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Ask MAX: Investing $20 a month?

February 24, 2005

Dear MAX,

I’m 21 years old and interested in starting to invest $20 a month, what do you recommend?


Dear Katherine,

Good idea. Most people don’t start investing until they have more money to invest. However, investing smaller amounts of money for a longer time period can be even more beneficial than investing larger amounts later in life.

It sounds impossible, but $20 invested today could be worth $500 when you hit 70 years old – and that’s using a fairly conservative growth rate below the historical stock market return.

Sadly, it can be difficult to invest small amounts of money. While you can always save in a bank account or even in a money market mutual fund, you’ll get a bigger bang for your buck in a lower fee mutual fund that invests in stocks. Mutual funds allow a small investor to invest in dozens of stocks for a reasonable fee.

Most good mutual funds require investors to fork over $2,500 to get started, although there are many good ones that require $1,000. Better for your situation, some waive the minimum if you agree to invest a small amount of money each month.

This sort of plan goes by different names depending on the fund company, but is broadly known as an automatic investing plan (some call it a systematic investment program). Think of the scene in the move Grease where John Travolta was describing the hot rod as “automatic, systematic” … o.k. maybe not.

T. Rowe Price has a number of good funds, but they carry a $2,500 minimum investment. Get on T. Rowe’s so-called “Automatic Asset Builder” and they’ll waive the minimum. You have to agree to let T. Rowe deduct $50 per month from your checking account and direct it into one of their funds.

A good choice is T. Rowe Price Equity Index 500 (PREIX), a low fee index fund. Another option is T. Rowe Price Retirement 2040 (TRRDX). This fund owns other T. Rowe price funds (known as a fund of funds) and will become more conservative (own more bonds and cash, less stock – what is known as a lifecycle fund) as time goes by – just as you should be as you near retirement. Go to www.troweprice.com or call 800-638-5660 for more information.

Of course, you want to invest just $20 per month - a small problem. Only load funds will take on clients who invest just $20 per month, as they take 5.75% of your monthly investment, and this can make such a small account worth bothering with.

As for no load funds, you may have to step up your savings to $25 per month. There are a few no load funds that allow such small monthly investments.

Exeter Funds (800-466-3863), managed by Manning & Napier, allows auto investing of just $25 per month. Consider Exeter Equity (EXEYX).

Be aware that your bank may charge a fee if you do not have $25 in your account at the time the fund tries to hit your account up for the monthly amount.

Alternatively, you can save your money each month in a regular savings account (or a money market fund), and when you hit $1,000 you can open an account at any number of good mutual funds. Two good $1000 minimum investment options are SSgA Disciplined Equity (SSMTX) 800-647-7327 Meridian Growth (MERDX) 800-446-6662 all fit the bill.

Most funds allow you to make additional investments of as little as $50-100 – and sometimes there is no minimum for subsequent investments - so you can continue to add to this account at your discretion.

You’re on the right track: save early, save often.

Thanks for the question.


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Fool’s Gold

December 30, 2004

One inalienable rule in the mutual fund business is that funds with hot track records bring in the most money. Like it or not, this is a business of performance chasing. But occasionally this law of past performance does not explain investor excitement over a particularly popular fund.

A good example is when Merrill Lynch brought in over a billion dollars into their new internet fund, which they launched in early 2000 – just in time to destroy investor’s money. There was no hot past performance, just clients of the broker who were hungry for Merrill’s expertise in an area that made other investors rich. In this case, the past performance of other funds in the category was enough to bring in investor money.

This year we are seeing another illogical success story in new fund launches, and this one is not even in a particularly hot category.

One of most popular funds (in terms of asset gathering) of 2004 is not an international, small cap value, emerging markets, or microcap fund. It’s not a foreign bond fund, or a utilities fund, or some hot Latin American fund. While there are funds in many of these now hot categories that are bringing in huge dollars, one new fund stands out: streetTRACKS Gold Shares (GLD), loosely defined an exchange traded fund, or ETF.

How successful has the fund been at attracting new money? It was launched in mid November of 2004, and in a few days it reached some $1.5 billion in assets. While this is remarkable for any one fund, it is most startling for a precious metals fund where no fund currently has (or in all likelihood has ever had) over a billion in assets. Today streetTRACKS Gold stands at around $1.3 billion in assets.

Until now it has been impossible to reach the billion dollar mark in precious metals funds, because every time investors have poured significant quantities of new money into them, the funds have fallen, and have fallen hard. Investors in gold funds have historically bought in only when the price of gold has neared a peak – and shortly before a precipitous drop in both an ounce of the yellow metal, precious metal mining company stocks, and therefore the share price of precious metals mutual funds.

Technically, streetTRACKS Gold Shares is not a fund at all. It is an exchange-traded trust not registered under the investment company act of 1940 – the operating rule set foundation of mutual funds, also known as investment companies.

The fund falls under the category of precious metals funds – a category that probably shouldn’t exist at all as these funds are really just a subset of the natural resource category. We don’t have an automotive or semiconductor fund category, even though both of these industries have far more in revenues than all precious metals mines combined.

The new streekTRACKS ETF makes investing in gold easier then ever before. Most precious metals funds own shares in gold mining companies. streetTRACKS Gold Shares lets investors effectively buy gold bullion.

