How Many Mutual Funds Should You Have in Your Investment Portfolio?

How Many Mutual Funds Should You Have in Your Investment Portfolio?
Time to take an inventory of your mutual funds. How many are there? What are their investment styles? Is your portfolio of mutual funds cluttered just like your closet? Have you owned some mutual funds so long that you have forgotten why you bought them? Are there some mutual funds on the top shelf, way in the back of your financial closet you haven't even looked at in a while?

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Adding new mutual funds to your portfolio is far easier than reorganizing your fund portfolio and discarding inappropriate, redundant, or simply poor-performing mutual funds. The answer to the question of how many mutual funds you should have in your portfolio is not just a number. But if you have many more than eight mutual funds in your closet, chances are you need to do some serious portfolio cleaning. Here's why.

First, in order to be well-diversified, your mutual fund portfolio should be invested in domestic and foreign stock mutual funds and in fixed-income mutual funds or income fund equivalents. Within the domestic stock market, your mutual funds should cover large stocks, small stocks, and stocks in-between.

Foreign investments should cover established firms in industrialized countries and stocks of countries that would be considered emerging markets. While geographic diversification domestically is relatively unimportant, diversification by region for foreign investments is. Representation in Europe for large stock international mutual funds is important, and investments in Latin America and the Pacific Rim are crucial when considering emerging stock mutual funds. Global mutual funds that invest domestically and abroad sound like a one-fund answer, but it is too much geography for one portfolio manager to cover and global funds tend to change domestic/foreign portfolio weights as world conditions change, neutralizing some diversification benefits.

Counting the Mutual Funds

Let's stop and take a count: one large stock domestic fund, one small stock domestic fund, one international large stock fund, one emerging market stock fund—so far, four mutual funds. Have we missed the mid-sized domestic stocks? Well, check your large-cap stock fund and your small-cap stock fund to see what they include. Usually, large stock funds leak down into the mid-size range and small stock funds push up into the mid-size range. If not, add a mid-size mutual fund to avoid any portfolio gaps. Now we may be up to five, all of which are stock mutual funds at this point.

If you want income and the diversification benefit of a fixed-income fund, then a simple choice would be to consider intermediate U.S. government bond mutual funds. The intermediate maturity—in other words, a three- to 10-year weighted average maturity for the bonds in the portfolio—captures most of the yield of longer-term mutual funds with much less volatility when interest rates change. If you are in a high federal tax bracket, a municipal bond fund might be a better choice. And if you live in a state with high state and local taxes such as California or New York, you may want to consider substituting a state-specific municipal bond fund to minimize federal, state and local taxes on the bond income. Aggressive investors can reach to high-yield corporate bond funds and if they are in a high tax bracket, hold the fund in a tax-sheltered account. While high-yield (junk) bond funds invest in lower-quality corporate debt that pays high income, the individual default risk of the bonds in the portfolio is softened through diversification and the high income dampens portfolio volatility. Furthermore, high-yield bonds tend to be sensitive to the economic cycle, acting more like stocks than government bonds.

One bond mutual fund in a portfolio may make sense, but it is difficult to imagine the value of more than two bond mutual funds. For high-tax bracket individuals, a municipal bond fund and perhaps a high-yield bond fund in a retirement account may make sense, but high-tax bracket investors often prefer growth through common stock mutual funds rather than income from any source.

So, if we add one to our fund count for a fixed-income fund we have a total of six mutual funds; two bond funds would push it to seven.

Other Categories of Mutual Funds

What about all those other categories of mutual funds? Do you need a gold fund, mortgage-backed bond fund, international bond fund, sector fund, index fund?

Let's take them one at a time.

• Gold mutual funds are concentrated sector funds holding gold mining stocks primarily in North America, South Africa, and Australia. They are extremely volatile, as gold price changes are magnified by the operating cost breakeven points of gold mining firms. Do you need a gold fund in your portfolio? No. Most investors use gold funds as a store of value, a hedge against inflation. Over the last decade, however, they have been neither. When stocks are roaring up, you would like your gold fund to behave like a stock, but it tends to act like gold bullion. When the stock market collapses, you hope your gold fund behaves like gold bullion, but unfortunately, it tends to act more like a stock.
• Should you consider mortgage-backed bond mutual funds for your portfolio? Probably not. A diversified portfolio of mortgages that promise higher returns than a U.S. government bond portfolio of similar maturity does have some appeal. However, mortgage-backed funds have at times behaved as badly as gold funds. When interest rates rise, bond prices fall and the share prices of bond mutual funds also fall. So, as an investor, when rates rise, you want a mortgage-backed bond fund to act contrary to a bond, but it doesn't. When interest rates fall, the prices of bonds and bond mutual funds rise, but a mortgage-backed bond fund will respond more to the mortgage market. When mortgage rates fall along with interest rates, mortgages are refinanced and part of your investment is essentially handed back to you to be reinvested at lower rates.
• International bond mutual funds often promise higher yields, but the difference in yields is usually due to differences in currency strength. A country with high interest rates is likely to be protecting a weak currency. When rates are high, investors buy the currency to buy the bonds and support the currency in the process. If the currency in which the foreign bonds are denominated weakens, the differences in yield may evaporate or even fall below domestic yields. Currency speculation is not a game most investors should play.
• Sector mutual funds concentrate on one industry or a few closely related industries. Because they are concentrated in an industry, they are not well diversified. Beyond the additional risk, the trick to master is just which sector funds to invest in. At the top of most "best-performing mutual funds" lists will be some sector funds, but they'll also appear on the "worst-performing mutual funds" lists—it's just a question of when. Most aggressively managed stock mutual funds concentrate in some industries and might be viewed as a combination of sector funds. Few investors are willing and able to place sector bets unless they have particular experience in a sector through their education, work experience or vocation, and if they do have expertise, selecting individual stocks may be more rewarding.
• Do index mutual funds have a place in your portfolio? Yes, but they don't add to the number of funds. They simply are another way of managing your assets in one of the fund categories necessary for a rational, well-diversified, non-redundant mutual fund portfolio. Index mutual funds should be employed in a situation where even the brightest and best of portfolio managers using superior timing and stock selection decisions would have difficulty overcoming the cost advantage of an index fund. Areas of the markets that are efficient, have readily available information, are well-researched and followed closely by the investment community, or are simply not susceptible to very profitable analysis are candidates for indexing. The market for large domestic stocks and the U.S. government bond market fit the index fund criteria. Small domestic stocks and emerging foreign markets do not. These markets have attributes that make intelligent, thorough analysis more likely to contribute returns that can overcome the cost of active fund management.

Style Diversification in a Portfolio of Mutual Funds

An added classification for domestic stock funds is investment style—mutual funds can be categorized as growth or value, or both. Growth mutual funds would typically invest in stocks with high earnings growth expectations; value mutual funds would invest in stocks with low prices relative to earnings and net asset values. The style label should be based not on what the fund says it is or what it says it will do, but on what it does. Investment style classification should serve to help investors avoid redundancies and coverage gaps. But they also beg the question, "Should a portfolio of stock mutual funds be diversified by style as well as size of stocks?" Size, yes. Style, perhaps.

Many mutual funds operate in more than one stock size range and many use approaches that are classified as both growth and value. Do you need a value and growth fund in each stock size category? No. One value fund, and it might be the large stock fund, and one growth fund covering the mid-sized and small stock area provide coverage of size and style. A large stock index fund will be both growth and value, and more extensive indexes will cover value and growth for more stocks and stock size ranges.

Eight Is Enough…

Understanding the style and stock size characteristics of mutual funds will help prevent duplications and unnecessary run-up in the number of mutual funds in your portfolio. Now, back to our count of mutual funds: We left off at six with one fixed-income fund, or seven funds with two fixed-income funds. Add a money market fund and the counter clicks to eight. Be sure you can justify adding mutual funds to your portfolio beyond eight. Make certain you need them, that they truly cover new ground in asset type, geography, or investment style, and that the addition is meaningful.

Taking the time to create an organized, understandable, appropriate and efficient portfolio of mutual funds may be your most important investment.

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Dollar Cost Averaging Amid Downturn

Dollar Cost Averaging Amid Downturn

This is a big issue for many of you right now. I know you are alarmed by what is happening in the economy, and terrified by what is happening to your savings. There is a lot of talk about the "worst case scenario," which historically was the collapse of 1929-1932. During that period the Dow Jones Industrial Average fell a simply stunning 89%, from peak to trough, and did not recover all its lost ground until 1954. To put that into context, a similar fall today would take the Dow down to about 1600.

At times like these it can be incredibly difficult to stick with your long-term investment plan. Nothing like this has happened in 80 years, and even long-standing market veterans are badly shaken. Many of you have simply given up. Yes, you know the time to buy shares is when shares are cheap. You may even concede that shares are probably pretty cheap now. But who has the stomach for yet more losses? What if things get a lot worse?

