Hedge Your Bets
Slate's Daniel Gross lists five reasons why he thinks there’s a hedge fund bubble, and that bubble is close to bursting. It's required reading for anyone who is thinking about choosing a hedge fund over a well-diversified mutual fund portfolio.
For the Internet, residential real estate (now officially popped), and alternative energy, there were always telltale signs of bubbleness.
Those same signs suggest that our next bubble is already here, and it's … hedge funds.
1. Public investors are getting really excited when insiders sell, believing they're being cut in on a great deal… The whole idea of hedge funds is that they are exclusive and that the massive rewards—2 percent management fees and 20 percent of the profits—flow to the guys who own it. The advantage of running a hedge fund, as opposed to a mutual fund, is that you don't have to tell the public how much you've made or shed any light on precisely how you did it. So, why are some of the sharpest tacks in the business willing to sell out now and sacrifice all the advantages inherent in the hedge-fund structure?...
2. Everybody and their mother is getting into the business… Now, we've got politicians, diplomats, and policy wonks, who are frequently the last to know about any important private-sector trend, starting hedge funds…
3. As the naive newbies are plunging in, the successful early adapters move on to the next big thing… Spectrem Group, which tracks the spending and investing habits of the very wealthy, in January reported that truly, filthy rich (those with household net worth of more than $25 million) have recently cut back sharply on their hedge investments...
4. In the late stages, the investment craze crosses over into the broader consumer culture. In the summer of 1929, stock promoter John J. Raskob's article in Ladies' Home Journal, which urged everyday Americans to build leveraged portfolios, was a clear sign of the top. In the 1990s, the appearance of theStreet.com money maven James Cramer in ads for Rockport shoes proved to be a similar omen...
5. My portfolio is in turnaround. If there's one group of businesspeople that is even slower on the uptake when it comes to hot trends than politicians, it's Hollywood executives. Which is why television shows are often excellent signs that a bubble is popping...
Welcome to MAXuniversity
Earn your degree from MAXuniversity – MAXfunds.com's own online institution of higher investing education.
Current courses include:
MAXuniversity - Part I – Investing Basics. An overview of the whole investing enchilada. We'll teach you the difference between a stock and a bond, give you the lowdown on options trading, and tell you why investing in Beanie Babies is not really such a good idea.
MAXuniversity - Part II – Everything you always wanted to know about mutual funds, but were afraid to ask. Here you'll learn what mutual funds are, how they work, and why you should probably be in 'em.
MAXuniversity - Part III – MAXfunds.com's Seven Rules of Mutual Fund Investing. A simple, step by step guide for finding this year's hot mutual funds, before they show up on the cover of next year's Money Magazine.
Welcome to Part II of MAXuniversity!
Mutual funds are one of the most popular investment vehicles in the history of the universe. According to the Investment Company Institute, nearly half of all households in America have some money invested in mutual funds - either directly or through a retirement plan.
Part II of MAXuniversity is all about mutual funds. In it, we'll talk a bit about what a mutual fund is, go over the basic types of funds available today, and review the major advantages and disadvantages of mutual fund investing.
So what the heck is a mutual fund, anyway?
A mutual fund is a company that gathers money from many different individuals and institutions, pools that money together, and invests it in stocks, bonds, or even other mutual funds (and occasionally other things too.) In return the mutual fund company is paid a fee that's a percentage of all the money in the fund.
All mutual funds are strictly regulated by the Securities and Exchange Commission. The SEC reads and approves each mutual fund's prospectus and annual report, periodically audits mutual fund financial records, and generally makes sure everything with the fund is on the up and up.
Types of Funds
Internet funds, small cap funds, bond funds, emerging market funds, growth and income funds, global telecom funds, pacific region funds – with all these different kinds of funds out there, how is a potential investor supposed to choose which ones to invest in?
Don't panic. Despite all the fancy names mutual funds call themselves, there really are just a few basic types. Here's a rundown.
Load vs. No-Load
First of all, just about every mutual fund is either a load or a no-load fund. What's the difference? A load fund is one in which you pay some kind of sales fee, at the time of purchase (called a front end load), at the time of sale (called a back end load) or at regular periods along the way (called a level load). This fee generally amounts to about 5% of your initial investment, and it usually goes to the broker that sold you the fund.
No-load funds don't charge a sales fee to buy or sell shares.