State Street, the people behind the fund, will have to sell gold in the trust to pay expenses of up to .40% a year. Unlike normal funds, which can pay fees from bond income and stock dividends, this trust will have to sell gold bars to pay management fees, because gold has no income stream, current or in the future.

Whatever investing legitimacy most precious metals funds had – owning real business that mined gold for a living – is out the window. streetTRACKS Gold investors can focus solely on the actual, honest-to-goodness, underlying shiny metal itself.

This may sound like a subtle difference, but imagine two energy funds: one owns stocks in companies like ExxonMobil and the other owns nothing but barrels of oil.

The fund does very well to make owning a gold bar a relatively simple affair. Gone are the hassles and costs of storage and insurance, as well as commissions to brokers and transportation.

Not gone are the poor tax consequences of investing in gold bars. The IRS does not consider gold an investment, but rather taxes any gains from trading the yellow metal as profits from selling a collectible. This means if you own gold bars – or shares of this new trust – for over a year, gains could be taxed at 28% and not the new low 15% long term capital gains rate applicable to real investments (real investments which include, by the way, shares in gold mining companies).

Owning raw gold bullion was apparently something many investors wanted to do. It is unlikely there will be other similar trusts to own other commodities like pork bellies or steel, and not simply because commodities offer lousy long term returns. The real reason other single commodity trusts would likely fail to bring in money is that investors do not see gold bullion as a commodity at all. Gold appears to have magical properties. It is a commodity masquerading as an investment, or worse, as better than money – and the only true world currency. This gold fever has historically lead to some ill timed investing decisions.

If investors bought gold (or just about any commodity) and left it alone for, say, fifty years, they wouldn’t do so badly – they would underperform investments like stocks and bonds, but they probably wouldn’t lose money and should keep up with the rate of inflation. But they don’t. They buy gold after it has done well (gone up in price), then sell it after it falls.

Would this new gold ETF have brought in any money if it were launched when Merrill Lynch was bringing in billions to their new internet fund? Considering gold was around $170 per ounce cheaper in price, it would have been a good time. But it is unlikely that investors would have flocked to this fund in 2000.

Investors don’t like cheap. They don’t like contrarian. They like past performance and a good story of why that past performance is bound to continue. While gold funds have been the weakest fund category over the last twelve months, raw gold has climbed around 60% since 2000, and it seems to offer a magical way to make money from global turmoil, a falling dollar, bear markets, and inflation (even though the last year has been unimpressive).

Reporters and analysts are just as guilty as performance-chasing investors. In 2000 there was nary a mention of gold in the financial press (too busy writing about opportunities in tech and telecom stocks) other than the occasional quoted rant by a crazed gold bug still holding on to gold bought at $800 an ounce in early 1980 in an otherwise negative article about gold.

CNBC is as infatuated with gold as oil these days. Gold as an investment has been legitimized by recent short term performance – just as it was in 25 years ago. The vague notions of gold as an inflation fighter, a cure for the falling dollar, or a hedge against global turmoil, are all reasons used to rationalize the natural attractiveness of strong, recent past performance.

As if investors needed another gold option, Barclay’s has a similar gold fund planned.

When a new fund is this attractive to investors the future returns are likely to turn sharply negative. In fact, gold seemed to peak at almost $460 an ounce just 11 trading days after this new fund launch – a level that could prove the high for the next several years.

The only way this fund would be a good investment over the next few years is if nobody wanted to buy it today – call it the great irony of investor infatuation. This brings us to one of the great rules of investing: whatever is most saleable today will perform the worst tomorrow.

How Mutual Funds Work - Capital Gains

December 14, 2004

We love mutual funds. Mutual funds provide cheap and easy investment diversification, they're easy to get in and out of, they're highly regulated, and they allow investors access to expert financial guidance at a low price. As investments go, we think that mutual funds are far and away the best option for the vast majority of investors in America.

But there are a couple of things about mutual funds that we don't like. Fund investors never know exactly what they're invested in. Mutual funds sometimes charge fees that are too high. Mutual funds can also hit investors with large and unexpected capital gains distributions.

How big can capital gains distributions get? Just ask shareholders who were invested in the Warburg Pincus Japan Small Company Fund (now called the Credit Suisse Japan Growth Company fund) in 2000.

That fund was down over 60% in 2000, making it one of the worst performing mutual funds in what had been a very bad year for investors. But while lousy performance like that wasn’t going to earn Warburg Pincus any Christmas cards, it was the Godzilla sized 55% (ouch!) capital gains distribution that really hurt shareholders.

An investor who had sunk $10,000 into the Japan Small Company Fund on December 31, 1999 saw the value of her investment drop to $4,000 by year’s end. When the fund issued the 55% distribution near the end of 2000, her shares dropped a further 55% in value (when a fund issues a distribution to its shareholders, the value of the fund drops by the exact amount of the distribution), and she received a taxable dividend distribution of $2,200. If she was in the 31% income tax bracket and she owned the fund in a taxable account, she would have owed the IRS $682 in tax on an investment that had already cost her $6,000. Not a good year.

To understand how you can get hit with a big capital gains tax bill from your mutual fund, you’ll need to know a little about the complex world of fund distributions.

By law, funds have to distribute any taxable gains from investing to shareholders each year.

