Mutual Fund Madness

This has been a tough year for the managers of some mutual funds - and their investors. If you’ve been paying attention to the news, you’ve surely heard about some managers’ -questionable - in some cases, illegal, behavior. Although the revelations are worrisome to those of us who invest in mutual funds, the result should be positive: We should end up with a much cleaner mutual fund arena and a more robust industry as a whole.

What does all this mean to the mutual fund investor? Let’s start by reviewing the allegations, which fall into two broad categories: after-hours trading and excessive trading.

While both of these behaviors are unethical, after-hours trading is against the law. Normally, mutual funds are priced once per trading day, at the close of the market. If you attempt to buy or sell mutual fund shares after the close of the market today at 4 p.m. EST, your transaction would be based on the closing price tomorrow. Unlike individual stocks, they cannot be purchased at various prices throughout the day. But some funds allowed certain investors to buy shares after the close of the market at that day’s closing price. This is illegal.

Excessive trading involves rapidly buying and selling shares in mutual funds in order to capture short-term changes in the share price. This is not a crime - not yet, anyway - but it’s certainly questionable, to say the least. Mutual funds are long-term investments and this behavior can hurt long-term shareholders by increasing expenses and affecting performance. Many mutual funds have short-term redemption fees to discourage this action. Excessive trading would have the most impact when done by institutional investors who buy and sell very large blocks of shares.

Still a good choice

So, are mutual funds still a good choice for retirement investing? Is it OK to put your life savings into this type of vehicle? The bottom line is yes - but you must do your homework, or pay someone to do it for you. The advantages still far outweigh the disadvantages for most investors. The professional management, diversification, and liquidity factors available in mutual funds are impressive and necessary.   

Still scared? Think about this: A study by Investment News, a financial publication, showed that both of the questionable behaviors mentioned above have not overtly hurt mutual fund investors. In fact, compare the performance of those funds that were affected to those that were not, and in most cases there is not much difference. Frankly, the mutual fund troubles pale in comparison to the scandals at Enron and WorldCom.

Now that you know what the hoopla was all about, should you do anything differently at this point?  

I still think mutual funds are the right investment for most people, and that the industry as a whole can only improve at this point. You can be sure that mutual funds will be more highly regulated moving forward than they were in the past. You can be sure that the “bad” funds will get caught eventually and be forced to make restitution for the error of their ways; this alone should be enough deterrent to keep the mutual funds in check.  

However, if your mutual fund choices are not monitored by a financial professional you trust, you have some work to do yourself. Pay close attention to the fund’s expenses and its policies on excessive trading. Try to find out if your fund company has a history of violating the late-trading rules and check its prospectuses to see if it has specific language describing how it stops such market-timing.

Make sure your funds are diversified - both in terms of investment choices within each fund, as well as how each fund plays its designated part in your overall asset allocation. Leave the rest of the policing to the regulatory bodies; moving forward, there should be enough policing to make everyone feel comfortable.

Watch expenses

You can certainly look out for yourself when it comes to fund expenses. With a basic understanding, you can be aware of what is reasonable and what is not.

A fund’s “expense ratio” is the operating expenses of the fund (payroll, office space, mailings, etc.) divided by the average amount of assets in the fund. The expense ratio is embedded internally in the fund and will not be charged directly to you as a fee. (There’s possible legislation in progress to change this.) You’re still paying those expenses, however, so be on the lookout. The expense ratio can be found in any prospectus, and it is up to you to examine it.

What is reasonable? That depends on the complexity of the assets managed.

A short-term bond fund, for instance, may just invest in short-term debt obligations and wait for maturity. This type of management would not be as complicated as, say, a fund that deals with currency exchanges, derivatives, aggressive growth stocks, and more complicated issues, which can require constant, ongoing, active management. The U.S. Securities and Exchange Commission, Division of Investment Management, published the table on page 56 in December 2000:

This chart can be deceiving, however, because the categories are extremely broad. For instance, the average expense for a U.S. government bond fund in 1996 was 1.02 percent. This is higher than the “average,” based on the table above, because of the “weighting” of the various kinds of bond funds. The average expense ratio for a growth stock fund in 1996 was 1.42 percent. (Figures obtained from www.TheDollarStretcher.com.)

This is all rather confusing, I realize, so let me simplify it: The best way to tell if your mutual fund’s expense ratio is too high is to compare it to other funds of the same type, similar size, and similar performance. If it is within 20-50 basis points (a basis point is 1/100 of 1 percent; in other words, there are 100 basis points in 1 percent) of comparable funds in the same category, this would be reasonable. If it is much higher than its competitors, you need to ask why. It could be that a manager has had such a consistently above-average performance when compared to his peers, that the higher expense ratio is justified. Or there may be absolutely no reason for the higher charge.  

But in general, the 1 percent to 1.5 percent on average you pay to invest in a mutual fund is well worth it. There are numerous advantages to funds that the average investor could rarely afford on his own, among them diversification, professional management, performance and financial updates, and (in some cases) liquidity. The bottom line is that you should consider the expenses as part of the selection process for mutual funds, not as the only factor.

Loaded funds

On top of the underlying expense ratio, you can encounter funds that are “loaded.” This simply means that there is a commission charged, which is generally deducted from your initial investment amount. Most loads are in the 4 percent to 6 percent range, but they can go as high as 8.5 percent.   

Financial professionals often recommend loaded funds. The advice in finding a suitable initial investment and the ongoing guidance you receive can be worth the extra expense. This does, however, place you at a slight disadvantage to someone who pays no load. It’s like a horserace in which the loaded horses start just a little behind all the others.  

Suppose you and your sister each have $10,000 to invest but your sister wants more guidance along the way and more help up-front. She invests in a load fund and you invest in a no-load. At the end of the year the funds’ performance is identical; both investments earn 10 percent in the first year, and you each get a 10 percent return. The difference is that if the load was 5 percent, your sister gets the 10 percent return on $9,500 to start, and you get 10 percent on the full $10,000.

There are many types of load funds in the mutual fund investment universe. Some charge up-front as described previously, some charge on the back-end, similar to a redemption fee. The main point here is to be aware that you are paying a load and why.   

The last common mutual fund fee you may encounter is that of a 12b-1. This is a fee associated with the costs of marketing and advertising, and it’s taken directly from the fund’s overall assets rather than from the management fees. This fee typically ranges from 0.25 percent to 0.5 percent. Generally, the overall expense ratio includes the 12b-1 fee. Therefore, if the overall expense ratio seems comparable with like kind funds, the fund with this type of fee may still be a viable option.

This article originally appeared in the November/December 2004 issue of Physicians Practice.