Investing by dollar cost averaging can help a lot. This simply means that you put exactly the same amount of money into mutual funds or shares every month. When markets are up, you get a little less. When markets are down, you get a little more.

When you choose to dollar cost average you are giving up any attempt to time or catch the absolute bottom of the market. Most investment veterans see that as a huge plus. Few if any fortunes have been made by those who tried to catch the falling knife. Legions have been lost. Dollar cost averaging will also underperform a bull market. If shares simply skyrocket over the next twenty years, the most money will be made by those who invested all at once at the start. But that's a big gamble.

To see how dollar cost averaging might have helped an ordinary investor during the worst meltdown in history, I looked at data from the Great Depression. (My data source was Ibbotson Associates, founded by Yale professor Roger Ibbotson and now part of Morningstar.) And I looked at total shareholder returns, which includes reinvested dividends, for a basket of the top 500 companies on the market.

At the worst moment in the crash of 1929-1932, someone who dollar cost averaged had still lost about two-thirds of his or her money.

That is plenty scary. Terrifying, even. But before you bolt from your mutual funds, never to return, let me add several things.

First, these are the numbers for the unluckiest investor - the guy who began dollar cost averaging at the absolute worst moment in history, namely Sept. 3, 1929. Those who started later in the crash did at least slightly better.

Second, the performance in real terms wasn't quite as bad as it seems. That's because of deflation - the phenomenon of falling prices that helped cause the crash in the first place. A dollar in 1932 bought a lot more than a dollar in 1929: Average prices fell by about a third. So in real terms even the unluckiest investor - one who started in September 1929 - was only down, at the low point, by just over a half.

Third, they recovered fast. When the market turned, those who stuck quietly to their plan got repaid quickly. Forget that stuff about 1954. According to Ibbotson data, someone who dollar cost averaged was back on level terms by 1933. And by 1936 he had doubled his money (though the crash of 1938 then knocked him back to evens for a while).

Incidentally, while Wall Street plummeted 89% at its lows, overseas markets did not do quite so badly. They fell, overall, about two-thirds according to data from Philippe Jorion, an economics professor at University of California-Irvine. That's still bad, but it is very different from 89%.

It's an argument for sticking to regular investments through this crash: Not bailing, and not jumping in with both feet either. The simplest strategy worked; investing the same amount, every month. It's also an argument for investing globally, and not just in the U.S., which is a lot easier to do today than it was in 1929.

Oh, one more thing. Someone who started in September 1929 and invested $100 a month, every month, in Wall Street for 30 years got rewarded in the end. His total investment came to $36,000. The size of his nest egg by 1959: An extraordinary $411,000, or more than 10 times as much.

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Introduction to Asset Allocation Allocation

Introduction to Asset Allocation Allocation
Asset allocation is a snappy phrase that simply means dividing your investments among several different categories in an attempt to protect your portfolio from wild swings in any one section.

Some experts believe that asset allocation is the single most important factor in investment success.

Generally, you will want to consider a mix of stocks, bonds, and cash. The percentage you select for each investment category is the process of asset allocation.

For example, you may decide that your particular situation calls for a mix of 80 percent stocks, 15 percent bonds, and 5 percent cash. You might further break it down this way:

Stocks 80%
Income 20%
Growth 40%
Foreign 10%
Small-Cap 10%
Total: 80%

Bonds 15%
Long-Term 10%
Mid-Term 5%
Total: 15%

Cash 5%
Short-Term Bond Fund 5%
Total: 5%

These are hypothetical numbers for a hypothetical investor. You should base your particular allocation on a number of factors, including:

• Risk tolerance
• Years to retirement
• Your income
• Your savings

Splitting your assets among different investment categories helps you weather the ups and downs that are part of the investing cycle. For example, bonds and cash may add balance to your portfolio.

Investors often use the terms “diversification” and “asset allocation” interchangeably; however, asset allocation is a much more thoughtful process. Diversification means not investing solely in any one investment category. Asset allocation takes that one step further and assigns specific percentages to each category.

A general guideline is that younger investors can afford to be more aggressive because they have more time to ride out short-term drops in the market cycle. Older investors may be more comfortable with a conservative plan, particularly as they get closer to retirement. The more time you have, the better chance you have to reach your goals.

Things to Remember:

• Asset allocation is the process of splitting your investments among stocks, bonds, and cash.
• A properly balanced portfolio can help protect you from severe market fluctuations.
• Risk tolerance plays a big role in portfolio selection.

Things to Do

• Look at your portfolio at least once a quarter for proper balance – more frequently in turbulent markets.
• Examine your current holdings and figure out the percentage you have invested in each category: stocks, bonds, and cash, and ask yourself if you are comfortable with that mix.

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Buy Stock or Buy Mutual Funds

Buy Stock or Buy Mutual Funds
Buy Stock of Individual Companies or Buy Stock via Mutual Funds

Answering the question of whether to buy stock of individual companies or buy stock via mutual funds, takes an exploration of your objectives and your willingness to take risk. If you understand the risks and rewards of investing in stocks, and you have the ability and willingness to take risk, then the next step is to decide if you would like to buy stocks of individual companies or buy stock via mutual funds.
Buy Stock of Individual Companies: Pros and Cons

If you are considering buying stocks of individual companies consider both the pros and cons versus the pros and cons of mutual funds.

Buy Stock of Individual Companies: Pros

* Control: You decide which stocks you buy, sell and hold in your stock portfolio.
* Ownership: When you buy stock in individual companies you have an ownership stake in the company.
* Ease of Execution: With the advent of the internet, there are dozens of discount and full service brokers where you can buy stocks online and/or with the assistance of a financial advisor.
* Cost: The competition amongst brokers (discount and full service) has driven the price to tens of dollars per trade. The cost generally depends upon the size of your portfolio with the broker, number of trades per month/year, number of shares you buy/sell, and whether you trade online or with an advisor.

Buy Stock of Individual Companies: Cons

* Lack of Diversification: If you decide to buy stock of individual companies, it is generally difficult to diversify your account to the same degree as if you buy stock via mutual funds. If you buy stock in individual companies you should be prepared for more volatility than if you buy stock via mutual funds.

* Resources: If you decide to buy stock of individual companies on your own, then it will take time, energy and dedication. It will also take research, patience and, sometimes, trial and error.

Buy Stock via a Mutual Fund: Pros and Cons

Mutual funds are an investment that allows investors to pool their money and hire a portfolio manager. The manager invests this money (the fund’s assets) in stocks, bonds or other investment securities (or a combination of stocks, bonds and securities). The fund manager then continues to buy stocks and sell stocks and securities according to the style dictated by the fund’s prospectus.

Buy Stock via a Mutual Fund: Pros

o Diversification:
The beauty of a mutual fund is that you can invest in a single mutual fund and obtain instant access to a hundreds of individual stocks or bonds.

o Professional Money Management:
Many investors don’t have the resources or the time to buy stock of individual companies. Investing in individual securities, such as stocks, not only takes resources, but a considerable amount of time. By contrast, mutual fund managers and analysts wake up each morning dedicating their professional lives to researching and analyzing current and potential holdings for their mutual fund.

o Systematic Investing and Withdrawals:
It is simple to invest regularly in a mutual fund. Many mutual fund companies allow investors to invest as little as $50 per month directly into a mutual fund. Money can be pulled directly from a bank account and invested directly in the mutual fund. On the other hand, money can be regularly withdrawn from a mutual fund and be deposited into a bank account. There are generally no fees for this service.
o Low Minimums:
Many mutual fund companies allow investors to get started in a mutual fund with as little as $1,000. Schwab’s mutual fund family has a minimum of $100 for many of their mutual funds.
Buy Stock via a Mutual Fund: Cons
o Management Fees: You get what you pay for. If you want to take advantage of the pros of mutual funds, you must pay for it.
o Choices: If you decide to buy stock via mutual funds you will find, odd as it may sound, more mutual funds to choose from than individual stocks trading on the New York Stock Exchange. Be prepared to spend time and resources in order to buy mutual funds and manage your portfolio.
Buy Stock or Not to Buy Stock

If you are investing for growth, whether or not you buy stock of individual companies or you buy stock via mutual funds, there will be patches of volatility. Prior to making the decision of which route, be sure to understand the pumps in the road, and whether or not you are willing to stay on the path.

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3 Must Read Guidelines On Rebalancing Your Portfolio

3 Must Read Guidelines On Rebalancing Your Portfolio
Once you decide on a long term investment strategy, you must commit to sticking with it. Develop rebalancing guidelines up front: rules that tell you how and when you will change your allocation.
Rebalancing Guideline #1– Automatic or Manual Rebalancing?

The Automatic Approach
Automatically rebalancing suggests that you rebalance your portfolio at the same time each year, to its starting target allocation, regardless of market conditions. It works like this:

Example: Assume your allocation is 50% stocks, 50% bonds. In years when the stock market is doing well, as equity values swell, your account may grow to a point where it is now 60% stocks/40% bonds. Rebalancing forces you to take profits from equities and buy bonds.