Your fund has profits and losses much like your own portfolio does. Funds can have losses from bad investments, gains in the form of short term or long term capital gains, ordinary income, and now, low tax dividend income.

Each year the fund accountants figure out how much income there is of each type. The tax liability is then passed on to the shareholders in the form of a dividend (the tax rate for each depends on the shareholder), which is why none of this matters in a tax deferred account like an IRA or 401(k).. .

Most investors choose to reinvest these dividends automatically, which means that the fund company converts shareholder’s capital gains and dividend money into more fund shares with the cash. The total account value doesn’t change, but shareholders wind up with more shares at a lower NAV.

To really understand what is going on behind the scenes, we’ve launched the hypothetical SuperMAX Growth and Income fund (SMGIX), and all stock offering.

Unlike real stock funds, SuperMAX Growth does not have to be diversified. In fact, the fund manager owns just two stocks: Apple Computer (AAPL) and Exxon Mobil (XOM). The fund had $1 million in assets a year ago and put half the portfolio in Apple and the other half in Exxon Mobil. Apple is a growth stock, while Exxon is a more income-oriented stock that pays a decent dividend – so the fund is keeping with its name.

About a year ago Apple stock was at $20 and Exxon around $36. Today Apple is at $68 and Exxon at $51, or up about 240% and 44% respectively. Because of these big gains, this fund has returned 142% for the year, which turned out to be a very good twelve months for iPods and Big Oil.

Figuring the capital gains on that 142% can get awfully tricky. Different potential tax distributions can occur depending on how the fund manager trades and how the fund has done in the past, as well as how popular the fund is with investors.

Scenario 1 – Buy and hold

If the fund manager of the SuperMAX fund never sold any stock, there would be little in the way of taxable distributions because the fund would never have realized any of these profits. A stock can go up forever—if the fund manger doesn’t sell any stocks at prices higher than he bought them, no gain is realized and no tax is due. (Do you think that doesn’t happen? It does. The Vanguard 500 Index fund is sitting on over twenty billion in unrealized gains.)

In fact, the only income to the SuperMAX fund is the dividend generated by the Exxon holding. Exxon paid a 3% stock dividend last year, so a fund shareholder could expect to receive a small dividend of about 1.5% of the fund’s NAV. This is because half the fund was in Exxon (at least before Apple stock took off).

BUT WAIT! Since most funds take management fees out of dividend and bond income first, it is very rare for a fund investor to get any dividend income. The simple reason is that most stocks barely pay a dividend higher than the fund management fee. Only those in high dividend funds or in funds with very low fees even see stock dividend distributions.

Scenario 2 – Buy and sell in less than a year

If the fund manger sells the Apple stock before the end of the year, shareholders could get hit with a big, taxable capital gain. Even worse, the gain will be passed on as a short term gain, which is taxable at shareholder’s ordinary income rate. Ouch!

Why would fund managers sell before the year is out when it could mean pain for the shareholders? Because they couldn’t care less about your problems, and because funds are ranked by their before-tax returns. Most fund managers are interested only in generating as large a total return as they can, because the bigger the number they can print in their magazine ad, the more performance-chasing investors they’ll attract.

Scenario 3 – Buy and sell in more than a year

If the fund manger sells the Apple stock after they have owned it for a year, but before the end of the fund fiscal year, shareholders will get a capital gains distribution. But it will be a low tax rate, long term gain.

Scenario 4 – Big losses on the books wipe out gains

If the fund manger sells the Apple stock and realizes the big gain, but has even bigger losses on the books from previous trades, the gain could very easily be wiped out – leaving shareholders without a big tax bill. Imagine that the SuperMAX fund bought Cisco near $100 a share in 2000 and sold at a loss in 2002 to raise cash to meet shareholder withdrawals. This scenario applies to many formerly hot funds that have rebounded recently. Few emerging market or precious metals funds ever pay big taxable gains because investors keep buying them high and selling them low, creating taxable losses on the fund books as the manager matches the flows.

Scenario 5 – Inflows of new money water down gains

If the fund manager sells the Apple stock and realizes the big gain, but gobs of new shareholders buy the fund in November because they see how well the fund has done, few investors in the fund from a year ago will be hit with much of a distribution. Funds figure out how much they have made in taxable distributions, and they will make that distribution to all the shareholders on the record date near the end of the year - even to shareholders who just bought the fund. This means if the fund brings in $100 million in new cash, the million or so in Apple stock gains and Exxon dividends will get passed on to all – maybe just $.02 cents per share in distributions. In this case, investor’s performance-chasing ways benefit those who got in when nobody wanted the fund. Late investors literally bought early investor’s tax liabilities.

Scenario 6 – Outflows of Money increase gains

This is a very rare scenario as fund investors are not very timely with their investments. Let’s say nobody new buys the hot, hypothetical fund after the big 142% run-up because they have listened to MAXfunds about watching out for the hottest funds of the past year.

Even worse, imagine if half of the shareholders in the fund cash out in November – partially because they don’t want to get hit with a dividend, and partially because they don’t think Apple and Exxon will be very good bets in 2005. If half the shareholders depart, the fund still has to distribute all the realized gains from the Apple sale, but now to only half the shareholders. This could lead to a traumatic event because current shareholders are getting the taxable gains of others shareholders who left before the distribution. Sad but true – although very, very rare, this once happened with a certain Japan fund in 2000.

