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Basics of Financial Investing – Part 5

Mutual Funds, Closed-End Funds, and Other Types of Investment Funds

Various types of pooled portfolio investment vehicles are designed to appeal to individual investors. If you want to obtain the benefits of diversification and professional management by having someone else manage part or all of your investable resources, you may want to consider mutual funds or similar types of investment companies. The following rules are designed to help you select a fund or funds that fit your own particular needs. First, lets explore the various types of pooled portfolio investments. They all have certain similarities, but each has some unique features. Each of these types of investment companies pools the resources from a group of investors and uses these resources to assemble a common portfolio. Each individual investor owns a share of this common portfolio.

All of the above types of investment companies have two features in common:

  1. They assemble and manage a common portfolio for the benefit of a group of investors, each of whom owns a piece of the portfolio.
  2. They are organized in such a way that they are not subject to the corporate income tax. The investors in the pooled portfolios are taxed directly on the portfolios incomes. The double taxation of corporate income (profits taxed at the corporate level, and then dividends and capital gains income taxed at the shareholder level) is avoided.

Types of Investment Companies

Mutual Fund: Mutual funds make a market in their own shares. They do so by standing ready to buy and sell their shares based on their daily closing new aet value (NAV), the market value of the funds portfolio divided by the number of shares outstanding.

Closed-End Fund: The fund allows the public market for its shares to determine the per-share price through the interplay of supply and demand. Most such funds are listed on an exchange or traded on the NASDAQ. The market-determined prices of the closed-end funds shares will vary from its NAV. Usually such closed-end funds trade at a discount from their NAVs.

Exchange Traded Fund: Like closed-end funds, they do not make a market in their own shares. They allow the per-share price to be determined by market forces. Most are set up as index funds and trade on an exchange. Their market price closely tracks their real-time NAV as it changes throughout the day. Exchange traded funds provide the investor with a vehicle for taking advantage of intra-day price fluctuations.

Unit Investment Trust: assembles a common portfolio of assets (usually debt investments) for the unit-holders. The net (of expenses) cash flows from the portfolio are paid out to the unit-holders over time. The portfolios composition is set at the trusts inception and not managed thereafter. As the debt instruments mature, the proceeds are paid out to the unit-holders. This process continues until all of the assets are liquidated and all of the funds are paid out. At that point this particular unit investment trust is dissolved. But, of course, you can reinvest the proceeds in another one.

Variable Annuity: Sold by insurance companies as part of a life insurance program. Unlike other types of funds, variable annuities are allowed to retain the portfolios income and reinvest it without attributing a current tax liability to the annuity-holders. The annuity-holders tax liabilities are deferred until they liquidate their variable annuity positions.

Hedge Fund: Pools funds of large, sophisticated investors into a common portfolio. Unlike other types of pooled portfolio funds, hedge funds are structured to allow their portfolio managers to undertake many risky types of trades and purchase many risky types of investments. More specifically, hedge funds are permitted to utilize leverage, sell short, purchase and write options and futures contracts, accumulate a concentrated position in a single security, and take an active role in managing companies in which they hold a position. Mutual and closed-end funds, in contrast, cannot do any of the above unless specifically authorized in their charter (which is rarely the case).

Real Estate Investment Trusts (REITs): assembles a common portfolio of real estate assets (developed property, land, real estate mortgages). The net income from their portfolio must be owed through to the REIT owners. The price of the REITs shares are determined by supply and demand in the public market.

Avoid load funds. If you want to buy a mutual fund, buy a no-load fund

Mutual funds are sold in two basic ways, with or without a sales fee. Load funds are sold through an agent who is paid a commission for making the sale. That fee is carved out of the money that the investor pays to buy the mutual funds shares. A standard load fund charges a sales commission equal to 6 percent of the purchase price paid by the investor. This load is used to cover marketing expenses, particularly the sales fee of the agent who handled the sale. As a result, only 94 percent of the investors money (100 - 6 = 94) actually goes toward buying the funds shares. Recall that the stock market averages a return of about 9 percent per year. Accordingly, a 6 percent load takes away the better part of an average years return. The purchaser of low-load and 12 b 1 funds also incurs a sales fee. In the case of low-load funds, the commission is typically 2 to 3 percent of the purchase price, and the 12 b 1 funds charge an annual fee. The lower sales charges of low-load funds are less of a burden than a full load of regular load funds, but still involve a sales fee that is carved out of the fundholders initial investment. The 12 b1 funds annual fees may actually result in higher total selling costs than a typical load fund. No-load funds, in contrast, are sold directly by the fund (without an agent) to the investor. Since no sales fee is carved out, the entire amount of the purchase price of no-load funds is used to buy fund shares.

