an investment salesperson, you will most likely pay a load. To keep your overall cost down match your share class with your time horizon. In the first few pages of the prospectus you should find a clear example of your total cost over different time periods. You should find that the total cost of ownership of Class A shares are higher in the early years and Class C in the later years. Read the prospectus for more information.
After the above explanation I am pleased to tell you that there are many funds that have no upfront load or CDSC. These are called “no-load” funds. All of your money goes to the purchase of shares and none to sales charges or commissions. With these you must do your own homework and make your own decisions. People who are experienced and knowledgeable on investing benefit from no-load funds. Those who are not can suffer some awkward circumstances from ill-informed decisions. Only you can decide if you are willing to do the homework or if you are better to pay someone to make your decisions remembering that they may have their own agenda.
Even with no upfront load, some funds may have a 12B-1 fee and/or “other” fees. You will find such disclosed in the prospectus.
Expense Ratio
Regardless of whether a load or no-load mutual fund is right for you, all fund managers are compensated for managing the assets. The fund pays a small percentage each year to the management team. In addition, the fund has other expenses. All of these fees combined are known as the Expense Ratio. There is no significant difference in the expense ratios because of load or no-load status.
Expense ratios have consistently fallen over the past two decades as investors have sought out lower cost funds. Recent reports show average expense ratios of equity funds at 0.63 or 63 cents annually for every $100 invested. Bond funds and passive funds will cost less while global and small cap funds will often cost more.
Rankings, Ratings and Advertisements
Where mutual funds rank compared to their peer group can be helpful but can be misleading if you don’t understand how the system works. Be cautious of mutual funds that tout themselves as #1 in a sector. Sometimes that means the fund went up in value more over the past year than its peers. What are the chances that it will repeat? You should evaluate the fund based on a three- or five-year average. For a fund that has performed well in longer time frames, you’ll also want to evaluate if the same management team that turned in those results is still in place. The best evaluation, in my opinion, is whether the fund’s return was better than its risk. Does the fund consistently have an above average?
return with a below average risk, for example. Such profiles usually indicate capable managers. As with any investment, do your homework, understand your investment and monitor its progress.
If you have any questions regarding this article, or if you need further assistance regarding your unique financial or tax situation, send us an email at info@zagmoutcpas.com, or call us at (312) 239-3716.
To learn more, visit Zagmout & Company CPAs at www.zagmoutcpas.com.
