Five Tough Questions to Ask About Your Mutual Fund
by Jerry Edgerton
As a mutual fund investor, you may well be indignant that some funds allegedly allowed improper trading by big investors and even by their own executives. Concerns have been raised that returns suffered for most shareholders in these funds. Profits went instead to hedge funds, to those making swift in-and-out trades contrary to stated fund rules, and to those involved in illegal late trading--placing an order after 4 p.m., but still buying at that day's closing price.
Even if you are lucky enough not to have money in any of the funds cited for violations by the Securities and Exchange Commission (SEC) or New York Attorney General Eliot Spitzer, use the scandal as a reminder to check up on the costs and conduct of mutual funds that you do own--either directly or as part of your employer's 401(k) retirement plan.
As Congress and the SEC move toward toughening up mutual fund regulation, how tough do you need to be if you have money in a fund or fund company tainted by the scandal? You may want to start looking at alternative funds for future new investments. Ron Roge, a Bohemia, N.Y., financial planner who manages money for clients, has a black list of companies where he will no longer invest because, he says, "They lost sight of their fiduciary responsibilities to their investors." (To see Roge's full black list, go to his Web site.)
Your credit union may be affiliated with an investment professional; ask for a referral.
In two cases, Strong Capital Management and PBHG funds, the founders and chief executives of the firms allegedly were making quick in-and-out trades themselves and have since resigned. Fund research firm Morningstar Inc. suggests that investors consider selling funds from these two companies plus Alger Funds, Bank of America Nations Funds, Bank One, and Janus.
But before you actually sell, consider your tax situation. If you've owned the fund for several years and selling would trigger sizable capital gains taxes that you don't want to pay, holding the fund at least for now may make better sense. If you are investing through a tax-deferred IRA (individual retirement account) or 401(k) plan, capital gains tax will not be an issue. But if selling one of these funds in your 401(k) would leave you without, say, another bond fund or another small-company stock fund to invest in, you might stick with it. However, most large-company and government agency retirement plans will have multiple choices. Consult your professional tax adviser or financial planner for questions you have about taxes and investing.
For funds you already may own or might consider buying from nontainted companies, you of course watch how their performance has been in terms of price gains or generating high income. But check also on their shareholder friendliness, whether the managers share your risk, and, most of all, the fees they are charging you. Here are five questions to ask about your fund: Find out if the fund managers invest in their own funds.
Did I pay a sales charge up front?
It's hard enough to build a nest egg without giving up 4% to 5% of each investment right from the start as a sales charge for the broker or financial planner who sold you the fund. If you've already paid such a sales load on existing investments, consider changing advisers for future money and seeking out "no load" funds with no initial sales charge.
How much do they keep charging me?
Mutual fund companies charge an annual percentage of their assets in management and other fees. The average stock fund recently carried an expense ratio of 1.59%, according to fund research firm Morningstar Inc., while the average bond fund charges were 1.1%.
Consider doing your homework before buying funds with high expense ratios. Look up fund expense ratios free at Morningstar's brief fund Snapshot report on each fund. (You need a paid subscription to get its analysts' fuller reports.) Given average expenses and the effort needed to research various classes of investments, Roge suggests these limits for fees: For funds investing in large-company stocks, keep your expenses below 1%. For funds specializing in more research-intensive small-company stocks, stay below 1.5%. For bond funds, stay below 0.75%, except for high-yield bond funds (often referred to as junk bonds). High-yield bonds need to be researched individually like stocks, so 1.0% is reasonable.
Many mutual fund companies charge an annual percentage of their assets in management and other fees.
Good funds are available within these guidelines from large firms like Fidelity Investments and T. Rowe Price, both of which have funds available in many major-company employee 401(k) plans. The perennial low-cost champ is Vanguard Group--which has a different, less costly structure than most fund groups.
Who's managing this fund?
A strong fund performance record may not mean much if most of it was compiled by a now-departed manager. Look at the Morningstar Manager Start Date in its Snapshot; if the manager has been with the fund five years or more, this may help you judge performance. A smooth transition, such as an assistant manager moving up to take over, still may give you continuity, but manager tenure is a good place to start.
Do the managers invest in their own funds?
When the people picking the stocks or bonds in your fund have a substantial portion of their own net worth tied up in the same portfolio, they are less likely to make improper or short-term moves that will hurt the average shareholder. Data on managers' holdings aren't always easy to find. But companies that publicize their managers' large stake in their funds send a positive signal. Among the fund companies that follow this virtuous path are Davis; Longleaf; and Tweedy, Browne. For others, call the mutual fund's customer service department to ask for information about the fund.Before you sell, consider your tax situation.
Are they running up my tax bill?
Funds that buy and sell stocks quickly can wind up costing you in taxes. Capital gains in the fund are passed on to you as a shareholder in a taxable account--even if you don't sell the fund. Look at the bottom of a Morningstar.com fund Snapshot for the "Annual turnover %" figure. A fund with, say, 100% turnover is doing a lot of trading. Then go to the side of that Snapshot page and click on "Tax Analysis," which will show you before- and after-tax returns for the fund. A fund like Fidelity Dividend Growth, with an after-tax return that is a high proportion of the overall return, is a good bet.
Some of these issues work together to determine if a fund is really putting its shareholders first. Funds that trade a lot, for instance, may need more employees and may run up bigger commissions--which may increase expenses and often lower performance. You want to invest in a fund that treats you as a partner and not just a source of cash to be skimmed for company profits.
Of course, individual circumstances vary. Consult a financial adviser for help with your particular situation.
Jerry Edgerton is a former mutual funds writer for Money magazine.
February 2, 2004
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