Ways Mutual Funds Are Sold

Load Fund: Sold through an agent who is paid an up-front selling fee. The load is typically 6 percent. A sliding scale is applied to large purchases such that very large purchases incur a reduced-percentage fee.

No-Load Fund: Sold directly to the investor by the fund. No agent is involved and no sales fee is charged.

Low-Load Fund: Also sold directly to the investor by the fund, but a small selling fee, usually 2 to 3 percent is incurred.

12 b 1 Fund: Sold through an agent who is paid an up-front commission. The fund charges its investors an annual fee designed to recapture the sales commission that the fund paid to the agent who handled the transaction. If a 12 b 1 funds shares are redeemed prior to a pre-specified number of years, an early termination fee is also assessed.

All of these types of mutual funds can be sold back to the fund for the funds NAV (sometimes less a redemption fee).

Redemption Fees: Some funds also charge a fee (typically 2%) when a funds shares are redeemed.

Management Fees: All funds charge a fee for their management services. Such fees are typically 0.5 to 0.75 percent of the fund's asset value per year.

The average gross returns on the portfolios of load, no-load, low-load, and 12 b 1 fund shares are indistinguishable. Moreover, for every type of sales-fee fund that one might find attractive, a comparable no-load fund can almost always be found.

Why pay the load? The one advantage to investing in a load fund is that such a fund affords you the opportunity to talk with the agent who handles the transaction. The agent has some specialized training and expertise in financial planning, including such matters as taxes, trusts, estates, and cash management. Thus mutual fund agents will be able to help novice investors understand the pros and cons of various financial products such as money market funds, tax-free bond funds, index funds, country funds, REIT funds, variable annuities, junk bond funds, and so on. Note, however, that such an agent is likely to show you only those products on which he or she is paid a sales fee (load funds). Moreover, they may have a short list of funds on which they receive incentive fees and are expected to push. Thus the agents interests and yours may not be aligned. Still, the agent should be able to help you understand the trade-offs. The availability of this service may be sufficient reason for some investors to choose to buy their funds through an agent. Most reasonably sophisticated investors, however, have little need for the agents services.

Indeed, one who is sufficiently interested in investing and money management to be reading this article is very likely to know or soon learn enough to be able to do without the agents help. One who does wish to obtain help from an expert might consider hiring a fee only financial planner. Such professionals do not have an incentive to direct their clients to investments that have high sales fees. They are therefore less subject to conflicts between what is best for their clients and what provides them with the highest fees.

Avoid actively managed mutual funds unless you believe that the portfolio manager has superior ability. Buy index funds instead

Most financial economists believe that a concept/theory called market efficiency provides a useful first approximation/description of how securities markets work. According to this theory (semi-strong form), the market always takes proper account of the publicly available information in pricing investment assets such as stocks and bonds. That is, the actions of informed buyers and sellers are said to drive security market prices to the levels where they accurately reflect the underlying values. If markets are fully efficient, portfolio managers will not be able to select securities that outperform the average return on the market (e.g., S&P 500 index) with any degree of consistency.

Nor will they be able to enter and exit the market at opportune times with any greater-than-random accuracy. According to this view, the investment selections and timing decisions of portfolio managers are about as likely to cause the funds that they manage to under-perform as to outperform the market.

Most financial economists do not believe that the market is always and everywhere as efficient as the efficient-market hypothesis contends. They do, however, believe that the market tends to be relatively efficient.