On the flip side, after bear markets, with equity values shrinking, your allocation may morph into 40% stocks/60% bonds. Rebalancing will force you to sell bonds and buy equities at bargain prices.

For most investors, this disciplined approach works best, and rebalancing once a year makes the most sense.

The Manual Approach
For investors taking a more active role, rebalance after periods of extreme returns in the market (equities up in excess of 20%), or just after times where you have experienced excess market losses (equities down more than 20%). This will force you to sell high and buy low.

This active approach is manual – rather than happening at the same time each year, you must initiate it based on market conditions. Using this approach you may only rebalance every other year, after extreme market moves, rather than automatically at a set time.

For an added twist, instead of rebalancing to your starting target allocation, use the two rebalancing guidelines below to force you to buy more equities when the market is down, and sell more equities when the market is up.

Rebalancing Guideline #2 - When To Become More Conservative

During bear markets, people’s appetite for risk decreases. They decide they only like risk when it is working in their favor. They make a decision to rebalance to a more conservative allocation.

If they had been 70% equities, perhaps they decide they only want 50% of their portfolio in equities. In this way, the hurt themselves by selling low, and abandoning their well thought out strategy at the worst possible time.

I would suggest that you decide that you will only rebalance to a more conservative portfolio after a year of excess equity returns. This simple rule will keep you from selling stocks at a low point – as in during an extreme bear market.

At year end, if equity markets are up 15% or more, that would be the time to consider rebalancing to a more conservative allocation.

If you are within five years of retirement, accelerate this plan. Instead of waiting until a year where the market is up 15%, shift assets to a more conservative allocation after years where the market is up 10%.
Rebalancing Guideline #3 - When To Become More Aggressive

The time to buy is when everyone else is selling. After extreme bear markets, consider increasing, rather than decreasing, your equity holdings.

At year end, if equity markets are down 15% or more, that would be the time to rebalance to a more aggressive allocation. Once markets recover, use Rebalancing Guideline #2 to tell you when to switch back to a more conservative portfolio.

If you are within ten years of retirement, take caution when using this guideline, or scrap it all together. If you do implement it, only become more aggressive if equity markets are down in excess of 25%. And then be quicker to rebalance back to a more conservative allocation after markets recover.

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Five Questions to Ask Before Buying a Mutual Fund

Five Questions to Ask Before Buying a Mutual Fund
You may feel intimidated by the task of picking a mutual fund. With more than 15,000 funds to choose from, it's tempting to buy a magazine or visit a Web site that will tell you exactly which funds you should buy, or to just pick the fund that's topping the performance charts.

These aren't the best ways to find the fund that will meet your goals or suit your investment personality, however. The next section will give you a better idea of how to approach the vast marketplace for mutual funds and will introduce five questions that you need to ask and answer before buying any stock fund.

1. How has it performed?
2. How risky has it been?
3. What does it own?
4. Who runs it?
5. What does it cost?

These questions form the foundation of Morningstar's approach to fund selection. We'll address these questions in depth in subsequent lessons, but here's a taste of what's to come.

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How to Choose a Mutual Fund

How to Choose a Mutual Fund
The average mutual fund investor tends to fare significantly worse than the average mutual fund. How so? Well investors tend to let their emotions get the best of them – and dash in and out of funds at precisely the wrong moments. You know how it goes -- you want to buy when the market is hot and sell when it’s going to pieces. If you simply create a well-diversified portfolio of stock and bond funds and left them alone, you’d be much better off.

As long as you do your homework upfront…

Everyone’s tempted to base their fund buying decision on a fund’s performance, but that shouldn’t be the only factor you consider. Today’s star performer could easily become tomorrow’s laggard. Here are some guidelines:

1.) Fit. To get started with mutual funds, you need to figure out what mix of stocks and bond funds best suits your objectives. The right mix depends on how long you’re going to invest your money for and how much risk you like to take on. Check out this asset allocation calculator which helps you figure out what types of investments you should make. Once you figure out your strategy, you’re ready to evaluate which particular funds will help you achieve its goals.

2.) Index Funds versus Active Funds. Consider whether you’re comfortable using index funds or whether you want to use actively managed funds.

Index funds are much cheaper to run, since, for one, the managers don’t have to travel around researching companies trying to find the right stocks to buy.

That cost advantage gives index funds a huge leg up compared with their actively-managed counterparts. Take, for instance, an actively-managed fund that skims 1.3% of your invested dollars off the top of your money pile each year. Instead of investing in that fund, you could have invested in an index fund that charges just 0.10% a year in fees. That means the active manager needs to do at least 1.2% better than the index fund each year to make up the difference. It ain’t easy, and most active fund managers fail at this task.

You probably have better things to do than spend hours upon hours tracking fund performance and searching for good active managers. But if you take pride in picking out active funds, then go for it. Just realize that your chances of picking funds that actually beat the market, or the index fund that tracks it, are really slim over the long haul.

Sometimes you might not have a good index fund to invest in – not all retirement plans offer them (if your 401k doesn’t offer index funds on the investment menu, ask your employer to add them).

3.) Expenses. This is the one piece of your fund’s performance you can control since costs directly impact your returns over time. There are a few different kinds of fees you need to consider:

a.) Expense Ratio - is the money skimmed from your account that goes towards paying a fund’s total annual expenses. It’s expressed as a percentage of a fund’s net assets. So, if you’re in a fund with an expense ratio of 1.0%, and you have $3,000 invested in that fund, you’ll pay $30 a year in expenses. An expense ratio of 0.10% will only cost you $3.

The average actively-managed fund carries an expense ratio of 1.31%, while the average index fund costs 0.74%, according to Morningstar. But paying the average doesn’t necessarily mean you’re getting a good deal. You can get the most bang for your buck with broad-market index funds: the Vanguard Total Stock Market Index, an index fund that tracks an index (MSCI US Broad Market Index ) representing the entire U.S. stock market, carries an expense ratio of 0.19%. Meanwhile, the Fidelity Spartan Total Market Index, which tracks another index that represents the entire stock market, is even lower at just 0.10%.

b.) Load - is a sales charge attached to the purchase or sale of a mutual fund. Try to avoid these fees. They usually pay financial professional involved in the transaction, like a stockbroker. If a broker is selling a fund, it’s most likely a load fund.

A “front-end load” is charged when you buy shares of the fund, whereas a deferred, or “back-end load,” is levied when you sell your shares. Back-end loads may gradually decline and disappear the longer you hold the fund, but another type of sales charge typically offsets that.

The average front-end load clocks in at 5.01%, while the average back-end stands at 4.67%, according to Morningstar.

There is such thing as a no-load fund – which is a mutual fund where shares are sold without a commission of sales charge. These funds are usually sold by the mutual fund company rather than a second party.

c.) 12b-1 fees - were first charged by mutual fund companies to investors in the 1980’s when mutual funds were new and struggling; they covered costs associated with marketing and distributing the fund. Today, the mutual fund industry is doing just fine; the fee is now paid to brokers for selling the funds (much like a load). It’s included in the fund’s expense ratio.

Funds with 12b-1 fees greater than 0.25% are also considered load funds, according to the Investment Company Institute, a mutual fund trade group.

d.) Redemption fees - are charged when a shareholder exits a fund before a certain period of time elapses; they were installed to discourage rapid trading in and out of funds. The time period varies, but is usually 30, 180 or 365 days. The fee doesn’t go into the fund company’s coffers, but into the fund itself, according to Morningstar.

4.) Fund company and manager. How long has the fund (or index) been around? How long has the manager been running the fund? Does the fund company have a long-standing solid reputation?

5.) Volatility. Are there a lot of sharp zigs and zags in the fund’s performance or are returns more consistent over time? All funds take on a certain degree of risk, but volatile funds tend to be more risky. You can usually find historical returns on the fund company’s website or on a site like Morningstar.com (you can find returns and other basic information for free, though more detailed information requires a subscription).

6.) Performance. Be sure to look at the funds’ 3-year, 5-year and 10-year records. You don’t want to invest in an unproved fund that only has a year or two of performance history.

Compare the fund to its relevant market index, otherwise known as its benchmark. This is a yardstick against which investors evaluate a fund’s performance. Index funds try to match the benchmark while actively managed funds try to beat it (make sure they’re beating in NET of fees.) A common benchmark for U.S. stock funds is the S&P 500 index fund. The Lehman Brothers Aggregate bond index is often used as a benchmark for U.S. bond funds.

Check out how the fund has weathered downturns in the market (you can tell when the downturns were by finding where the benchmark veered south).

With newer funds, be wary of “back-tested” results, or results the fund may have achieved in the past if it existed at that time. The fund company could’ve have chosen the best time periods to make the fund look like it did better than it might actually have done.