Ask MAX: Avoid Buying Funds In December?

December 7, 2004

Dear MAX,

I was told by a friend that I shouldn’t buy mutual funds at the end of the year because I can be hit with additional fees. Is this true?


Dear Martha,

Your friend was referring to capital gain distributions, which are actually a different animal than ordinary mutual fund expenses (like management fees, expense ratios, or 12b-1’s). But while your friend is right (cap gains do pose a potential risk to investors who purchase a fund near the end of the year), the distribution trap is a hazard that can usually be avoided with a simple phone call.

Capital gains and dividends are taxed the same, whether they are generated by stocks owned by your mutual fund, or by those in your individual portfolio. If you have ever sold an individual stock for a profit, you know that the profit is called a capital gain, and you had to pay a tax on it.

The same goes for mutual fund investors, but the process is a little bit different. A fund manager might make hundreds of trades a year, some for a profit, and some for a loss. If the manager’s trading creates a net profit that isn’t offset by the previous year’s losses, those profits are distributed to fund shareholders, usually once a year, either in the form of cash or by re-investment into the fund. Most mutual funds issue these capital gains distributions in December.

Fund shareholders are then liable for taxes on those capital gains, and each fund shareholder owes the same amount per share – no matter what time of year they invested in the fund. A guy who invested in February owes the same amount per share as a gal who bought the fund the day before the distribution was announced.

So, you’re thinking, that doesn’t sound bad at all: I invest in November, and in December the fund company sends me a check, a portion of which I owe in taxes. I still end up with free money, right? Wrong. The thing is, when a fund issues a distribution to its shareholders, the value of the fund drops by the exact amount of the distribution. If a fund issues a distribution of a buck a share, the fund’s NAV will drop by a dollar a share on the day the distribution is made. Shareholders gain absolutely nothing but a tax liability when capital gains are distributed.

The guy who invested back in February doesn’t mind this liability too much, because he’s been watching the value of his mutual fund investment rise for most of the year. But if you had been the gal who invested in the fund in December, you’d still owe as much per share as Mr. February does, even though you had missed out on most of the fund’s gains. Yes, it seems awfully unfair, but that’s the way the tax law is written.

The good news is, now that you are aware of the capital gains trap, it is very easy to avoid. If you are buying the fund through an IRA or 401(k) account, you’re in the clear right off the bat because you aren’t liable for taxable gains generated in these tax-deferred accounts. If you are investing in a fund through a taxable account, call up the fund company or check their web site and ask them to tell you the dates and amounts of any upcoming distributions. This is worth doing any time of the year, not just in December, because while most fund companies distribute taxable gains just before the ball drops in Times Square, they can (and some do) make their distributions at other times of year as well.

If the phone rep tells you that a sizable distribution is coming up, just wait until the day after what is know as the “record date” (the date you have to be a shareholder in the fund in order to get the distribution) to invest. You’ll be starting fresh, with a clean capital gains slate, and it’ll be the other guy who gets stuck with the unfair tax bill.

Thanks for the question.


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Ask MAX: Where do I start?

November 10, 2004

Dear MAX,

I’m 21 and in the U.S. Navy, currently serving on the ground in Iraq. I have saved about $2000 and I plan on saving and investing an additional $500 a month. I want an investment that will grow, but I don’t want a crazy amount of risk either. How should I invest? Thanks!


Dear Matthew,

I don’t claim to be the Amazing Kreskin, but allow me to look into the future and reveal to you this: you are going to be a terrifically successful investor, and you’ll retire fat, rich, and happy.

How do I know? Because you’re just 21 years old and you’re already building an investment portfolio, and because right off the bat you are being sensible about risk.

Starting early means that you have years upon years of compounding returns coming your way. The money you invest will make you money. Then you begin making money on the original investment plus the return you’ve made. As your investment grows, you’ll earn a return on a bigger and bigger pool of money.

The fact that you are concerned about risk at your age is equally impressive. Many investors a heck of a lot older than you still don’t realize that they need to consider both the upside and downside potential of an investment. You are quite right in wanting to build a growth-focused investment portfolio, but even aggressive investors should have some exposure to lower risk securities like government bonds.

So how should a young sailor with a few grand and a dream invest? Here’s our advice:

The first thing you need to do is keep doing what you’re doing for another two months. You’re starting off with $2,000 and you’re saving $500 bucks per month. In two months you’ll have $3000, which just happens to be the minimum investment requirement of the Vanguard LifeStrategy Growth Fund (VASGX). We want you to open an account at Vanguard and invest all of your hard earned money in this one single fund.

Think of the Vanguard LifeStrategy Growth fund as the investment equivalent of a multivitamin. It is an entire, stand alone, well-diversified investment portfolio, all in one little fund. The Vanguard LifeStrategy Growth is a fund of funds, meaning that its holdings are not individual stocks and bonds like most other mutual funds, other mutual funds – in this case four Vanguard mutual funds. The current allocation breakdown, according to Vanguard’s website, looks like this:


The funds allocation is roughly 77% stocks, 13% bonds, and 10% cash, which for a young investor like you, is a darn good mix. Like most Vanguard funds, the LifeStrategy Growth fund has a minuscule expense ratio (in this case just 0.28%), and comes with absolutely no load charge of any kind (if it did, we wouldn’t be recommending it).