Numerous studies have all come to more or le the same conclusion: The average mutual fund generates a return that is, after deducting its fees and expenses, a bit below the average returns on the market as a whole (e.g., the S&P 500). This finding implies that active fund managers efforts to select winners and time the market do not, in general, succeed in producing returns that are sufficiently above the market averages to offset the cost impact of their fees and trading costs.

Extensive evidence supports the approximate validity of the (semi-strong form) efficient-market hypothesis. These market efficiency results coupled with the rather pessimistic findings on average mutual fund performance have led to the development, growth, and popularity of a type of investment company called an index fund. Such funds do not attempt to outperform the market averages. They do not attempt to time the market, nor do they try to assemble a portfolio of undervalued stocks. Rather, they seek only to assemble a portfolio whose performance comes close to equaling that of their chosen benchmark. Index funds assemble portfolios designed to mimic a particular market index (often the S&P 500). Because they are not trying to pick winning stocks and not trying to move in and out of the market at the most opportune times, they engage in much less trading than do actively managed funds. The passively managed index funds incur much lower trading costs and charge much smaller management fees than do actively managed funds. Moreover, with much less buying and selling going on, the realized taxable gains on an index funds portfolio tend to be much more modest. Most of the index funds gains remain unrealized and therefore not subject to tax. Thus in an efficient-market environment, index funds are likely both to outperform actively managed funds and throw off less taxable income. Some circumstances may, however, tip the balance back in favor of actively managed funds. First, certain portfolio managers do appear to have superior ability (e.g., Warren Buffett, Peter Lynch, John Marks Templeton). Such managers may be able to produce a superior return by taking advantage of any residual market inefficiencies, even if the average manager will turn in only average results. Second, the investor may believe that a particular sector (e.g., real estate) is especially likely to outperform the market. Such an investor will wish to take advantage of this expected superior performance by purchasing shares in a fund with that attribute. A few index funds may exist for some specialized sectors. The odds are much greater, however, for finding an actively managed fund that can provide the investor with exposure to a specific, desired sector.

In choosing among index funds, select a fund that has a record of low expenses

Most index funds track their chosen benchmark index rather effectively. Any differences in the performances of index funds tracking the same index largely relate to their level of operational efficiency. Index funds incur some expenses (commissions, management fees, etc.) in the management of their portfolio. The actual indexes (e.g., S&P 500) performances are computed without reference to any expenses. Accordingly, the funds net returns will typically be a bit below that of their benchmark index. Some funds will under-perform their index by 0.2 percent. Others, suffering the drag of a greater expense ratio, will generate returns that are 0.5 percent below the index. Because of the dead weight of their expenses, all index funds are likely to under-perform their benchmark index. Clearly you would prefer to own a fund that under-performs its benchmark index as little as possible. Funds that have the lowest ratio of expenses-to-assets will generally come closest to equaling the returns of their benchmark indexes. Those are the funds that you will find to be the most attractive (produce the highest returns for a given benchmark). You incur taxes on investments in mutual and closed-end funds in two basic ways. Plan accordingly.

The fund itself generates taxable income as a result of the dividends it receives and the gains it realizes on its portfolio. That income must be distributed to the fundholders on an annual basis. The fund-holders are responsible for any tax liability on the distributions. The fund-holder cannot avoid incurring this tax. If you own shares of the fund at the time of the distributions (and not necessarily when the income is earned), you will incur the tax liability. Both you and the IRS will receive a statement (Form 1099) reporting the amount of such income. The fundholders will also be taxed on any gains realized on the purchase and sale of their funds shares. This tax liability is, however, incurred only when the fund-holder elects to sell his or her shares.

Unrealized gains remain untaxed

The fund-holder can avoid (defer) the second category of tax liability (unrealized) by continuing to hold his or her shares, but cannot avoid the first (realized). Since index funds do not undertake nearly as much buying and selling as actively managed funds, they tend to impose much lower tax liabilities on their fundholders. This reduced exposure to a tax liability is a significant advantage for index fund investors.

Avoid buying shares of closed-end funds at their original issue price. This original issue price is above their NAV. The share prices of such funds usually fall to a discount from their NAVs once they are issued and begin trading on their own.

