November 30, 2009

MUTUAL FUNDS (Putting the Prospectus into Perspective)

While the argument for index funds is a compelling one, there will always be investors that opt for the more "tantalizing" world of actively managed mutual funds. If you find yourself in this camp, understanding the objectives and "fit" of the fund relative to your particular goals is paramount. The mutual fund prospectus will be one of your most valuable tools to address these questions. The prospectus is a summary of a funds investment philosophy, its management, its financial highlights (and lowlights), costs, etc. It is wise to spend time perusing the prospectus prior to ever putting a dollar into a fund. The prospectus ultimately helps you to "know what you're investing in" ...


FUND COSTS. One of the first things to examine is the funds cost structure. The amount of money charged in fees tends to vary dramatically from fund to fund.
Expense Ratio – Total percentage of annual assets that a fund takes to cover operational costs (i.e., marketing, etc.). Some funds have expense ratios in excess of 2%; many, however, have expense ratios at or lower than 1%.
Loads – Sales commissions tacked onto funds - come in numerous 'flavors' - front-end, back-end, level, or no-load.

FUND SUMMARY/OBJECTIVE. What is the fund trying to accomplish? What is the philosophy of the company (i.e., value, growth, etc.)? What area is the fund focusing on - a certain sector (i.e., technology, health care, etc.); international companies; small, medium, or large companies, etc.? What are the specific risks with investing in this fund? Obviously the funds objectives are critical - I should be investing in something I understand, as well as something that will ultimately meet my [long-term] investment goals.

FUND HISTORY. How well has the fund performed over the past year, 3 years, 5 years, 10 years, and since inception? How does the fund compare with its index (and "peer" funds) during that time? How did the fund hold up during the market meltdown? How has it rebounded during the market upswing since last March? Keep in mind this is a "rear view mirror" approach to performance and doesn't guarantee that it will continue to perform at the same level that it has in the past (for good or bad).

FUND MANAGEMENT. The importance of fund management seems fairly obvious. A more challenging question perhaps is ... How much of the performance should I attribute to the person(s) managing the fund? Should I sell my fund if the fund manager is no longer managing the fund? Some people prefer funds managed by a group; perhaps group management may have less volatility in the transition if someone were to leave (in theory anyway). What is the experience/ track record of the manager/ management team? Do any research on Peter Lynch during his time running the Magellan Fund at Fidelity if you don’t think the manager of a particular fund makes a difference (he averaged a return of 29% per year during his 13 year tenure)!

FUND TURNOVER. Indicates how frequently a fund buys and sells its holdings. The higher the percentage, the greater the fund's buying and selling activity. A rate of 100%, for example, would indicate that a fund essentially changes all of its holdings once a year. Typically a higher turnover rate generally indicates a more aggressive manager -- engaging in more frequent buying and selling -- a practice which has both pros and cons.

ADDITIONAL INFO. Some funds will also offer information from outside agencies. Companies like Standard & Poor's and Morningstar are independent agencies that rate mutual funds on numerous criteria and rank them relative to "peer funds." Obviously there is more to fund selection than if one of these companies suggests the fund is good, but it is one more thing you can look at in the decision-making process.

I wanted to make this as easy an exercise for you as possible, so I have taken three mutual funds from three different no-load mutual fund companies and provided the links for you to be able to go directly to the funds prospectus. YOU SHOULD NOT VIEW THIS AS AN ENDORSEMENT OF THE FUNDS. I HAVE SELECTED THREE PROSPECTUSES FOR YOU TO REVIEW TO AID IN AN EDUCATIONAL PROCESS. You will notice that each fund has very different objectives.

-- Fairholme Fund

-- Fidelity Low-Priced Stock Fund

-- T. Rowe Price Mid-Cap Value Fund