After you open an account at Vanguard and invest in this fund, you won’t be quite done yet. You should then call Vanguard and set up an automatic investment plan that will enable you to transfer a fixed investment amount from your bank account every month. Vanguard will invest each month’s check in the LifeStrategy Growth fund for you – you won’t have to do a thing. Having the money transferred automatically will eliminate the possibility that you’ll forget to send a check one month, lose interest, or blow all your savings while on shore leave in Manila.

After you’ve invested in the Vanguard LifeStrategy Growth fund and set up an automatic investing plan, just sit back and watch your money grow – until your nest egg reaches $15k (and if you follow the steps we’ve outline above, that’ll happen in no time). When it does, let us know. We’ll give you our advice on what to do next.

Thanks for the question, Matthew. Thanks also for your service, and come back safe.


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Ask MAX - Are Roth IRAs Too Good to be True?

May 24, 2004

Dear MAX,

I can't seem to find a clear description of how the tax implications work with Roth IRAs. I understand that what I put into the ROTH is never taxed. Please correct me if I am not understanding that correctly.

My confusion is in the capital gains and distribution of dividends into the ROTH account. Are gains taxed? It would seem like too much of a plus for the investor if they (gains) were not taxed. I have been to several web sites to find a clear definition of the ROTH itself before I commit to opening an account.

North Carolina

Dear Daria,

Roth IRA's have only been around since 1997, when the Senate passed the Taxpayer Relief Act. The differences between a regular IRA and a Roth IRA are significant, and choosing the one that's right for you could have a big impact on how much money you end up with in your golden years. Please keep in mind when reading this that IRAs are a concept originated by the United States Government and hence are rife with ins, outs, and what-have-yous.

Are Roth IRA's too good to be true? Well, they are pretty terrific.

Roth IRAs are a fantastic savings vehicle, because, yes, They DO allow all contributions to grow tax free. You can contribute up to $3,000 per year to a Roth IRA, and if you're over 50, you can add another $500 as a 'catch-up' contribution. These contribution limits increase to $4,000 for years 2005-2007 and then go up to $5,000 in 2008, when contribution limits will be indexed with inflation. The catch-up provision stays at $500 until year 2006, when it goes up to $1,000.

The big difference between a Traditional and a Roth IRA has to do with how the money you put in and take out is taxed.

The money you put into a regular IRA is tax deductible, while that which you put in a Roth IRA is not. So if, for example, you make $30k a year and you put $3k in a regular IRA, come April 15th you would only pay income tax on $27K. If you put $3k in a Roth IRA, you pay income tax on your entire salary. Roth IRA contributions are never tax deductible like they could be with Traditional IRAs. That's because your distribution that you will eventually take is designed to be tax free.

Conversely, the money you pull out of a Roth IRA isn't taxed, while the money you pull out of a traditional IRA is. A distribution form a Roth IRA is not included in your income if it is a "qualified distribution" or if it is a return of your original contribution.

What's a "qualified distribution"?

For a distribution to be qualified, it must satisfy both of the following tests (bear with us, this gets a little technical):

1. The distribution must be made after a 5-taxable-year-period- which begins January 1st of the taxable year you make a contribution. So, if you make a contribution for the taxable year 2001, whether you actually write the check in 2001 or just in time to make the income tax deadline on April 15th of 2002, your 5-year clock technically starts on January 1st of 2001. Thus a qualified distribution could technically be taken as of January 1st of 2006.

2. In addition to the five-year test, the distribution must satisfy one of the following requirements:

a) made on or after the date on which the owner attains age 59 1/2, or
b) made to a beneficiary or estate of the owner on or after the date of the owner's death, or
c) is attributed to the owner being disabled, or
d) for a first-time home purchase (subject to a $10,000 life time limit)

So, if your adjusted gross income allows you to contribute to a Roth, and you meet these tests when you're ready to withdraw all or part of your money, it is ALL tax free and penalty free- capital gains, earnings, and all!

One additional and oft-overlooked benefit of Roth IRA's is that if you need to withdraw ROTH IRA money for education expenses, and it doesn't meet the "qualified distribution" tests above, you will have to pay taxes on the earnings only, but you avoid the 10% penalty on the earnings.

Unfortunately, not everyone is permitted to contribute to a Roth IRA. For starters, you can make full contributions to a Roth IRA only if you are a) single and make less than $95,000 a year or b) married and you and your spouse collectively make less than $150,000 a year (partial contributions are allowed if you're in what's called the "phase out range": $95-110K for singles, $150-160k if you're hitched.) You can put money in a regular IRA no matter how much money you make.

Thanks for the question.


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Are You Paying a Sales Load?

May 21, 2004

If you've know anything about MAXfunds, you know that we think load funds are bad and no-load funds are good. These days, however, determining if you are paying a sales commission when you buy into a mutual fund is more difficult then you may think. There is no boldface text on the application that says "This is a load fund". The load information is hidden in complex fee tables deep in a document most investors don't even glance at, the prospectus.

Mutual funds come in two basic forms: with built in sales commissions (loads) or without (no-loads). Determining which one you are buying can be confusing. Our own informal research has determined most people who own a load fund don't know they paid a sales commission.