Unlike mutual funds, that buy their shares directly from and sell directly to their fundholders, closed-end funds do not make a market in their own shares. Rather, their shares prices emerge from the interplay of supply and demand in the public market. Many closed-end funds are listed for trading on an exchange. Those not listed on an exchange trade in the over-the-counter market (usually NASDAQ). Generally (but not always), the price established by the interplay of supply and demand is below the funds NAV (net asset value per share). Financial economists have long debated why such funds tend to sell at a discount from their NAVs, but the evidence that they do so is overwhelming.

When a new closed-end fund is established, it must be sold to the public at a premium to its NAV. That premium (typically 8 to 10 percent) is needed to cover both the cost of organizing and setting up the fund as well as the cost of marketing its shares. Once the dust settles and supply and demand take over, the closed-end funds shares are very likely to trade more or less as such funds typically do. That is, the funds price will probably settle down to a discount from its NAV. If, for example, the fund was originally sold at a 10 percent premium to its NAV and once trading starts, the market price declines to a 10 percent discount, the investor could experience a 20 percent decline in the value of his or her investment. So, one who is interested in investing in a closed-end fund that is about to go public should wait until the fund has had at least a few weeks (or months) of trading before buying any shares. At that point, the funds shares are very likely to be selling for significantly less than its NAV and therefore very likely to be selling for substantially less than its original offer price.

Do not invest in funds of funds. You can create your own and save

The fund of funds concept is like a bad penny. It just keeps coming back no matter how bad an idea it is. As the name implies, a fund of funds is a mutual or hedge fund that invests in a diversified portfolio of mutual funds or, in some cases, other types of funds such as hedge funds. By assembling a diversified portfolio of funds, one can put together a rather flexible and diversified portfolio of portfolios. Each separate portfolio is diversified within its asset class, and the portfolio of portfolios provides diversification across asset classes.

With such a homemade fund of funds, the investor can easily shift his or her exposure to various market sectors by altering the relative portfolio weights. In a simple example, an investor could purchase shares in both a stock fund and a bond fund. When stocks (bonds) were thought to be the better value, the percentage of the portfolio invested in the stock (bond) fund could be increased and that on the bond (stock) fund decreased. If the components of the homemade portfolio of funds all reside in the same family of mutual funds (e.g., Fidelity, Vanguard, etc.), the investor can shift exposure from fund to fund with a phone call and usually without having to pay more than a modest fee ($5). As long as the investor is not engaged in frequent hair-trigger market timing, the funds family is happy to accommodate the moves.

Funds of funds are, however, quite different from a homemade portfolio of funds. The fund of funds concept is weighted down by the double impact of its fees and expenses. Each fund in the fund of funds portfolio has its own set of fees and expenses. Each component funds net return is the result of deducting these costs from that gross return on the funds portfolio. The fund of funds layers its own fees and expenses on top of those of its components. Thus the fund of funds own fees and expenses are also subtracted from the gross returns. A single dose of fees is enough to tip the balance in favor of index (as opposed to actively managed) funds for many investors. The comparison becomes all the more insidious when two layers of fees are imposed by the fund of funds structure.

The managers of fund of funds contend that they are particularly adept at selecting well-managed (mutual or closed-end) funds and moving money in and out of various market sectors at opportune times. Ask yourself the following question: If these fund managers are so skilled at fund selection and market timing, why cant they use these same skills to manage their own mutual fund? Why make you pay two sets of fees?

If you want to take a position in a component of the market during the course of the day, consider the use of exchange-traded funds

Exchange-traded funds are a relatively recent market innovation. They are essentially closed-end index funds that trade on an exchange throughout the day. Traditional closed-end funds also trade throughout the day, but at prices that can vary widely from their NAVs. Mutual funds are set up to trade once a day at their daily closing NAVs. In order to trade at that days closing prices, you must place your order before the markets close. When you seek to buy or sell a mutual fund, you do not know what the per-share price will be until the end of the day. If you enter your order before 4:00 P.M. EST, you will know only what the prior days closing NAV was. You will not know what that days closing NAV will be until after the time that you have entered your order. Later in the evening (or perhaps the next morning), after the markets have closed, you may be able to learn the new NAV. That new days closing NAV is the price at which you will trade.