Besides load funds charging a sales fee and no-loads funds not, there is absolutely no difference between the two. Load funds don't attract better money managers than do no-load funds. Load funds don't have lower annual expense ratios than no-load funds. When you buy shares of a load fund, you don't get a free honey-baked ham. So why would any thinking person ever want to invest in a load fund? The answer is, they wouldn't. To put it as plainly as we can, only suckers buy load funds.
Equity Funds
Equity Funds are mutual funds that invest primarily in stocks of publicly traded companies, like GM or Microsoft. That's pretty cut and dried, right?
Right. It does get a little bit tricky when you try to sort out all the different categories by which equity funds are identified. Bear with us, this isn't as complicated as it seems.
Equity funds are often described by the kind of stocks they invest in. Funds that invest in growth stocks (stocks of companies with positive outlooks for growth) are described as growth funds. Funds that invest in value stocks (stocks of companies that are currently considered to be cheap based on fundamental data like earnings, revenue, and assets) are described as value funds.
So far so good? In addition to putting stocks in either the value or growth camp, stocks are also defined by their overall market capitalization, or the total value of the company as calculated by total shares multiplied by outstanding market price. Small cap stocks have capitalizations less than $1 billion. If that doesn't sound very small to you, it's because large cap stocks have capitalizations over $5 billion (with some as high as $500 billion). Mid-cap stocks are between the two. Mutual funds can invest in any and all of the preceding types of stocks, so there can be small cap value funds, mid cap growth funds, or large cap core or blend funds.
Some mutual funds invest only in stocks of foreign companies. These are called International funds. Global funds are those that invest in stocks of both foreign and U.S. companies. Sector funds are those that invest in stocks of a particular industry or area, i.e., technology, real estate, and precious metals.
That said, it's important to remember that while fund classifications are useful as a starting point when picking a fund, it's up to the investor to take it from there and do a little research. Mutual fund managers have an unfortunate tendency to drift away from their stated investment strategies, so how a fund is classified isn't necessarily a completely accurate description of what it's invested in. Study the prospectus of any mutual fund you're considering buying. And if you already own a fund, it's crucial that you read its annual and semi-annual reports (your fund company should be sending these to you when they're published). If you discover that your fund isn't investing the way it says it is, it might be time to find a new fund.
Bond Funds
Bond funds invest in debt instruments (bonds) of corporations and governments, including state, local, federal, and foreign country bonds. Bond funds are generally a safer investment than equity funds because bonds are generally safer than stocks.
Some experts question paying a fee to join a bond fund. Good bonds are already almost risk free, so the diversification bond funds provide is unnecessary. This is not the case with higher risk bonds like junk bonds and emerging market bonds, where diversification offers the same benefits as with stocks. One thing that is for certain - since most bond funds provide pretty meager returns - the management fee you pay should be very low.
Income Funds
Income funds can invest in stocks that are bought primarily for their income (dividends) potential, not so much for their growth potential. A utility stock is an example of a stock in an income fund. They are generally safer than growth funds, buy more risky than straight bond funds.
Hybrid or Growth and Income
A Hybrid mutual fund is one that invests in both stocks and bonds.
Money Market Funds
Money market funds pool investor money and invest in short-term debt securities like treasury bills. Because T-bills are basically risk free, money markets are among the safest investments available - with the microscopic returns to prove it. The best you should realistically hope from a money market fund long term is returns that slightly exceed the inflation rate.
Fund of Funds
A mutual fund whose portfolio is made up of other mutual funds is called a fund of funds. Some large mutual fund families offer funds that invest only in the mutual funds of that family, often with no extra expenses than the individual funds in the fund levy. Other 'true' fund of funds invest in any mutual funds they think will achieve the highest return. Fund of funds offer about the quickest and easiest route to a truly diversified portfolio that exists in the investing world today. On the downside, some fund of funds returns are hindered by an additional layer of expenses (the expenses of the fund of funds itself, plus the expenses of all the funds the fund of funds has invested in).
Closed-end funds
The common kind of mutual fund is open-end, which means there is almost no limit to the amount of shares of itself it can sell.
A closed-end fund is set up differently. It issues a set amount of shares, which trade on an exchange like shares of a stock. And like a stock, if you want to purchase shares of a closed-end fund, you have to do so from an existing shareholder. Because of this, some out-of-favor closed-end funds trade at a lower price than the fund's NAV (the NAV, or net asset value, is the price of the fund, and is all the assets in the fund divided by the number of shares outstanding). Other, more popular closed-end funds trade at a higher price.