7.) Taxes. If you’re investing in a taxable brokerage account (as opposed to your retirement accounts, like an IRA or 401k, where you generally don’t pay taxes until you start withdrawing money) you’ll want to evaluate the fund’s portfolio turnover, which can trigger taxable gains.

Portfolio turnover is a rough measure of how often a fund manager buys and sells securities within the fund. The more often a portfolio turns over, or churns, the more trading costs it incurs (trading costs are fees the fund pays to buy and sell its shares). It may also trigger taxable capital gains, which it distributes to you at the end of the year; you report those profits (if any) to the IRS and may owe taxes.

That’s why if your fund is in a taxable account, you generally want to look for funds with turnover of less than 25%, says Christine Benz, director of mutual fund analysis at Morningstar, preferably in the single-digits. A 100% turnover rate means assets equal to the fund’s entire portfolio were sold during the year. Lower turnover indicate the manager is using a longer-term strategy of buying securities and then holding them for a while (buy-and-hold, in investing language). Taxable investors also want to be on alert if a fund’s manager changes, she adds, because the new manager might sell securities with big gains.

Naturally, some funds are more prone to higher turnover: a small-cap growth fund chock full of volatile stocks is going to experience a lot more churn than a retirement-focused fund.

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Choosing an Actively Managed Fund

Choosing an Actively Managed Fund
It's like asking a vegetarian to name his favorite cut of beef.

Market-tracking index funds regularly beat most actively managed funds, institutional investors have a third of their stock-market money indexed, and the proposed Social Security private accounts will likely be limited to a menu of index funds. Yet ordinary investors seem oblivious to indexing's success, continuing to keep 86% of their money in actively managed stock funds.

Still hunting for the next superstar stock fund? Trust me, you need all the help you can get, so I called on the collective wisdom of an unlikely group of experts -- some of my fellow index-fund investors.

Their advice: If you are going to buy actively managed funds, stick with funds that have a long-term focus -- and which seek shareholders with the same mentality. To that end, consider these nine criteria. If a fund meets at least seven of the nine, you may have yourself a winner.

1. Cutting costs. If you use a commission-charging broker, you will end up in load funds. If you invest on your own, you should buy no-load funds. But either way, you want stock funds with annual expenses below 1.5% and preferably below 1%, thus ensuring you keep more of whatever your funds make.

Annual expenses are also an excellent indicator of management's attitude toward shareholders. If a fund is hosing you on expenses, it probably doesn't have your best interests at heart.

2. Sitting tight. William Bernstein, an avid indexer and author of "Four Pillars of Investing," argues that low portfolio turnover is as important as rock-bottom annual expenses and no sales commission.

"What you want in an actively managed fund is a real fear of trading costs," he says. "The markets are really very efficient and you don't want to mess with them too much." That's why he likes companies such as Dodge & Cox and Tweedy, Browne Co., both of which offer actively managed funds with notoriously low turnover. As an added bonus, low-turnover funds are typically more tax-efficient.

3. No billboards. Mr. Bernstein also prefers funds that rarely or never advertise, because heavy advertising is a sign that management's chief focus is hauling in a heap of assets.

4. Case closed. Similarly, look fondly on companies that regularly close funds that grow too fast or get too large. Such closings indicate management is willing to sacrifice its own bottom line for the sake of shareholders.

Also try to limit yourself to smaller funds, favoring large-cap funds with less than $5 billion in assets and small-cap funds with less than $500 million. "Once a fund gets too huge, it becomes impossible to beat the market, because the fund is forced to own the market," argues Larry Swedroe, an investment adviser in St. Louis and author of four books, all of which advocate indexing.

5. Keeping it private. John Bogle, founder of Vanguard Group in Malvern, Pa., and the fund industry's most famous proponent of indexing, advises sticking with fund companies that are privately held, rather than publicly traded.

The reason: Fund managers who are part of stock-market-listed companies are often under pressure to deliver regular earnings and revenue growth. That can drive them to engage in dubious tactics like promoting top-performing funds and bringing out new funds in hot market sectors.

6. Limited selection. Mr. Bogle is clearly a staunch supporter of Vanguard, which now has 110 varieties of fund. But he says a more limited array of funds is often a good omen, because it suggests a company isn't greedily trying to pull in assets by offering funds in every possible category.

7. Weighing results. Investors typically put the most weight on past performance. That's understandable. If you are going to buy an actively managed fund, you want evidence the manager is talented, such as a sparkling five or 10-year record. Still, because past performance is such a rotten guide to future results, never pick a fund on performance alone.

8. Counting stars. If you buy a fund with strong performance, make sure the manager responsible for the record is still at the helm. You might even protect yourself against manager turnover by favoring funds run by investment teams.

Mr. Swedroe says team-run funds are also less prone to "style drift," shifting into different market sectors and thereby messing up your portfolio's diversification. Among team-run funds, he likes American Funds, Dodge & Cox, Tweedy Browne and Vanguard Windsor and Windsor II.

9. Erratic behavior. One reason I like index funds is they offer greater certainty. Whatever the underlying index delivers, that is the performance you should get.

By contrast, you want actively managed funds to have inconsistent performance. As Mr. Bogle notes, for funds to beat their category's benchmark index, they need to hold a selection of stocks that is different from the index. With any luck, those stocks will outperform. But because their portfolios don't look like the market, "good managers are going to have inconsistent performance," he says.

Which fund companies meet Mr. Bogle's various criteria? He mentions Dodge & Cox, Oakmark Funds, Royce Funds, Torray Funds and Weitz Funds.

Mutual Admiration

Index-fund aficionados praise actively managed stock funds at these fund families.

FUND COMPANY PHONE

American Funds 800-421-0180

Dodge & Cox 800-621-3979

Oakmark Funds 800-625-6275

Royce Funds 800-221-4268

Torray Funds 800-626-9769

Tweedy Browne 800-432-4789

Vanguard Group 800-662-7447

Weitz Funds 800-232-4161

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Past Performance is No Guarantee of Future Results

Past Performance is No Guarantee of Future Results
Famed hockey player Wayne Gretzky summed up his secret to success when he said, “go where the puck will be, not where it is.” When analyzing a company or mutual fund, many investors would do well to heed the same advice. Instead, they suffer from what is known in the business as “performance chasing”. As soon as they see a hot asset class or sector, they pull their money out of their other investments and pour it into the new object of their affection. The result is much akin to someone chasing lighting – they go where it has struck and then wonder why they continue to compound at lower than average rates of return; a tragedy that is exasperated by frictional expenses.

As the late Benjamin Graham, father of value investing, pointed out to his readers, past performance is useful in calculating the value of a stock, bond, mutual fund, or other asset only so far as it is indicative of what is to come in the future. Often, the very best time to invest in a particular area is when it has suffered from horrific industry trends over the recent past. Take the oil sector, for example. In the late 1990’s, black gold was trading at $10 a barrel and very few analysts saw an end to the energy sector’s woes. Yet, over the past six years, an investor in refiners such as Valero or an integrated giant such as Exxon Mobile have experienced wonderful returns.

How can you help ensure you aren’t guilty of jumping into a hot sector? Ask yourself the following questions.

* What makes me think the earnings of this company will be materially higher in the future than they are at the present time?

* What are the risks to my hypothesis of higher earnings? How likely is it that these theoretical risks will become actual realities?

* What were the original causes of the company’s underperformance? If it was in any way linked to aggressive accounting, what makes you sure that the situation has been permanently resolved and integrity restored to the firm? If it was an industry specific problem, what makes you think that the economics going forward will be different? A temporary supply and demand situation? Lower input costs?

* Has this particular sector, industry, or stock experienced a rapid increase in price in recent history? Knowing the principle that price is paramount, does this still make the investment attractive? Have the prospects for better earnings already been priced into the security?

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Choosing a Target-Date Mutual Fund

Choosing a Target-Date Mutual Fund

Target-date mutual funds were created more than 10 years ago and billed as a simple, one-size-fits-all investment solution. But is anything ever quite that easy? The simple answer, of course, is, “No.”

Why Own a Target-Date Mutual Fund?

If you plan to retire in 20 years, you might consider buying a target-date mutual fund that matches your time frame -- that is, a fund with a target of 20 years. As you approach your retirement date, the fund moves its allocation away from riskier, but often higher-rewarding mutual funds (with holdings like equities) to more conservative mutual fund investments (with holdings like bonds and cash). The idea is to save you from having to ensure that your portfolio is re-allocated based on your changing needs: Let the fund do all the work.

The target-date mutual fund's re-allocation over a predetermined period to reflect investors’ changing tolerances for risk is known as the target-date fund’s "glide path." This glide path sets the fund’s allocation among various asset classes over time, adjusting the mix from more aggressive investments early in the life of the target-date fund to more conservative investments as the fund matures and investors approach their target retirement date goal.
Analyzing Target-Date Mutual Fund Options

If you are counting on target-date mutual funds as a simple solution to your retirement investments, be careful. Just as with any investment, you need to do some homework first. All target-date mutual funds are not all created equal.

