Picking Funds Is a Whole New Game
By JONATHAN CLEMENTS
When I first started writing about mutual funds in the late 1980s, the fund business was a relatively modest affair. Back then, if you had mentioned a stock fund, there was a good chance I knew what strategy the fund used, how it had fared in recent years and possibly even the manager's name.
Believe me, those days are long gone.
Today, I regularly discover there are entire fund companies I have never before heard of. But it isn't just the proliferation of funds that has been so astonishing. Over the past 16 or 17 years, the fund business has been utterly transformed -- and that, in turn, should transform the way you pick funds.
In the 1980s, fund-performance data was hard to come by. Indeed, folks would subscribe to investment newsletters, simply to get monthly updates on their funds' results.
Now, by contrast, you can get year-to-date performance in many newspapers and even more detailed information online at www.morningstar.com, the indispensable Web site run by Chicago fund researcher Morningstar Inc. The fund results you see don't just reflect share-price changes. They also take into account fund income and capital-gains distributions.
The increasing availability of performance data has made it painfully clear just how mediocre most funds are. Result: Investors have become quicker to dump lackluster performers and shift money into better funds.
The glut of data has also spurred the growth of index funds, which seek to replicate the results of a market index by buying the stocks or bonds that constitute the index. With so many actively managed funds earning such poor returns, purchasing index funds and thereby mimicking the market has started to look awfully attractive.
Picking Your Mix
According to Morningstar, there are 6,700 stock, bond and money-market funds, up 40% from 10 years ago. With this rapid growth has come increasing specialization.
Forget vague promises that a fund will invest in U.S. stocks or in foreign shares. Today, funds tend to stick with well-defined market niches, such as midsize U.S. stocks, emerging-market debt or small foreign growth companies.
This specialization has changed the whole fund-picking process. Before, investors sought talented managers who could deliver decent returns year in and year out. Now, with funds focused on narrower market niches, investors also need to give serious thought to the market sectors they are tapping into.
The new strategy: First, decide which market sectors you want exposure to and what percentage of your portfolio you will invest in each. Next, for each sector, pick a top-notch fund to give you your desired market exposure. In effect, funds have become portfolio building blocks, rather than being viewed as stand-alone investments.
As an investor, you want great performance at low cost. But fund companies have a different goal: They want to gather heaps of assets and charge fat management fees. This nasty clash of interests has become more intense in recent years -- and it exploded into public view with the 2003 and 2004 mutual-fund scandals.
Take the issue of market timing. If you are a long-term investor, you don't want market timers flitting in and out of your funds, because these traders disrupt a fund's portfolio and their quick trades may effectively steal returns that should belong to long-term holders. But unfortunately, some fund companies have welcomed timers, because these traders mean additional fund assets and hence fatter money-management fees.
Fund companies' lust for assets also underlies the sales abuses involving mutual-fund B shares. In the late 1980s, most funds either were sold through brokers and charged a large upfront commission or they were offered directly to investors without a "load," as sales commissions are known in mutual-fund lingo.
But that simple world has, I regret, disappeared. Broker-sold-fund companies have introduced a slew of new share classes, including B shares. Buyers of B shares don't fork over an initial sales commission. Instead, they pay hefty annual expenses, plus a back-end load of as much as 5% if they sell in the first six years or so.
This cost structure has led unscrupulous brokers to pitch B shares as "no-load" funds. To make matters worse, brokers often can earn larger commissions by selling B shares than by selling traditional front-end-load funds, now known as A shares.
The reason: If investors stash at least $25,000 or $50,000 at a single fund company, they often qualify for a reduced commission on A shares. That, in turn, reduces the broker's take. But B shares don't offer such "breakpoints," which is why unscrupulous brokers love to sell them.
Given that B shares are so open to abuse, why did fund companies introduce them? You guessed it: Funds want to pull in more assets, even if it means hoodwinking investors.
How can you protect yourself against all this? If you use a broker and the broker is pushing B shares, be extremely suspicious.
As an alternative, look for an adviser who will get you A shares at a discounted commission or who, in return for a quarterly asset-management fee, will help you purchase no-load funds. Better still, teach yourself to invest, so you can save money by buying no-load funds without an adviser's help.
At the same time, steer clear of fund companies that seem too anxious to haul in assets. In particular, avoid companies that advertise funds with dazzling short-term performance or that launch aggressive funds in currently hot market sectors.
Instead, aim to invest with fund companies that really seem to care about long-term shareholders. What signs should you look for? More ethical fund companies limit the number of shareholder trades, hit you with redemption fees if you sell in the first two or three months and close funds to new investors if money starts pouring in.
Sure, these restrictions are an inconvenience. But it's an inconvenience that should ultimately mean more wealth for you and other long-term holders.
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