Index funds
To understand what an index fund is, it helps to first know what an index is. An index is a group of stocks that are picked by certain companies that are meant to represent a particular sector or segment of the economy. The oft-quoted Dow Jones Industrial (it becomes less and less "industrial" as the years roll on) Index is a group of 30 stocks of prominent American companies like Coca-Cola, Intel and General Motors. The S&P 500 consists of 500 companies chosen by Standard and Poors. Among other prominent stock indices are the Russell 500 Index, the Wilshire 5000 Equity Index, and the NASDAQ Composite Index.
An Index fund is a mutual fund that tries to mimic, as closely as possible, the holdings of a particular index. The manager of an S&P 500 fund does nothing but track the S&P 500 Index. If a stock is added to the S&P 500, the fund manager purchases that stock. Whenever Standard and Poor's drops a particular stock, the fund manager sells their holdings in that stock.
Index funds are what is called a passively managed fund. Managers of index funds don't actively seek out new investments; they follow as closely as they can the holdings of one of these indexes. Because costs of running an index fund are so low (all index fund managers need is some software to help allocate stocks in their proper weight to the index) a well-trained monkey could do the rest) index funds generally have a lower expense ratio than actively managed funds.
Mutual Funds – Why We Like 'Em
We think mutual funds are just great (we did start an entire website about them after all.) Here's why:
Expert Management: Mutual fund investors are handing off the responsibility of managing their money to people who know a lot more about investments then they do. Most mutual funds maintain sophisticated, well-staffed research facilities. Mutual fund managers frequently meet with representatives of companies they're considering investing in. They tour factories, pour over complex financial data, and ask tough questions to CEO's. We're quite happy having them do these things instead of us. Aren't you?
You've got better things to do with your time (we hope): Here's a list of things we'd rather do than to research potential investment opportunities, listed alphabetically: 1. Anything 2. Everything. Finding good investments is time consuming. It's tedious. It's expensive (how much is a subscription to Value Line™?!).
Mutual fund managers do the research for you. It's their job, and believe it or not, most of them even like it. That's not to say you should write a check to a mutual fund and cross your fingers. It's still each investor's responsibility to monitor the performance of the funds they're invested in and make changes when things aren't going the way they're supposed to. But trying to do yourself what mutual funds companies do for you would be pretty close to impossible.
The Big Pool: Put your little bit of money together with a lot of other people's little bits of money and pretty soon it becomes a whole lot of money. And investing a whole lot of money has certain distinct benefits over investing a little bit of money, including ease of diversification, reduced transaction costs, and shared research expenses.
Diversify, Young Man: As we said in part I of MAXuniversity, diversification is the practice of spreading your investment money out among many different types of investments in order to reduce the volatility of your portfolio. Mutual funds provide the cheapest and quickest way to achieve diversification available today. Whatever amount you invest in a fund is automatically divided amongst the 30 or 80 or 300 securities the fund holds. And that's a very good thing.
Mutual Funds – The Negatives
There are a few negatives to mutual fund investing, but in our opinion the good far outweighs the bad. Even so, lets quickly run down some of the issues often sighted as drawbacks:
Loss of direct control over your investments: When you hand your money over to a mutual fund, the manager decides what the fund buys and sells, you don't. If you're the type of person who doesn't like to sit in the passenger seat, this could be a problem.
Taxes: Because you lose direct control over your investments, you also lose control of your tax situation. If a fund sells a stock for a profit, you are liable to pay a tax on that profit even if you haven't sold any of your shares in the fund. Because you don't control when a fund sells a stock, you don't have control over the tax liability you are incurring.
Expenses: Having someone else manage your money isn't free. As we've said, mutual funds charge shareholders a management fee that is a percentage of the money each investor has placed in the fund. This fee varies wildly from fund to fund. Obviously, the lower the fee, the better (for an equity fund, an expense ratio above 1.75% is difficult to justify), but in our opinion, paying a reasonable management fee to a good fund is well worth the cost.
You have to pick: Like with every type of investment, some mutual funds are better than others. There are so many different funds, and so many different investing styles and categories, that trying to choose the right ones can be a daunting task. In part III of MAXuniversity, we reveal our top secret fund picking methods that we think just might revolutionize the industry.