Exchange-traded funds, unlike traditional closed-end funds, are structured so that their market prices almost never depart very much from their NAVs. Shares are created or destroyed as needed to maintain parity with their NAV. Their market prices track their NAVs throughout the course of the day. Exchange-traded funds are available on a number of different broad and narrow indexes. So if you want to trade on the basis of very-short-term expectations, you may want to buy and sell exchange-traded funds.

Invest some of your resources in mutual funds that hold portfolios of securities of companies located outside the United States in order to obtain their diversification potential, but be mindful of the risks

Diversification involves spreading your resources across a number of different assets and asset classes. It is a much recommended and very useful method for managing risk. The risk-reducing benefits of diversification within U.S. markets are, however, limited. U.S. stocks all tend to be affected by conditions in the economy. Thus most individual U.S. stocks tend to move up and down with the overall U.S. market. So, for example, the movement of the U.S. stock market as reflected in the movements of the broad market indexes, such as the S&P 500 or Dow Jones industrial average, will have a substantial impact on the performance of individual U.S. stocks. Diversifying into other asset classes such as bonds and real estate can help reduce portfolio risk. Still, the performances of all of these markets are to some degree dependent upon the performance of the U.S. economy.

Diversifying outside the U.S. markets provides an additional opportunity to reduce risk. Just as the economies of other nations move in different cycles from those of the U.S. economy, the securities markets located outside the United States fluctuate in different cycles from those in the U.S. Sometimes the U.S. markets are rising when various foreign markets are falling, and vice-versa. As a result, diversifying internationally can reduce risk by a greater amount than can be accomplished by diversifying exclusively within U.S. markets alone. Put another way, once you have obtained all of the risk reduction available from diversifying across U.S. securities, you can reduce risk still further by adding non-U. S. securities to your portfolio.

Investing in U.S.-based firms that have large international operations (e.g., Coca-Cola) does not provide the same degree of diversification benefit as investing in firms based outside the United States. The stocks of such U.S.- based international firms continue to move largely in sympathy with the U.S. stock markets.

Diversifying internationally is, however, appreciably more complicated than diversifying within the U.S. market. One who would do so needs to understand the various options that are available to accomplish this objective. Buying individual securities of companies based outside the United States is possible, but poses a number of hurdles. Those individual foreign securities that have actively traded American deposit receipts (ADRs) are the easiest to buy and sell in the United States. ADRs are warehouse receipts reflecting beneficial ownership of foreign shares. The actual shares are held in the name of the trustee who, for a small fee, sets up and manages the ADRs. These ADRs provide a convenient way for dealing with foreign taxes, currency translation, and avoiding the need to trade in a foreign country's securities markets. Still, investing in individual foreign securities is challenging for a number of reasons (e.g., the difficulty of obtaining relevant accessible information in English).

Accordingly, many investors utilize international mutual and closed-end funds to provide them with exposure to the international securities markets. Both mutual and closed-end funds exist in the following categories:

While investing in foreign securities does have diversification benefits, a number of additional risks should not be overlooked. First, when you invest in foreign securities, you are subjecting your portfolio to foreign exchange risk. If, for example, you invest in a fund that owns a portfolio of stocks of companies based in the European Union, their sales, profits, and stock prices will be denominated in euros. As the value of the euro fluctuates relative to the dollar, these funds values in dollar terms will move up and down. In a period when the dollars value is rising (falling) relative to the euro, securities priced in euros will tend to fall (rise) in dollar terms even when they do not fall (rise) in euro terms. Sensitivity to changing relative currency values is called exchange rate risk. Exchange rates can, of course, move in your favor. The fact, however, that exchange rates for different currencies can move in either direction adds an element of risk to international investing that is not present in domestic investing.

Categories of International Funds

International funds invest in a diversified portfolio of stocks of companies based in countries around the world. They tend to be among the most diversified funds available. Some fund managers, like the gnomes of Zurich, try to move their money around seeking exposure in the countries with the hottest or most undervalued stock markets. Others simply try to hold a representative portfolio of international stocks with weights more or less reflecting the market capitalization of the various stock markets around the world.