Funds with identical target dates may have very different asset allocations. For instance, the T. Rowe Price Retirement 2030 Fund has 66% invested in equities at the target date, while the Vanguard 2030 Retirement Fund has 50% invested in equities at the target date. While the two funds have the same target date, the asset allocation at the target date is drastically different. You need to carefully determine your comfort level with the target-date fund's current asset allocation and be aware of the fund's higher/lower equity allocation at your target date. One size does not fit all.

When looking for the right target-date mutual fund for you, consider the following:

* Asset allocation --
Look carefully at your target-date fund’s allocation between equities, bonds and cash, and examine how these holdings change as the fund moves closer to your target date and beyond. Remember that in the example described above, the allocation among various asset classes can be different from fund to fund.
* Diversification --
Does the fund predominantly invest in US stock funds or is a portion invested in international stock funds, emerging market stock funds and hard asset funds? Does the target-date fund allocate a portion of your assets to Treasury Inflation-Protected securities or does it stick with plain vanilla bond funds.
* Quality of Underlying Funds --
Look at the funds within the target-date fund. Are they mediocre, or do they have a reasonable track record when compared against their peers?
* Fund Families --
Does your target-date fund invest in funds outside of the fund's fund family? In other words, if you buy a target-date fund from Fidelity, does it only invest in Fidelity funds or does it look to other fund families to manage a portion of the fund? Often times, one fund family specializes in one particular investment style (equities for example) while another fund family may specialize in another investment sytle (bonds for example).
* Expenses --
with any investment, costs should always be a consideration. Is your target-date fund a no-load fund, or is there a front-end or back-end load associated with the fund? How does the expense ratio of the fund compare with other target-date funds? While it's never a good idea to simply purchase a fund because it has the lowest cost structure, your target-date fund's costs should be carefully weighed along with the benefits.

Unfortunately, there is not a simple solution to choosing the right target-date fund. Like any proper investment, you must do your homework by researching and understanding the asset allocation, diversification, underlying funds, and cost structure. A little research, will put you a long way toward finding the right fund for you.

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In this Corner Money Market vs. Certificate of Deposit

In this Corner: Money Market vs. Certificate of Deposit
One of the biggest questions investors face is, "what do I do with my cash when I'm in-between investments?". This article seeks to examine two of the most popular choices - certificates of deposits and money markets - and weighs the pros and cons of each.

In the left corner: certificates of deposit

Certificates of deposit (or CDs for short) are debt instruments issued by banks and other financial institutions to investors. In exchange for lending the institution money for a predetermined length of time, the investor is paid a set rate of interest. Maturities on certificates of deposit can range from only a few weeks to several years with the interest rate earned by the investor increasing in proportion to the time his capital is tied up in the investment.

Pros:
The investor can calculate his expected earnings at the outset of the investment. Certificates of deposited are FDIC insured for up to $100,000 and offer an easy solution for the elderly who desire only to maintain their capital for the remainder of their life.

Cons:
If the investor opts for a longer maturity and, thus, higher rate of interest, he will lose access to his funds and forgo alternative uses of his capital.

In the right corner: money markets

Money markets, on the other hand, offer many of the same benefits as certificates of deposit with the added features of a checking account. Technically speaking, a money market is more or less a mutual fund that attempts to keep its share price at a constant $1. Professional money managers will take the funds deposited in the money market and invest them in government t-bills, savings bonds, certificates of deposit, and other safe and conservative financial instruments. This income is then paid out to the owners of the money market.

Investors can open a money market account at most financial institutions. They generally receive a checkbook with which they can draw upon funds in the account.

Pros:
Depositing money in a money market is as easy as depositing cash into a savings or checking account. Cash is immediately available for alternative investments.

Cons:
Some financial institutions place a limit on the number of checks that can be drawn against the account in any given month. The rate of interest is directly proportional to the investor's level of deposited assets, not to maturity as is the case with certificates of deposit. Hence, money markets are disproportionately beneficial to wealthier investors.

The verdict
Although both can be useful, for those who need access to their capital, money markets are far superior. Many brokerage houses automatically sweep their customer’s uninvested cash into money markets to earn interest between investments. This is the ideal solution if you regularly invest because the funds can be used immediately to purchase stocks, bonds, or mutual funds.

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Money Market Funds

Money Market FundsDefinition: Money markets refer to money market mutual funds, which invest only in low-risk securities such as government securities, certificates of deposit, or commercial paper of companies. For that reason, they are usually considered very low risk. Since they are low risk, and they generally invest in short-term securities, they pay very low dividends or interest that usually reflects short-term interest rates.

Unlike mutual funds that are invested in stocks, money market funds usually try to keep the net asset value of (NAV) of each share at a dollar. Therefore, the value of the money market fund is dependent on the yield or interest rate, which does vary. It is very rare for the NAV to fall below a dollar, called breaking the buck, but it can happen if the investments do poorly.

This is what happened on September 16, 2008, to the $62 billion Reserve Primary Fund, the nation's oldest money market fund. The money market had invested in Lehman Brothers short-term debt, and when that investment bank went bankrupt, Reserves NAV dropped to 97 cents. Since it was first money fund in 14 years to break the buck, it caused panicked investors to withdraw $139 billion out of money market funds in the next two days, according to IMoneyNet.

As a result, on September 19, 2008, the Treasury Department stepped in to guarantee money market funds. This run on money market funds made Treasury Secretary Henry Paulson realize that credit markets were shutting down, and he needed to submit the $700 billion bailout bill to Congress. On October 21, the Federal Reserve agreed to buy assets from money market funds who needed cash to pay for redemptions. (Source: SEC, Money Market Funds)
Also Known As: Short term debt funds

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Money Market Safety - The Basics of Money Market Safety and Risk

Money Market Safety - The Basics of Money Market Safety and Risk
In recent years, money market accounts have become popular alternatives to CD’s, short-term bonds, and classic savings accounts. In large part, this increase has been fueled by competitive yields, daily access to the money, and until recently, a sense of safety and stability. Many investors have discovered however, that even money market funds offered by the top banks and brokerage houses are not immune to a loss in value or liquidity.

While investors holding money market funds that have “broken the dollar” mark or become illiquid may be tempted to hunt down their broker or banker, they may not have much of a case. The reality is that most money market funds, though they seem very safe, are in fact mutual funds that can lose value just like any other mutual fund. This important fact, along with many others, is disclosed in accordance with SEC regulations in the prospectus that all investors are supposed to be delivered at or before the time of their initial purchase.

To help you keep your portfolio out of the red, here are some important facets every investor should understand about money market safety.

Mutual Fund Structure

True money market funds are not savings accounts but mutual funds. Instead of a bank loaning out your deposit and paying you part of the interest they earn, a money market fund actually uses your money to buy into a large pool of very short-term bonds. Depending on the type of money market fund, this pool of investments may include government bonds, corporate bonds, or municipal bonds.

Unlike most stock and bond mutual funds whose share price fluctuates, money market funds attempt to maintain a stable share price (also known as net asset value) of $1.00 per share. By keeping a stable share price of $1.00, investors get the sense that they can take out tomorrow what they put in today, with virtually no risk.

Money markets however, are not without risk. Since they ultimately represent a pool of assets owned by multiple investors, they are subject to a number of factors that could drive their share price below $1.00, creating a loss.

The largest factor that would likely contribute to a money market fund “breaking the dollar” barrier would be if enough of the assets in the underlying investment pool declined in value or became worthless. In other words, if the companies whose bonds the money market fund owns gets into financial trouble, those bonds will decline in value or become worthless. That in turn, causes each investor’s proportionate piece of the money market fund to also decline in value.

Another factor that might contribute to a loss in value is a rush on redemptions by the people invested in the money market fund. Since the majority of the money in a money market fund is invested in short-term bonds that mature at some point in the future, it’d create a major problem if a large number of investors wanted their money all at once.

Large simultaneous withdrawals could force a money market fund to sell some of its prior to their maturity date, which can also lead to a decline in the value. This can occur even in money market funds that only invest in U.S. Treasury securities, since the U.S. Treasury only backs securities held until maturity.

FDIC Insurance

Despite what many investors think, most money market funds are not FDIC insured. Even money markets that are offered through FDIC insured banks are not necessarily insured. Remember, a money market fund is a mutual fund that is subject to loss because of conditions in the investment market, just like any other stock or bond mutual fund. FDIC and SIPC insurance only cover accounts that are at risk because your banking or brokerage institution is going out of business. They do not protect you against poor investment choices or recommendations.

Some banks do offer FDIC insured money market accounts, but this is the exception more than the rule. To make sure your investments are covered, you need to ask your banker or broker specifically about FDIC insurance, as well as ask for a prospectus.