Next up, MAXuniversity part III - Picking funds the MAXfunds way.
New Small Cap Fund Coming From Fidelity
Fidelity is attempting to ease some of the strain on its overstuffed small-cap funds by launching yet another one.
The financial services giant filed with the Securities and Exchange Commission last month to launch the Fidelity Small Cap Opportunities Fund, which will invest in the stocks of both "growth" and "value" companies in the U.S. and abroad.
Manager Lionel Harris has been with Fidelity since 1995 and has run the firm's $786 million Small Cap Growth fund (FCPGX) since April 2005.
Morningstar analyst Dan Lefkovitz says Harris has put together a decent record over the past decade. But he's concerned that capacity could be an issue, because Fidelity already runs a lot of money in small-cap funds."
Small cap funds are particularly susceptible to the danger of asset bloat. As assets rise in a small cap fund the more difficult it is to find good small-cap stocks in which to invest.
Fidelity launched one small caps in 2005: Fidelity International Small Cap Opportunity (FSCOX), and two in 2004: Fidelity Small Cap Value (FCPVX), and Fidelity Small Cap Growth (FCPGX). They also run the largest small cap fund in the business, the $39 billion Fidelity Low Priced Stock fund (FLPSX).
Mad at Blodget
Henry Blodget at Slate doesn’t think people should be following Jim Cramer’s advice any more than we do. Cramer's army of dedicated fans disagree:
My article about Jim Cramer two weeks ago generated a lot of feedback. For starters, I underestimated how many people take Mad Money seriously. Here are some of the arguments his fans made to me. My responses follow.
1. "Jim Cramer does not think you should speculate with your retirement savings—just your 'mad money.'" If this is true, phew. (I say "if" because I didn't see this caveat in the Mad Money show description or in the introduction to Cramer's new book, Mad Money: Watch TV, Get Rich.) Assuming you define "mad money" as "the amount you would be willing to blow on a weekend in Vegas," you'll be OK. The odds of winning the speculation game—e.g., doing better than a low-cost index fund—are low, but as long as you understand this, there's nothing inherently wrong with speculating. Speculating is fascinating, entertaining, and fun. Unless you have a major talent or information edge, however, it's also a bad investment strategy...
2. "Jim Cramer is right a lot." No argument here. Cramer's a smart guy and an experienced trader, so of course he's right a lot. He predicted Google would go to $500, for example, when most Wall Street analysts were suggesting it might peak at $200. I am not arguing that Cramer is usually wrong. I am arguing that his overall investment advice—try to out-trade the pros—is lousy. A far more intelligent strategy, one that will beat most pros, is to buy and hold a diversified portfolio of low-cost index funds. In the vast majority of cases, this will yield higher returns with less risk, time, effort, and stress than short-term speculation. The good news is, even if you pursue the smarter strategy, you can still watch Cramer's show. Just don't fool yourself into thinking that it will give you a good chance of winning the speculation game...
3. "If you had followed Jim Cramer's Mad Money recommendations, you would have beaten the market." I have seen no studies that conclude that Cramer's recommendations have beaten the market even before costs (and I have seen a couple that have concluded the opposite). In the real world, of course, you can't ignore costs, and costs usually bring even talented speculators to their knees...
4. "Jim doesn't say you should just blindly do what he says. He recommends that do your own research—and he tells you how to do it." At first blush, this sounds responsible and persuasive (and it's certainly more responsible than "watch TV, get rich.") The trouble is that it encourages amateur investors to believe that, if only they watch the show and do a bit of research, they can win the speculation game. The reality is that your odds of winning are low even if you have above-average skill and even if you do nothing but research..."
Using Dividends To Divine Future Returns Part II
In the first part of this article, we’ve talked about the S&P500 index in general and the current, somewhat paltry yield. Funny thing is, when you look at the actual stocks in the index, things look a little brighter.