International funds with a theme also invest around the world but with a specific concentration. For example, such funds may focus on a particular industry (telecommunications), region (Latin America), or country type (emerging markets). Investors who have a positive opinion about the relative potential of such themes may want to buy a fund that mirrors that exposure.

Country funds invest in a diversified portfolio of companies based in a particular country. Country funds now exist for a large number of countries. Indeed, index funds are available for most countries that have their own stock markets.

Foreign bond funds invest in the debt securities of companies based outside the United States. International funds may be organized as either mutual or closed-end funds. Moreover, many hedge funds invest internationally.

Dollar Value of an Investment Fund Worth 10 Euros Per Share

  • Exchange rate $1 = 1 euro = $8
  • Exchange rate $1 = 1 euro =$10
  • Exchange rate $1 = 7/8 euro =$12.50
  • Exchange rate $1 = 3/4 euro =$15
  • Exchange rate $1 = 5/8 euro =$17.50
  • Exchange rate $1 = ½ euro =$20

The second type of additional risk associated with international investing is what is called country or political risk. Those who invest in U.S.-based companies are protected by the American legal system. They can rely upon the stability of the U.S. political system as backed up by the U.S. military establishment.

Investing outside the United States, in contrast, may involve not insignificant risks of economic lo resulting from the potential for political/ legal turmoil. We in the United States are bleed with a relatively stable political system coupled with a legal system that does a rather effective job of enforcing rights to property and performance under valid contracts. While these kinds of protections exist in many other countries, they may be present only in weaker form. Moreover, local governments tend to be much more interested in protecting the property rights of their own citizen/voters than those of investors from outside the host country. Both violent revolutions (China, Russia, Cuba, Iran, etc.) as well as more peaceful change of government (Chile, Argentina, Mexico, Brazil, etc.) can result in a radical change in the investment climate. In some cases, foreign-owned property may be expropriated outright. In other cases, increased tax rates and/or restrictions on repatriation of profits limit the investors upside potential. Political risk varies greatly from country to country. Political risk is much less of a concern for countries that have a history of stable economic development like Canada, the UK, and those in Western Europe than for many of the less-developed countries of Africa, Latin America, or Asia.

Notwithstanding the risks inherent in international investing, the universe of securities available throughout the world provides a much larger set of investment opportunities than the constellation of securities originating in the United States. Moreover, stock and bond markets around the world are often rising when U.S. markets are falling (and vice versa). So, those who invest internationally have a much larger set of securities from which to choose and substantially greater diversification opportunities, coupled with the unavoidable acceptance of exchange and country risks not present in U.S.-only investing. Like virtually all other aspects of investing, international investing involves trade-offs.

Individual investment managers are another money management option. Unless you have a rather large portfolio, they are probably too costly for you

One alternative to investing in professionally managed investment companies is to hire your own personal portfolio manager. Either approach assigns most of the day-to-day investment decision-making to a professional money manager. You might choose to work through the trust department of a bank or hire an individual manager who is part of a firm that is established as a separate investment management enterprise. Alternatively, you could set up a discretionary account with a brokerage firm. Depending upon the amount of money you have to invest, your investment manager may place your funds into a set of common investment pools (smaller sum), or may manage and maintain a separate portfolio just for you (larger sum). In either case, the manager will (or at least should) try to build an overall portfolio that matches your preferences for such objectives as:

  • risk tolerance
  • liquidity
  • tax-sheltering
  • capital preservation
  • current income
  • desired social policy

Individual money managers have one major disadvantage compared to the investment company option. Unless the sums to be invested are quite large, the fees of these individual money managers relative to the assets under management tend to be rather high. Two percent of assets plus expenses is a typical annual fee structure. Moreover, the performance of the typical individual portfolio manager tends to be no better than the market averages. Indeed, some unscrupulous portfolio managers have been known to embezzle their clients money, thereby greatly reducing the relevant portfolio performances. For all of these reasons, mutual funds and other types of investment companies usually provide a preferred way of having your funds managed by professionals, particularly if the amount to be managed is relatively small.

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