The most obvious culprit for the confusion is a fund industry that has purposely created mysterious share classes and fee structures. Obscuring the sales fees paid by the investor (AKA: mark) helps the brokers who sell the funds avoid having to answer uncomfortable questions, and ultimately increases assets under management.

But figuring out if a fund you are interested in comes with a load isn't t that tough. Read below for some warning sings that a fund on your shopping list might come with an unpleasant surprise.

A sales person, accountant, bank employee, broker, advisor, or other "expert" recommends the fund to you

Load funds are generally sold, not bought, meaning somebody on commission is recommending them to get a commission paid by the fund company that comes directly out of your investment. Make sure to read any and all literature associated with a fund your broker is recommending you buy.

Somebody is "affiliated" or on "record" or a "representative" with your account

When you fill out an application for a load fund, often there is the name or code of a salesperson so the fund company knows who to send a check to.

The fund has a letter after the name, like Super Growth Fund "A", "B", or "C"

While there are exceptions to this naming rule, load funds come in various share classes of the same fund, all with a different sales fee structure to deal with different kinds of customers. Traditionally, "A", "B", and "C" share classes are the ones to watch out for, but "Adv" classes can have higher fees to compensate advisors selling the fund to you, and some funds have introduced bizarre classes like "T" or "Y". Note: some letters or letter combinations, like "Inv" or "I" often denote a retail no-load class, or a no-load institutional class available to retirement plan investors.

The fund has a 12b-1 fee of over .25%

While you generally will have to dig into the prospectus to find out this number, the 12b-1 fee is a good indication of whether you are buying a load fund or no-load fund. No-load funds can not call themselves "no-load" if they charge 12b-1 fees in excess of .25%. Most load funds, particularly "B" and "C" class load funds have 1% per year 12b-1 fees on top of the fund management fees that are used to pay commissions to salespeople year in and year out. That's why "B" class mutual funds are often the "gift that keeps on giving" to a broker who sells you on it.

The fund has a total annual expense ratio of over 2%

While there is (sadly) no rule about total expense ratios and load and no-load status, funds with a total expense ratio over 2% per year are generally "B" class load funds, largely because of higher 12b-1 fees (see above). Regardless, you don't want to own any fund, load or no-load, with a total expense ratio of over 2% each year, so it doesn't really matter anyway.

The fund does not mention "no-load" in sales literature

While the broker or planner may mislead you about a fund being "no-front-end-load", your "not having to pay any sales loads out of your money up front" or some other gibberish, any prospectus or literature for a load fund will never say in writing it is a "no-load" fund as the term has certain requirements to be used. Most no-load funds brag about it in their literature, so be suspicious of any fund that doesn't mention it's "no-load" status prominently.

Just ask

"Would the SEC allow you to call this a no-load mutual fund?" to any person or fund company behind a fund you are looking into, this question is sure to get an honest response. There are two reasons we like to word the question this way, 1) The use of the term "SEC" or Securities and Exchange Commission, snaps unscrupulous salespeople out of "closing" mode and into "better watch what I say" mode, and 2) we can't tell you how many times we worded the question "is this a no-load fund" only to get an obtuse response like "the fund is sold without a front-end sales load" which is technically correct if the fund is a "B" or "C" class load fund, but clearly dodges the question at hand.

The Worst Fund Advice Ever

March 31, 2004

We’ve been telling investors for years that they should never, ever buy a load fund, be it a front end, back end, or the intentionally deceptive level load funds. Loads are built in sales commissions primarily used to compensate brokers who sell funds to investors.

The gist of our anti-load argument is simple: there is no difference between load and no load funds other then the added sales commission. It’s like running a race with wet boots on – you’re at a disadvantage from the get-go.

But has our anti-load proselytizing been wrong all these years? If you had read a recent article in Investors Business Daily, you might think so. In it the case is made that individual investors should sometimes choose load funds over no load funds. The main concepts in support of this argument are:

1. Whether to go no load or load should not be your first decision when picking funds

2. There are more important decisions then whether the fund is load or not

3. If a load fund has a better performance record then a no load fund, you should go with the load fund

4. Few load funds have identical no load twins

5. Over the long haul loads only add about .44% a year in extra expenses

Our response to the article? It is complete and utter nonsense.

Here’s our point by point rebuttal:

1. Whether to go no load or load should not be your first decision when picking funds.

There is no difference between load and no load funds other then that one (load funds) has a built in sales commission to compensate brokers to sell the fund and one (no-load) does not. The management fees are the same, the management quality is the same, the categories are the same.

If there were two electronics stores side by side and both sold the exact same television only one charged 5.75% more to compensate the sales people in the store, at which would you buy your TV? The only reason to go load is because an investor wants a broker to pick their funds for them – the same reason a novice video equipment shopper might chose the higher priced electronics store – presumably the staff there could help pick out a TV that’s right for you (although there are other ways to get help in building an investment portfolio that don’t come with an intrinsic conflict of interest risk.)

2. There are more important decisions then whether the fund is load or not.

A retired investor living off income should not have all of their money in a biotech fund – this decision is more important then making sure the biotech fund is load or not. Low risk investors need to be in low-risk funds. But while we can’t argue with the basic premise of this point, why not choose a no-load low-risk fund over a loaded one?