Here are the top 10 stocks and dividend yields in this market cap-weighted index:
| Ticker | Name | Div Yield |
| XOM | ExxonMobil | 2.11% |
| GE | General Electric | 2.90% |
| MSFT | Microsoft | 1.29% |
| C | Citigroup | 4.14% |
| BAC | Bank of America | 4.26% |
| PG | Procter & Gamble | 2.10% |
| PFE | Pfizer Inc. | 3.63% |
| AIG | American Intn’l Group | 0.90% |
| JNJ | Johnson & Johnson | 2.20% |
| MO | Altria Group | 4.35% |
Note that almost all of these stocks pay larger dividends than the S&P500 as an index (1.7%). How is this possible, when these stocks make up some 20% of the index? ...read the rest of this article»
Mutual Fund Longshots
George Mason did very well in the NCAA playoffs: the underdog college basketball team got all the way to the final four. Few thought it was possible – the odds of the Patriots winning started out at a long shot 150-to-1. Such odds, which are set by experts and betting behavior, meant that almost nobody thought the Patriots would do as well as they did.
In fact, the Patriots were this year's Cinderella team – even beating favorites like UCONN and North Carolina. With sports, big upsets are quite rare. With mutual fund investing, the favorites often lose.
There is a high correlation between past performance and future performance in sports. Chances are, Tiger Woods will beat most other golfers this year. Mike Tyson, in his prime, was a near-guaranteed winner. Just having Michael Jordan on your team practically assured an NBA championship. ...read the rest of this article»
Ask MAX: We Aren't Married, Will She Owe Taxes When I Die?
Ron from Atlanta asks: 'I'm 62 years old and am not married but I have lived with my girlfriend for over 17 years. She is the main benefactor in my will (which includes a house and a decent-sized mutual fund portfolio), and I plan on leaving her my IRA assets. Will she be required to pay taxes on those assets?
Stuffy old Uncle Sam still doesn't give his full blessing to unmarried couples.
When married people die, they may leave their spouse an unlimited amount of assets free of federal estate taxes. That's called the marital deduction.
Unmarried couples do not receive an unlimited marital deduction, and therefore your girlfriend could be due a nasty tax bill after you leave this mortal coil.
Your estate is the total value of all of your assets, less any debts, at the time of your death.
If you died tomorrow and your assets total less than $2 million (the current federal estate exemption, increasing to $3.5 million in 2009), your girlfriend won't have to pay anything by way of taxes.
If you want to leave an IRA or property in excess of the exemption, it will trigger the dreaded estate tax - currently as much a 46% of the estate's value. ...read the rest of this article»
Ask MAX: Capital Gains Quickies
Andrew from Minneapolis asks: 'I'm a mutual fund investor who was hit with taxes on my fund holdings this year (after a few years without paying any). Frankly, I'm not entirely clear on what a capital gains distribution is. I asked my accountant and he didn't seem to be able to explain it to me. Can you help?'
In most cases, mutual fund investors haven't had to worry about their fund’s tax bills since 2000. Weak market returns from 2000-2002 meant that there weren't any capital gains to distribute in the early part of the decade, and the losses many funds realized offset some of the gains made in the following years. But strong performance of many funds from 2003 to 2005 has finally caught up with fund investors, creating a rough tax burden for many of them this year. In 2005 Lipper estimates fund investors paid a whopping 58% more in taxes on fund distributions than in 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 available 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, some mutual funds charge excessive fees, and worst of all, mutual funds sometimes hit investors with large and unexpected taxable distributions. ...read the rest of this article»
Welcome to Part III of MAXuniversity
One of the things we hoped to achieve when we started MAXfunds.com was to help investors to make better-informed mutual fund investing decisions – to give them a better way to look at mutual funds. Part III of MAXuniversity shows you how, by revealing our seven golden rules of mutual fund investing.
Rule #1: No Loads!
Like we said in MAXuniversity part II, you should never, ever buy a fund that comes with a front end or back end load. To repeat, you start 5% or more behind a no-load fund. Also, it does not matter whether the load is up front, back end, or one of them newfangled level loads.
Rule # 2: Don't overestimate Past Performance figures
At MAXfunds.com, every employee is required to get the phrase "Past Performance Is No Indication of Future Returns" tattooed somewhere on their body. Preferably their foreheads. They must be able to recite it in some twelve languages. We make them post it over their beds, so it is the first thing they see when they wake up in the morning, the last thing they see before falling asleep at night.
We know, you've heard it a million times before. But despite this phrase's presence in practically every mutual fund ad ever created, not enough investors pay attention to it.
According to a report by the investment company institute, 88% of fund buyers cite past performance as the primary reason they select one fund over another. And really, it's hard to blame them. It seems perfectly reasonable to think that if a fund has posted 25%+ returns for 3 years in a row it's got a pretty good shot of doing it again next year too. And why shouldn't it? The fund manager must be doing something right. Three years in a row, that's no fluke.