Doing Your Homework

The most important thing every money market fund investor should do visit one of the main mutual fund rating sites such as S&P or Fitch’s. If you’re looking for a safer place to park you cash assets, you should settle for nothing less than a top-rated money market fund.

Additionally, the SEC requires money market funds to regularly disclose a number of important facts, including their most recent list of holdings. Every investor should visit the corporate websites of money market funds they’re considering and review the funds’ most recent holdings. Be on guard for funds that own bonds from other companies or government agencies that have recently reported negative financial news.

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Money Market Funds vs Money Market Accounts

Money Market Funds vs Money Market Accounts
Money market accounts are bank alternatives to money market mutual funds. What’s the difference? The main factors are risk and choices. Let’s do a comparison of money market funds vs. money market accounts so you can make the best choice.
Money Market Accounts
Money market accounts are your plain-vanilla option. They’re what you’ll find at a bank. Money market accounts should pay you a nice annual percentage yield (APY) while keeping your money safe.
Money Market Funds

Money market funds are more complex – you’ll find more options and you’ll likely earn a slightly higher yield than you’d get from a money market account. Some examples of money market fund options are:

* US Treasury backed money market funds
* US government and agency backed money market funds
* Municipal money market funds
* Local municipal money market funds
* Socially responsible money market funds

The options listed above allow an investor to choose the money market instruments used in the fund. Some people are only comfortable with securities backed by the US government. Likewise, some people use municipal money market funds in order to earn tax-free income.
Safety First
For some investors, safety is more important than high returns. If you agree, you should stick with money market accounts. Money market accounts offered by banks are typically FDIC insured (although you should check with your bank and the FDIC for details).

If money market accounts are FDIC insured, it’s only fair that they would offer a slightly lower rate than a money market fund.
Money Market Account or Money Market Fund?
Which should you use? It depends on what you want. Money market accounts have their place, as do funds.

The main thing is to consider your needs. If you don’t need the options available from funds, just use a money market account. You should get a competitive return from a money market account, and you can sleep at night knowing that you’re taking less risk.

In addition, you should consider how much time and energy you’re willing to invest. Money market accounts will be easier to find at standard banks. For a money market fund, you may have to open an account with a brokerage firm or mutual fund company.

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The Basics of Money Market Funds

The Basics of Money Market Funds
(LifeWire) - Over the years, most investors have come to regard their money market funds as nearly the same as cash, and for good reason -- most of them have performed like cash checking accounts and paid a bit more interest.

It's important to remember two points, though:

• Money market funds are not cash and can suffer losses, although they rarely have.
• Unlike a bank deposit, money market funds are not insured by the federal government.

What is a Money Market Fund?

A money market fund is a mutual fund that invests in ultra-conservative bonds and other short-term debt instruments. The goal of all money market funds is to keep their share price at $1, while paying a bit of interest to their shareholders.

Securities and Exchange Commission rules prohibit money market funds from investing in any kind of debt security with a maturity date longer than 90 days. The types of debt that any given fund holds could range from totally secure short-term US Treasury Bills to slightly riskier corporate debt, including bonds, overnight paper and other more exotic instruments.

How Safe Are Money Market Funds?

Although more than $3 trillion was held in money market funds as of spring 2007, investor losses have been minimal. Between 1993 and 2008, only two money market funds in the US had fallen below $1 per share -- known as "breaking the buck" -- in part because most firms that issue money market funds are willing to defend them with their own capital if the funds suffer temporary losses.

For total security, investors can turn to similarly named money market accounts, which are bank-issued savings accounts insured up to $250,000 through 2009 by the Federal Deposit Insurance Corp. (The FDIC coverage is scheduled to drop back to $100,000 on Jan. 1, 2010, unless Congress acts to make the $250,000 limit permanent.) Because of the lower risk, money market accounts rarely pay interest rates as high as a money market fund.

Despite the occasional hiccups, money market funds can be the best place for most investors to park short-term cash, given their statistical safety and relatively higher returns.

Types of Money Market Funds

There are two main types of funds: taxable and tax-exempt.

• Taxable funds: These invest primarily in the private debts of corporations. The most conservative ones stick with blue-chip companies, but some venture into the riskier debts of lower-rated companies in pursuit of higher interest rates.

• Tax-exempt funds: These invest in debts issued by the federal government or those issued by a mix of federal, state and local governments. Depending on the investor's state of residence, they may generate interest that's partially or totally tax-exempt. Because of their lower risk, they generally offer lower interest rates than taxable funds.

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Advantages of Money Market Funds

Advantages of Money Market Funds
If you have a mattress full of money, you might want to consider purchasing a money market fund. A money market fund offers similar protection as the mattress, but offers the benefit of paying a yield on your money.

What Is a Money Market Fund?

A money market fund is a mutual fund that invests in short-term, high-quality fixed income securities. The goal of a money market fund is to have a net asset value that does not deviate from $1 per share. In other words, if you invest $1,000 in a money market fund, the goal is to return $1,000 plus a nominal yield (generally close to 90 day T-bill rates). Losses in money markets have been rare, but, unfortunately, they have occurred.
Money market funds are regulated by the US Securities and Exchange Commission (SEC). The SEC seeks to assure that risks are limited and investors’ interests are protected. SEC Rule 2a-7 governs several areas:

Maturity of Holdings:
Money market funds cannot hold investments with a maturity of greater than 397 days. The weighted average maturity of the portfolio cannot exceed 90 days.

Credit Quality:
No less than 5% of a money market fund’s holdings may be in investments that are in the second-highest short-term rating categories.

Diversification: Money market funds are required to maintain a diversified portfolio. A money market fund cannot have any one holding that exceeds 5% of the value of the fund (with the exception of US Treasury and government agency holdings).

Advantages of Money Market Funds

The regulation of money market funds is the key to several advantages:

Safety:
Preservation of capital the objective of money market funds. While a few money market funds have broken the buck (gone below $1) in most cases, the fund company or sponsor has stepped in to absorb the losses.

Liquidity:
Money market funds provide excellent access to cash. Most brokerage accounts, including Schwab and Fidelity, offer a money market fund as a sweep option. In other words, when an investment is bought/sold money comes out of/goes into, the money market fund.

Yield:
Money market funds pay a yield based on the holdings of the underlying fund. The yield is generally automatically reinvested into the fund via purchase of additional shares in the fund. This yield makes money market funds an attractive alternative to the mattress.

As with all investing, it is recommended that you read the prospectus, along with other available shareholder reports and information.

See more About this :http://mutualfunds.about.com/od/moneymarketfunds/a/advmoneymkt.htm

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The Three General Types of Mutual Funds

The Three General Types of Mutual Funds

Mutual funds can generally be placed into one of three primary categories: stock, bond or money market. Many investors will diversify their portfolio by including a mix of the three.

Stock Funds

Stock funds, also called equity funds, are the most volatile of the three, with their value sometimes rising and falling sharply over a short period. But historically stocks have performed better over the long term than other types of investments. That’s because stocks are traded on the expectation that a company’s future results will include expanded market share, greater revenues and higher profits. All of that would increase shareholder value.

Generally stocks fluctuate because of investors’ assessment of economic conditions and their likely impact on corporate earnings. Socially responsible investors also factor in other risks to earnings such as exposure to fines or lawsuits from polluting the economy or discriminating against particular employees.

Not all stock funds are the same. Some common funds include:

• Growth funds, which offer the potential for large capital appreciation but may not pay a regular dividend.
• Income funds that invest in stocks that pay regular dividends.
• Index funds, which try to mirror the performance of a particular market index, such as the S&P 500 Composite Stock Price Index..
• Sector funds usually specialize in a particular industry segment, such as finance, health care or technology

Bond Funds

Bond funds, also known as fixed income, invest in corporate and government debt with the purpose of providing income through dividend payments. Bond funds are often included in a portfolio to boost an investor’s total return, by providing steady income when stock funds lose value.

Just as stock funds can be organized by sector, so too bond funds can be categorized. They can range in risk from low, such as a U.S.-backed Treasury bond, to very risky in the form of high-yield or junk bonds, which have a lower credit rating than investment-grade corporate bonds.

Though usually safer than stock funds, bond funds face their own risks including:

• The possibility that the issuer of the bonds, such as companies or municipalities, may fail to pay back their debts.
• The chance that interest rates will rise, which causes the value of the bonds to decline
• The possibility that a bond will be paid off early. When that happens within bond funds there is the chance the manager may not be able to reinvest the proceeds in something else that pays as high a return.

Money Market Funds

Money market funds have relatively low risks, compared to other mutual funds and most other investments. By law, they are limited to investing only in specific high-quality, short-term investments issued by the U.S. government, U.S. corporations, and state and local governments.

Money market funds try to keep their “net asset value” (NAV) — which represents the value of one share in a fund — at a constant $1 per share. But the NAV may fall below $1 if the fund's investments perform poorly.

