Cliff’s Corner

STOCK MUTUAL FUNDS
Q: What is a stock mutual fund, and why invest there?
A: A stock mutual fund is one that holds a majority of its portfolio assets in the stock market. Such a fund provides investors with easy access to the stock market at a reasonable outlay, and investing in the stock market is critical to achieving long-term financial success. The risk is real, but no risk means little or no reward.

Q: How do I pick a stock mutual fund?
A: Set some clear-cut requirements, like settling only for funds that do not impose a sales charge front or back (that is, "no-load" funds), that levy annual fees of 1 percent or less, which have been in business at least 10 years, and which have shown highly competitive performances over that stretch. Look at the average annual compound returns over the intervening three, five and 10 years to establish consistency of performance. Avoid narrowly diversified (sector) funds, those set up for institutional and high-net-worth investors, and, of course, those closed to new customers. Bypass at this stage any foreign funds. These requirements are the basis for our annual No-Load Stock Mutual Funds Honor Roll. We use as raw material the Barron's/Lipper quarterly table carried in Barron's, a weekly financial publication.

Q: Why are loads placed on stock funds, and why would any buyer pay one when no-load funds abound? Is it because load funds generally outperform no-load funds?
A: Actually, the opposite is true. Numerous surveys over the years have shown that no-loads outperform load funds. A load, which by law can run as high as 8.5 percent of the amount invested, provides revenue to compensate brokers and financial planners for recommending the fund to their clients. It's a self-serving game because the salespeople are naturally going to recommend load funds. A common load is 5.75 percent and no self-respecting investor should be willing to have a salesperson lop off and pocket $575 on a $10,000 purchase. No-loads are the meat of independent investors.

Q: So do load funds impose an annual fee on top of the load?
A: Yes. All mutual funds, even money market funds, impose an annual fee of varying sizes, collected inside the fund. The money goes to pay fund managers and cover ongoing fund expenses. The annual fee is often called an "expense ratio" because it's set at a certain percentage of the average annual assets of the fund. It's important to avoid high-fee funds because over time the annual drain can cut heavily into returns.

Q: I keep hearing about 12b-1 fees on mutual funds. What are they all about?
A: By an inane law, funds are allowed to impose a special annual fee to pay for advertising and promotional costs, and it's called a 12b-1 fee after the code section allowing it. The fees are imposed mainly by load funds. But, unnecessary confusion results because funds are required to include 12b-1 fees in the total annual fees they quote. So the independent investor looks for annual fees of 1 percent or less, not worrying what the fund does with the money.

Q: Isn't your system of picking funds on the basis of past performance flawed? I keep hearing that past performance doesn't guarantee future results.
A: No fund picker or picking system can guarantee future results, so why not at least start with funds that have been big winners in the past? We review the funds on our Honor Roll once a year and make any necessary changes. But some funds have been Honor Roll mainstays for a number of years.

Q: Many investors leap into a hot, new fund, one up sharply over a few months or a year, and end up making money. What's wrong with this approach?
A: Avoid "hot, new funds" like the plague. Mature funds are easier to judge.

Q: Many investors pick funds based on the record of the manager, and then seem to worry if reports disclose that the manager plans to quit.
A: It's needless worry. We believe that if the fund's performance was good then the manager was good. So performance is the bottom line. A departing manager prompts provocative stories in the financial press, but usually it turns out to be a non-event. Fund owners will do whatever they can to stabilize fund performance because they don't want investors bailing out.

Q: Morningstar, the popular fund tracker, assigns stars to good fund picks and its system relies only in part on past performance. What's wrong with this approach?
A: Morningstar employees its proprietary "risk analysis" to come up with its selections. Our problem with the tracker's system is that high marks, four and five stars, are assigned to hundreds of funds. In no way does that help the public pick funds. One of the chief benefits of our Honor Roll system is the boiling-down effect. We cut thousands of funds down to a few in the Honor Roll carried in our newsletter.

Q: I keep reading that "index funds" are the best way to go because they simply buy, for example, all the stocks in the Standard & Poor's 500 Stock Index, and the fund will always at least keep up with the index performance. Also, index funds, they say, charge lower fees because they are not actively managed. What do you say?
A: The problem with an index fund is that it will never outperform the index, that is the overall market. Our Honor Roll funds, at least in retrospect, outgun the overall market. The Vanguard 500 Index Fund has made the Honor Roll in the past when the market was particularly hot.

Q: Stock funds continuously distribute dividends and capital gains to shareholders and all this is taxable income. So even if you avoid capital gains taxes by holding onto your shares you still have to face this annual tax liability. That can make a fund quite a tax burden. Isn't this a problem?
A: No one likes to pay taxes, but a tax is triggered by only one thing -- taxable income. And what's wrong with income? Some funds show little movement in the net asset value (price-per-share) with most of their returns coming in the form of fund distributions. While these funds are going to be more heavily taxed than others, they are some of the best long-term performers. To explain, the dividends are paid out by companies held in the fund portfolio and the capital gains are created by the fund manager as he or she buys and sells stock in the fund at a net capital gain.

Q: But shouldn't we look for tax-managed funds, ones that control those distributions?
A: Again, too many so-called tax-managed funds don't have good long-term performance records. Besides, a tax-managed fund cannot hold the line through thick and thin. If the market falls and redemptions pick up, the manager will have to sell good stocks to cover those redemptions, thus creating a taxable gain. A yearly fund table in Business Week magazine pegs tax consequences, and the magazine had to set the running tax rate at 31 percent to make the tax burden look half-way significant. Most people are in the 15 percent tax bracket.

Q: What should I do with the distributions from funds -- put the money in my pocket or reinvest it in additional shares?
A: Reinvest it. That way you will not only achieve compound growth, but you can then measure the performance of your funds with those carried in performance tables, which usually include reinvestments in their figures.

Q: Just what does "net asset value" mean?
A: It's a fancy name for the price-per-share of a fund. At the close of the markets each day, every fund calculates its net asset value by adding up the value of stocks, other investments, plus cash not yet distributed, subtracts daily expenses and divides the result by the number of shares outstanding. That figure, its net asset value, goes into the next day's mutual fund tables in newspapers across the country.

Q: The net asset value of my fund has not moved, so I'm assuming I'm no farther ahead even though the market has risen.
A: You are probably ahead of the game because if you are reinvesting dividends and capital gains your share count should be higher. Multiply that by the net asset value and the result is your total equity in the fund, no doubt on the upside.

Q: The net asset value of my fund fell sharply yesterday as the stock market rose. What happened?
A: Your fund probably made a major distribution of dividend and capitals gains. That removed a lot of cash from the formula for calculating the net asset value, causing the NAV to fall artificially. You suffered no loss. The cash either went into additional shares or its headed for your pocket.

Q: I understand that "dollar-cost averaging" is a good way to invest in stock mutual funds. How does it work?
A: It calls for investing a like amount of money at like intervals -- say $30 a month or $100 a quarter. That way you buy more shares when the price is down and fewer shares when the price is up and your average cost of your shares remain below the average value. It's a great way for beginners or people with steady income to invest in an ongoing basis. But if you have the money to cover the minimum entry cost, jump in. Holding off for better days means you're attempting to time the market, which can be a losing game.