No, it's not a fluke, but chances are performance like that isn't sustainable either. As crazy as it sounds, often the better a mutual fund has performed in the past, the more difficult it becomes for the fund to perform well in the future. According to a study by The Financial Research Corporation, over the ten-year period of 1988-1998, funds whose performance placed them in the top 10% (10th percentile or higher) of all mutual funds one year fell, on average, to the 51st percentile (woefully average) the next year.
When a fund posts good returns for a few years in a row, a lot of people want to invest in it. The more people that want to invest in it, the more money the fund has to invest. The more money the fund has to invest, the more difficult it is to continue posting good returns. Why? Read on!
Rule # 3: No Fat Funds
Did you know mutual funds can get fat? They can. A fat fund is one that has so much money the manager literally has trouble investing it all.
Mutual funds exist to make money for the people who put them together. The way they make it is by charging a management fee to shareholders that is a percentage of each shareholder's investment. If a fund charges shareholders a fee of 1.5%, and the fund has assets of $1 million dollars, the fund management company will make $15,000. With assets of $10 million dollars, they will make $150,000. Assets of $100 million dollars produces fees of $1.5 million dollars. The more money the mutual fund takes in from shareholders, the higher their fee works out to be. It's only natural that a fund will try to pull in as much money from as many people as it can.
The problem is that very often the more money a fund manager has to invest, the worse the fund performs. Why? Because finding good investments is not that easy, even for professional money managers.
Here's an example: Let's say a fund manager, we'll call her Marge, runs 'The Marge in Charge Fund' a small-cap fund with modest assets of $30 million dollars. She and her research team find 30 small cap stocks to invest in - and they put a million dollars into each company.
Now Marge and her team pick well. Her fund goes up 30% the first year, 40% the next year, and 40% the year after that. In fact the fund's performance is so good, it shows up on the cover of Money Magazine as one of the "Top 5 Funds Every Investor Must Buy Immediately or Life Just Isn't Worth Living." Investors see the article and figure Money Magazine knows what it's talking about. They start writing checks. In a few months, Marge's fund has $500 million dollars of new investor money (not an unreasonable scenario, we assure you).
Marge's small-cap fund just got fat.
Marge now has two options: she can invest the $500 million in the same thirty stocks the fund's portfolio already owns, she can look around for a bunch of new stocks to buy.
The problem with investing the $500 million into the 30 stocks she already owns (and each of which she's already invested a million dollars) is that for a mutual fund, it's bad to have too large of a position in any single stock. If a fund owns much more than 1% of any company and decides to sell those shares, it will negatively affect the price of the shares it sells. Fund managers want to get in and out of stocks quickly and efficiently without moving the price a lot. If they own too much of one stock, this becomes extremely difficult.
Option two isn't much better. Even for professional money managers, it's not that easy researching and finding good stocks – you have to really analyze each company and its competition. The average small company stock has a market cap of about $500 million dollars. For Marge's fund to try and invest the $500 million dollars in her fund and not exceed a 1% stake in each company, she'd have to find another 100 good small cap stocks to invest in. That's a lot of different stocks, and Marge had a hard enough time finding 30 good ones. What's likely is that she'll find a few good companies to invest in, and a few that aren't so good. With each not so good stock she adds to her portfolio, the more mediocre her returns in the future.
Marge does have a third option. She can stop accepting new money once the fund reaches a certain asset level, say $250 or $300 million, and not have to make as many sacrifices in her portfolio management. From a shareholder standpoint, this is what Marge should do. From Marge's perspective, this option is not very attractive. Marge's fund charges a 1% management fee. For every $100 a shareholder invests in the fund, Marge makes $1 each year. With assets of 30 million dollars, Marge and her team make $300,000. Not bad. But Marge lives in New York City, and nowadays in the Big Apple 300 large doesn't get you very far. But with assets of $500 million dollars, the management fee would be $5 million per year. Those are 5 million very good reasons for Marge not to close the fund to new investors. Hello Tavern on the Green, goodbye Benny's Burritos. Hello Tribeca loft, goodbye 4th floor 500 square foot walk up. Hello... you get the picture.