The author’s idea is akin to saying the most important decision is not getting the best price on a new car, it’s if you wear your safety belt or not. True, but you can still buy a car and get the best price AND wear your safety belt. Wearing your safety belt is an easy and important decision you can make after you decide not to pay excessive fees.

3. If a load fund has a better performance record then a no load fund, you should go with the load fund.

This is even worse advice then recommending buying a no load fund simply because it has a better performance record then another no load fund regardless of fees. The assumption here is a good track record is worth paying for, even if it means paying a huge sales commission on top of already high annual fund fees. It is very difficult to consistently pick funds that will perform better than most other funds going forward. Raw past performance data really is no indication of future results, and is certainly no rationale for paying higher fees. Past performance is fleeting. Expenses are eternal.

4. Few load funds have identical no load twins.

The implication is if you find a good load fund you should buy it, as most load funds don’t have a no-load alternative. In the latest Value Line Mutual Fund Survey there are roughly 13,000 mutual funds. There are probably 3,700 more funds too small, new, or hidden for Value Line to track. While Value Line’s database represents multiple shares classes of the same underlying fund (A,B,C,D, I,Y,Z…) there are at least 6,500 distinct mutual funds out there – both load and no load.

There are maybe a dozen cases where an investor wouldn’t be able to find a comparable no load fund that does essentially the same thing as well as a load fund does. These few lone load funds with no loadless equal probably have an ETF or closed end fund equal or represent alternative strategies that would at best be small percentages of a portfolio. Often an investor can even find a no load funds run by the same manager who runs a load fund. Bottom line: few load funds don’t have a similar, less expensive, no load twin.

5. Over the long haul loads only add about .44% a year in extra expenses.

Maybe so, but .44% per year is still a great deal to give away over the long haul, especially if you don’t have to.

The reason index funds beat most actively managed mutual funds is because most fund manager’s stock picking skills don’t often make up for the extra 1.20% more a year in annual fees a typical actively managed stock fund charges over an index fund.

Adding an additional .44% in annual expenses onto the typical no load fund fee structure is only going to make it that much more difficult to perform well. Over any 10 year time frame a no load index fund beats more actively managed load funds then actively managed no load funds – there’s all the proof you need that the extra .44% in fees only hurts your odds of success.

Moreover, there are other reasons to avoid load funds (like you need more). One big one is if your time horizon is less then a decade. As the average holding period for a fund has dwindled down to just a couple of years, there is a good chance you are a relatively short-term investor. In such a scenario the extra cost over no load funds is far more then .44% per year.

Imagine buying a fund and paying a 5.75% front end load, and then finding out the manager leaves a few months later. Should you stick around 10 years with a new manger, or sell and lose up to 5.75% of your investment? A load may spread out to “just” .44% a year over a decade, but over a year or two it’s a killer. Since you bought the overpriced fund in the first place because of the great track record, sticking around after the manager leaves doesn’t make any sense

Load funds are for two types of investors: 1) clients of honest commission based brokers (there are probably one or two out there) and 2) wealthy investors who are rich enough to have the load fees waived (sadly some brokers have even kept their rich clients in the dark about the fee breakpoints). Everyone else doing their own fund picking should never buy a load fund.

Ask MAX: What's better: an index fund or an actively managed fund?

March 21, 2004

Dear MAX,

What's better: an index fund or an actively managed fund?

Sarasota, FL

Dear Blanche,

Can't we all just get along?

The rivalry that exists between active fund people and index fund people is a long and bitter one, and has been growing in intensity ever since Vanguard's John Bogle launched the first index fund, the Vanguard 500 Index Fund (VFINX), back in 1976. Supporters of index funds think active fund owners are suckers who pay higher fees for worse performance. Active fund owners consider index fund owners over-diversified, risk-averse wimps.

I want to be very careful here, Blanche. Because of the highly controversial nature of your question and the potential for harm an incomplete answer could cause on one side or the other, I'm going make sure to respond to it as carefully and completely as I can.

An index fund is a mutual fund that tries to mimic, as closely as possible, the holdings of a particular index. Depending on the fund, the index tracked might be the S&P 500 Index, the Dow Jones Industrial Average, the Wilshire 5000 Equity Index, the NASDAQ Composite Index, or any one of the scores of other indexes that have sprung up over the years.

An actively managed mutual fund doesn't follow an index. Active managers build their funds one company at a time, through painstaking research and analysis. The job of an active fund manager is to identify and buy the very best stocks that fit their fund's prospectus objective.

Both actively managed and index funds have aspects to them that are good, and aspects that are not so good. In our MAXadvisor Newsletter model portfolios we invest in both index and actively managed funds. Which one is 'better' depends on who it is that is buying the fund, what that person hopes to achieve with the money they place in the fund, and even the markets conditions that exist during the life of the investment.

Advantage Index Funds

Expense Ratio - The one thing supporters of index funds cite as being the single biggest advantage index funds have over actively managed funds is their cost of ownership. Index funds are almost always cheaper to own than actively managed funds.

Why? Because essentially all the manager of an index fund does is check the paper each morning and make sure that their fund owns the same stocks in the same percentages as the underlying index. If the index has added a new company, the manager buys shares of the new company and adds them to the fund's portfolio. If the index has dropped a company, the manager sells the shares of that company that their fund owns.