Historically the returns for money market funds have been lower than for either bond or stock funds, leaving them vulnerable to rising inflation. In other words, if a money market fund paid a guaranteed rate of 3 percent, but over the investment period inflation rose by 4 percent, the value of the investor’s money would have been eroded by that 1 percent.

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Lifestyle or Target Date Funds Can Provide Easy Diversification

Lifestyle or Target Date Funds Can Provide Easy Diversification

If you invest in your company retirement plan then you are probably familiar with these types of funds. Some are created with a target retirement date, others are based on where you are in your financial life such as an Intermediate-Term Horizon or Long-Term Horizon fund. One of the benefits of these funds is that it makes investing very simple for people who do not want to worry about their investments or regularly make changes.

In a target date fund, the investments are automatically rebalanced and the allocations are adjusted as the target retirement date nears. This eliminates the need for the investor to actively make adjustments to their holdings. The lifestyle funds are also similar in the fact that they are a fund of funds approach that is based on an asset allocation suitable for that particular time frame, taking some of the work out of investing.

There Are Some Drawbacks

One common issue can be when you use one of these fund types as your core holding, and in an attempt to diversify you invest in a few other more specific funds or index choices. If you don’t know what your target or lifestyle fund actually holds, you could be simply duplicating many of your holdings and paying additional expenses to do so. The whole point of diversifying is to create a broad investment mix to maximize returns and reduce volatility. If most of your funds have a sizable amount of overlap, the diversification is not going to be as effective.

Ultimately these can be good investment choices, but only if you take the time to understand the fund, how it works and what positions it holds. Then you can make additional investment decisions that will best benefit your diversification and investment objectives without paying additional expenses for overlapping.

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A Primer on Treasury Inflation-Protected Securities

A Primer on Treasury Inflation-Protected Securities
Do you remember Wimpy? He was the Popeye’s cartoon character who understood that inflation erodes purchasing power. Wimpy made the famous and oft quoted offer, “I will gladly pay you Tuesday for a hamburger today.” He obviously understood inflation (or maybe he simply didn’t want to pay for his burger). His dollar was worth more today than tomorrow.

Wimpy battled inflation with his charm while in the real world, investors buy stocks. Another investment to fight inflation is Treasury Inflation-Protected Securities (TIPS). TIPS can be purchased from the US Treasury or on the secondary market (through brokerage firms and banks). You can also buy mutual funds that own TIPS.
What Are Treasury Inflation-Protected Securities?

The US Treasury began issuing Treasury Inflation-Protected Securities in 1997. TIPS are quite different than a typical US Treasury Bond.

Characteristics of TIPS are:

* Available with maturities of 5, 10 and 20 years
* Principal of the bond increases/decreases with the rate of the Consumer Price Index (CPI)
* Interest payments are a fixed percentage applied to an increasing/decreasing principal
* Principal adjustments and interest payments are made twice a year
* The adjusted principal or the original principal, whichever is greater, is paid to the investor upon maturity (if bought at par value at the initial offering/auction)

Example of a Treasury Inflation-Protected Security

Treasury Inflation-Protected Securities are very different from conventional bonds. A conventional fixed rate coupon bond makes coupon payments on the par amount (example: 5% annual interest payment on $1,000) and the par amount is returned at maturity of the bond. Not so with TIPS.

I have outlined an example of a TIPS investment from beginning to end. For the sake of simplicity, the example demonstrates a bond that is purchased at the US Treasury auction, at par value and with a steadily increasing Consumer Price Index.

* An investor goes to www.treasurydirect.gov and buys a five-year $10,000 Treasury Inflation-Protected Security at auction with a 1.00% coupon.
* The Consumer Price Index for the first period is 3% (a semi-annual rate of 1.5%)
* As a result of the CPI, the value of the bond is increased by 1.5% to $10,150.
* A coupon payment of $50.75 (50% of the 1.00% fixed coupon multiplied by the adjusted principal of $10,150) is made to the investor.
* At the end of calendar year one, the investor is taxed on the coupon payments and the adjustments to principal. This taxation is continued throughout the life of the bond.
* The investor continues to receive the coupon rate multiplied by the adjusted principal on a semi-annual basis (in this case the adjusted principal is increased by 1.5% every six months).
* At maturity, five years from the date of the auction, the investor receives the adjusted principal of $11,605.41 and the final coupon payment of $174.08 (1.5% on the $11,605.41).

Taxation of Treasury Inflation-Protected Securities

The example mentions that the investor is taxed on both the annual income and the amount of the adjusted principal (i.e., the increase in the principal amount due to CPI). The tax on the adjustment is referred to as “phantom income.” Many investors wisely choose to hold TIPS in a tax-deferred retirement account (e.g., IRA) to avoid the taxation. TIPS investors will receive a Form 1099-OID for the phantom income and a Form 1099-INT for the interest payments (if the TIPS are held in a taxable account).

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What Is a Sector Fund?

What Is a Sector Fund?
Concentrate and focus. No need to strain yourself; I’m describing a sector fund.

A sector fund is a mutual fund or exchange-traded fund that concentrates its investments in a single sector of the market. A sector is a slice of the market that is focused on the same line of business. For example, Bank of America is in the financial services sector, while Wal-Mart is in the consumer services sector.
Three Common Characteristics of Sector Funds

There are three characteristics that are common among sector funds:

1. Focused on stocks within a certain business or industry
2. Concentrated number of holdings
3. More volatile than the overall stock market

How Many Sectors Are There?

It depends who you ask. There are several organizations which have formally divided the market into various sectors and subsets of sectors. In other words, Wal-Mart is in the consumer services sector, but it can be further categorized as a discount store. Bank of America and Allstate are both in the financial services sector, but upon further categorizing, Bank of America is in the banking sector while Allstate is in the insurance sector. You can invest in most of these sectors through a mutual fund or exchange-traded fund.
Morningstar Sectors

As for sector fund investing, Morningstar takes a stab at labeling the various categories of sector
funds in eight categories:

1. Technology
2. Financials
3. Communications
4. Utilities
5. Natural Resources
6. Healthcare
7. Real Estate
8. Precious Metals

Trendy

Although Morningstar’s eight sectors are helpful in categorizing sector funds, the trend has been to identify an increasing number of sectors and create products (mutual funds, exchange-traded funds, etc.) based on those sectors. Your head might spin when you’re trying to pick a fund in the healthcare sector. In that case, you might run across a fund focused on identifying companies that develop products and services that detect and treat cancer. You can also buy a fund that focuses on investing in companies that manage nursing homes and hospitals.
Should I Invest in a Sector Fund?

Should you invest in a sector fund? It depends. Do you want to try picking the hottest sector of the next decade? In 1999, the technology sector was all the rage until it stumbled in March 2000. The NYSE Arca Tech 100 Index (an index comprised of stocks of technology-related companies) is down 20% from December 1999 to December 2008.

Despite the volatility of individual sectors, such as the technology sector, investors may find sector funds useful depending on their needs.
Sector Funds for Diversification

If you’re planning a steak dinner and only have a salad on the side, you might want to add another dish—I like sweet potato casserole. Just the same, if you have a 401(k) that has limited investment options and you find yourself with a lack of representation in one sector or another, you can turn to sector funds in your IRA or brokerage account to fill the void.

If you invest in individual stocks and you’re uncomfortable investing in stocks within a particular sector, then you may benefit from sector funds. You can diversify your portfolio by adding the neglected sector via a sector fund.
Sector Funds for Speculation

Speculative investing entails placing bets on stocks or funds that you think will soar in value. It’s a risky proposition, as speculators generally try to make huge profits in a very short period. Although I am not a fan of speculative investing, if you want to speculate with a small portion of your portfolio based on a hunch you have about a particular stock, you might be better off buying the sector fund that holds the stock. That way, if you’re wrong about the stock, at least you are diversified among your other holdings.
How Do I Invest in a Sector Mutual Fund?

Many fund companies offer sector funds. Fidelity has 43 sector mutual funds and Vanguard has more than 30 sector funds -- including mutual funds and ETFs. Clearly, there is no shortage of sector funds. If you decide to make a sector bet, do your homework and make sure you are well diversified.
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What Are Closed-End Funds?

What Are Closed-End Funds?

Closed-end funds are often confused with, and mistakenly called, mutual funds. A major difference is that closed-end funds behave more like a stock -- the market value is driven by supply and demand for the shares. On the other hand, an open-end mutual fund continually issues new shares to investors and does not trade on an exchange.

Perhaps the best way to understand a closed-end fund is to compare it with an open-end mutual fund.

Open-End Mutual Funds vs. Closed-End Funds

You can think of a mutual fund as “open-ended” because the cash flow door -- both into and out of the fund -- is always open. In other words, the portfolio manager continues to invest new cash from investors, and the fund company continues to offer new shares of the fund to new investors.