Because index fund managers don't really make any decisions about which stocks to buy or sell, index funds are said to be passively managed. And because index fund managers don't have to spend any money researching potential investments, the expenses of index funds are generally pretty low.

Portfolio managers of actively managed funds have to spend a lot more money (and work a whole lot harder) than passive managers to determine which stocks to buy and sell, and many of them get paid a lot of money (some too much money) for thier trouble.

You might not realize it, but investment research is an expensive, time-consuming process. Good fund managers buy a lot of very pricey research material. They employ large research staffs. They take a lot of trips, meet a lot of CEOs and, tour a lot of factories. Because of the money actively managed funds have to shell out on research each year that passively managed funds don't, the expense ratio of actively managed funds are generally higher than those of index funds.

The average index fund charges an expense ratio of .67% a year, while the average domestic equity fund (excluding index funds) charges 1.48%. While the difference might not seem like that much, over the years the money you save on expense ratios by investing in an index fund can really add up.

Turnover Ratio - Expense ratios aren't the only place where index funds save you money. Because of their low turnover ratio, index funds usually produce little or no capital gains distributions. Taxes paid on capital gains distributions are a hidden fee that most people don't think about when assessing the performance of a mutual fund they're considering investing in.

Knowing Exactly What You're Investing In - When you buy shares of an actively managed fund, you have a general idea of the kind of company the fund manager is supposed to invest in, but usually not what the exact companies in the portfolio are. Sometimes active managers stray from their stated investment strategies, succumbing to what is known as 'style drift.'

Owners of most index funds can find out exactly what companies they are invested in by checking the holdings of the index their fund tracks by looking in the newspaper or on the Internet.

Eliminates Bad Managers - Index fund managers make no decisions concerning what stocks they buy or sell. They come in each morning, check the data to make sure no new company has been added to their index, do a little rebalancing, make a few calls, have lunch, go home. That's about it.

Index fund managers never make a big bet on a risky investment because it's getting close to bonus time and they need to stoke their fund's returns. They don't buy a crappy stock because they're too lazy to find anything better. They don't drive a fund into the ground because they simply don't know what the hell they're doing. Index funds, for the most part, take the manager out of the equation, which protects your money from mistakes and incompetent portfolio managers.

Diversification - What will the next hot sector be? Are Internet funds poised for a comeback? Will small cap funds continue to outperform other types of funds? Who knows?

Most popular index funds invest in a broad market. When you invest in an index fund you're usually not making a bet on a specific industry or sector, but are investing in the market as a whole. You don't have to worry about picking "the right" portion of the market to invest in, because you're investing in almost the entire thing.

Performance - The lower a mutual fund's management fee, the more money that fund has at work for investors. Because index funds on average have lower fees than actively managed funds, over a long period of time the universe of index funds tends to outperform the universe of actively managed funds.

Advantage Actively Managed Funds

Performance - Index funds usually give investors slow and steady performance. Investors in traditional index funds won't get really creamed, but will never have a huge performance year, either. Index funds usually do not show up at the top of the "best performing funds of the year" list. Index fund investors are hoping to make a nice, solid, average return. (Note: some index funds track narrow, sector specific indexes. These funds differ significantly from traditional index funds in terms of risk and potential return.)

But who wants to be average? Actively managed funds give investors a chance for so much more. If you build a portfolio of good actively managed funds, you should get much better performance than you could with a portfolio of index funds. Of course actively managed funds can fall a lot farther than index funds, too.

Index fund proponents say that the lower expense ratios most index funds charge make index funds, over a 10-15 year period, difficult to beat, and they have a good point. But what if your investing time horizon is less than 10 or 15 years?

Lower expense ratios make a big difference over time as the money investors save appreciates exponentially, but in the short term, say 5 years or less, the benefits of appreciation aren't that substantial. The increased performance numbers that actively managed funds put up in a good year should more than compensate for a reasonably higher expense ratio.

Expert Management - Like I said in part one of your answer, it doesn't take a whole lot to be the manager of an index fund. All index fund managers have to do is make sure their funds own the same stocks, in the correct percentages, as the underlying index. They don't do any research or make decisions as to what stocks their fund buys or sells. Whatever education, experience and training the manager of an index fund has is not really utilized. If the manager of an index fund learns that one of the stock her fund owns is about to tank, they can't sell unless the index drops it first.

Actively managed fund managers can buy whatever great stock they want, as long as it fits with their funds stated investment strategy (and, unfortunately, sometimes even if it doesn't). They don't have to buy whatever it is some index tells them too, but are free to purchase whatever stocks they think have the best chance of performing well.

Actively managed funds benefit from the expertise of good managers. An active fund a manager who knows what she's doing can usually trounce the returns of an index fund.

So Which is Better?

Sorry to say it, there is no easy answer to the question. Like I outlined above, both have distinct advantages and disadvantages. Its our opinion that investors will do better over time investing in well-chosen low-fee actively managed funds, but picking good actively managed funds takes a little work.

If you're an investor who wants to park your money in an investment and forget about it for 20 years, a good old S&P 500 or Wilshire 5000 index fund is probably a good choice for you. If you're looking for a shorter term investment, don't mind a little risk, and think you're knowledgeable enough to be able to recognize a good mutual fund, I think you'd be better off investing in an actively managed fund.


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