You can think of a closed-end fund, then, as “closed-ended” because the cash flow door -- into and out of the fund -- is always (with a few exceptions) closed. The manager only invests a fixed amount of cash that was raised in an initial public offering of the fund’s shares. If you want to buy shares of the fund, you buy the shares from another investor via a stock exchange. The number of fund shares do not fluctuate based on investor demand.

Similarities in Closed-End Funds and Mutual Funds

Like mutual funds, closed-end funds are:

• A diversified portfolio of stocks, bonds, or a combination of the two
• Professionally managed by an investment advisor
• Either actively or passively managed
• Required to distribute capital gains and dividends to shareholders
• Regulated by the U.S. Securities and Exchange Commission

Differences in Closed-End Funds and Mutual Funds

Unlike mutual funds, closed-end funds:

• Are traded on a stock exchange (NSYE) or over-the-counter (NASDAQ)
• Are bought and sold at market price versus the underlying securities’ value
• Are valued based on supply and demand for the fund
• Can be purchased and sold throughout the trading day
• Use leverage (borrow cash to invest in more assets) to enhance their returns

If you want to know more about the nitty-gritty of closed-end funds, take a closer look at a few of the differences that I have listed below.

Buying and Selling Closed-End Funds

A closed-end fund trades like a stock -- on a stock exchange or over-the-counter -- while an open-end mutual fund is bought and sold directly with the fund company. The cost of the transaction for a closed-end fund is similar to the cost of a stock trade. There are also internal management fees paid to the fund company to manage the fund.

Another cost to be aware of is the bid-ask spread. If you place an order to buy a closed-end fund and, at the same time, place an order to sell the fund, the prices for both would be different. In other words, your cost to buy the fund and the price you would get for selling the fund would be different. For instance, you might sell at the bid price of $9.90, while you would buy at the ask price of $10. This $.10 difference is known as the bid-ask spread and is considered the cost of doing business on the exchange or over the counter.

You can buy both types of funds through a broker. The broker processes the transaction on the stock exchange in the case of closed-ends, or with the fund company in the case of mutual funds.

Net Asset Value vs. Price of Closed-End Funds

It is easy to confuse the net asset value (NAV) of the fund with the fund’s price. To avoid confusion, you can simply think of the NAV as the value of the fund’s holdings (stocks, bonds, cash, etc.) minus any liabilities, divided by the total number of fund shares that are held by investors. Therefore, unlike a mutual fund, the NAV of a closed-end fund is not the price you pay for a share of the fund.

Closed-end funds are often bought or sold at a discount to their NAV. In other words, if a closed-end fund owns 100 stocks that have a combined value of $1,000,000 with $0 liabilities and 100,000 shares outstanding, the fund has an NAV of $10. Investors might not value the portfolio manager’s ability to pick stocks, however, so they might only be willing to pay $9 per share of the fund. So, this fund would be trading at a discount of 10% to its NAV.

Why Do Fund Companies Choose the Closed-End Structure?

There are many reasons a fund company might decide to structure their fund as a closed-end fund rather than an open-end mutual fund (and vice-versa). It could be that the fund company has a particular niche that is better served through closed-ends. For example, if a fund company wants to manage a fund that holds securities that are not easy to trade (illiquid, such as stock of a very small company that is rarely traded on the stock exchange), then they might form a closed-end fund.

Another reason to form a closed-end fund, which will also help clarify the previous reason, is because the fund managers of closed-end funds are not forced to sell a particular security when an investor wants to sell his/her shares of the fund. For example, let’s say we have a manager who is running two funds that differ only in structure -- one is a closed-end fund, while the other is an open-end mutual fund. The funds both hold Wal-Mart and Target shares. The fund manager loves both stocks.

If an investor wants to sell his/her shares of the closed-end fund, then there is no problem; the fund manager is able to continue to hold both stocks because the investor goes to an exchange to sell his/her shares to another investor. On the other hand, because investors in a mutual fund go to the fund company to redeem his/her shares, the fund manager must sell either Wal-Mart or Target shares in order to meet redemption needs and raise cash for the investor.

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Index Funds vs. Actively-Managed Funds

Index Funds vs. Actively-Managed Funds
What do the Yankees and Red Sox have in common with index funds and actively-managed funds? Each seems like an age-old rival with die-hard fans on each side that are unwilling to concede -- despite the winning streaks and losing streaks.

Well, let’s face it, the Red Sox are better than the Yankees.
What Is an Actively-Managed Fund?

The portfolio manager of an actively-managed fund tries to beat the market by picking and choosing investments. The manager performs an in-depth analysis of many investments in an attempt to outperform the market index -- like the S&P 500.
What Is an Index Fund?

Index funds are considered to be passively managed. The manager of an index fund tries to mimic the returns of the index it follows by purchasing all -- or almost all -- of the holdings in the index. Hundreds of market indexes can be invested in via mutual funds and exchange-traded funds.
Should You Own Actively-Managed Funds or Index Funds?

The potential to outperform the market is one advantage that actively-managed funds have over index funds, and this notion of outperformance is attractive to investors. After all, why settle for an index fund when you know you will only receive the market return, less a nominal fee, to the fund’s manager? Unfortunately, evidence that actively-managed funds can consistently outperform their relevant index is difficult to find. It’s even more challenging for an individual investor to identify which actively-managed fund will outperform the index in a given year.

According to Vanguard, for the 10 years leading up to 2007, the majority of actively-managed U.S. stock funds underperformed the index they were seeking to outperform. For instance, 84% of actively-managed U.S. large blend funds underperformed their index, and 68% of actively-managed U.S. small value funds underperformed, as well. The case is even worse for actively-managed bond funds. In that case, almost 95% of actively-managed bond funds underperformed their indexes for the 10 years leading up to 2007.
Luck or Skill?

You might point out that some funds indeed beat their indexes, so why not buy those? Well, how do we know whether the active manager was skilled in his or her investment selection, or was just lucky? The evidence from a Barclays Global Investors study shows that the chance is slim for continued outperformance by an active manager to continue beating the index.

For the period of December 31, 1992 to December 31, 2007, only 41.6% of actively-managed U.S. large company funds that beat the S&P 500 in a particular year were able to beat the S&P 500 in the next year. After three years, only 9.7% of the original group was still beating the index. The numbers are similar for actively-managed small cap funds and emerging market funds.
Cost Considerations

Actively-managed funds start at a disadvantage when compared to index funds. The average ongoing management expense of an actively-managed fund costs 1% more than its passively managed cousin. The expense issue is one reason why actively-managed funds underperform their index.
Tax Considerations

Another issue, which is not reflected in fund return numbers, is that the portfolio manager of an actively-managed fund—who is in search of extra returns—buys and sells investments more frequently than an index fund. This buying and selling of stocks by the active manager-- known as turnover -- results in taxable capital gains to the fund shareholders, provided the fund is owned in a non-retirement account.

The evidence shows that there are good active managers, but finding such managers in advance of their outperformance is difficult. More importantly, as the Barclays study suggests, uncertainty always surrounds the good managers. Can they continue to outperform?

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Diversification: The 3 Most Important Things About Investing

Diversification: The 3 Most Important Things About Investing
If the three most important things about investing in real estate are location, location and location, then the three most important things about investing in equities are diversification, diversification and diversification.
What Is Diversification?

Diversification is a basic tenet of investing. But what is diversification?
According to Dictionary.com, diversification is defined as:

1. the act or process of diversifying; state of being diversified.

2. the act or practice of manufacturing a variety of products, investing in a variety of securities, selling a variety of merchandise, etc., so that a failure in or an economic slump affecting one of them will not be disastrous.

The key phrase about diversification listed above is: “…so that a failure in or an economic slump affecting one of them will not be disastrous.” In other words, don’t put all of your eggs in one basket.

Mutual Funds and Diversification

Diversification is one of the many advantages of investing in mutual funds. When it comes to diversification, mutual funds can help an investor in two ways. First, the beauty of mutual funds is that you can invest a few thousand dollars in one fund and obtain instant access to a diversified portfolio. Otherwise, in order to diversify your portfolio, you might have to buy individual securities, which exposes you to more risk. In other words, a mutual fund allows an investor to diversify into many different stocks for a nominal investment.

Sometimes, when it comes to diversification, it’s not good enough to simply own many different stocks. For example, if you own 100 stocks within a mutual fund, and those 100 stocks are in the financial sector (a sector mutual fund), more than likely as the financial sector moves up and down, so does the value of your mutual fund. That brings us to the second point. A mutual fund also allows for diversification between various styles, sectors, countries, and, well, you name it. You can either buy a mutual fund that is broadly diversified, or you can buy a portfolio of mutual funds across various sectors -- creating your own diversification.
Risk, Reward and Diversification

In summary, a mutual fund allows for diversification between many different stocks and also allows for diversification between various sectors, styles, etc. This diversification allows investors to reduce the risk of one particular stock or sector, but also allows for more potential reward by offering a broader exposure to various stocks and sectors.

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