How do you know if a fund is too fat? Look at its Fat Fund Index, found on each fund's MAXinsights page. We've figured out what each fund's maximum asset size should be and compared it with the fund's actual assets. A Fat Fund Index of 1 or 2 is ideal. It means that fund is slimmer than Michael Jordan and isn't in danger of getting fat anytime soon. A Fat Fund Index of 3 is still acceptable, but is developing some love handles and should watch it's new shareholder money intake (and so should you). A 4 means a fund is too fat - it's exceeded its maximum recommended asset size and will probably start producing less than stellar returns in the very near future. A fund with a Fat Fund Index of 5 is a real glutton - bloated, slow, and unhealthy. A fund with a Fat Fund Index of 5 should be avoided at all costs.
Rule # 4: The Younger the Better
Does the age of a mutual fund have anything to do with the kind of returns it produces? Very often, the answer is yes.
Younger mutual funds will tend to have lower asset levels than older funds. As we talked about above, funds with lower asset levels generally produce better returns than fatter funds. But that's not the only reason younger funds do well.
Mutual fund companies know that many investors use past performance as the primary factor in deciding whether to buy a fund or not, and a fund that produces exceptional returns for its first several years can continue to attract investor money long after its glory days are behind it. Fund companies often pull out every stop to make sure their newest funds produce the best returns they possibly can. They do this in several different ways.
Large fund companies will seed their younger funds with hot initial public offerings. An I.P.O. is when a company first offers shares of itself for sale to the public. Big investors like mutual funds can get in on I.P.O.'s at the offering price, not the first traded price like your average investor. When the public starts buying, the shares owned by the fund are almost guaranteed to go sky-high. A few good I.P.O.'s in a new fund's portfolio can do wonders for a fund's performance figures.
Another way fund companies boost the performance of their younger funds is by front-running - purchasing shares of a company for the younger fund's portfolio just before they make a big purchase for one of their larger funds (or talk the stock up on CNBC). Some mutual funds are so big and make such large stock purchases that they actually cause the shares of the company they are buying to go up. If their little brother already owns shares of that stock, it's going to help the younger fund's returns.
You can tell how old a fund is by finding its F.P.O. (first public offering) on the top of it's MAXinsights page. While you're at it, check out the funds Family Advantage Index - a statistic that reveals to what degree a fund is helped by belonging to a large fund family. A fund with a Family Advantage Rating of 1 belongs to a large and wealthy fund family which will almost certainly help its early performance. A fund with a Family Advantage Rating of 5 is an only child, so it's not going to benefit as much from I.P.O. seedings, or front-running.
Rule # 5: Watch Expenses
The expense ratio is the percentage of investor money the fund uses each year to run the fund and pay the manager. An expense ratio of 2% means that 2% of your money last year went to things such as administrative costs, management fees, research trips, legal counsel, accounting, printing statements and literature, advertising fees, investment conference junkets to Bermuda, fancy promotional materials and other stuff.
The most important thing to remember about expense ratios is that they vary widely, and differences from fund to fund really do matter. Some mutual funds charge only one-half of one percent to manage investors' money. Others have sky-high expense ratios of nearly five percent. In our opinion, there is very little reason to invest in a fund with an expense ratio of more than 2.0% (and even that's only for the rarest gems in the fund world).
Seek out funds with expense ratios of 1.25% or less. Anything higher and it's just too hard for the fund manager to produce returns that are worth the risk of investing. You can find the expense ratio for each fund at the very top of its MAXinsights page. You may need to cut a small or new fund a little slack on this rule because it is difficult to keep costs down as low as the big funds. Very often, the advantages offered by small fund offset the handicap of a slightly higher expense ratio.
Rule # 6: Check Performance Relative To Class
We know, we told you not to look at past performance when deciding to invest in a fund. But there is real value in knowing how well a fund has done against other funds of the same type. If you're in a Latin America fund that was up 20% last year you're probably pretty happy. But if all the other Latin American funds are up 50% in the same time period, all of a sudden your fund isn't looking so good. Performance Relative to Class is one of the most effective indicators a mutual fund shopper can use to weed out under-performing managers.
Rule #7: Know The Fund's Risk Level
One of the trickiest things about picking funds is figuring out how risky the fund is that's being considered. Potential investors often just see the performance, the rankings, or the slick advertisements and buy, buy, buy. Usually the funds that end on top of "The Best Performing Fund of the Year" list took some big risks to get there.
It's not that risk is necessarily bad, but investors should always find out how risky the fund they're considering investing in is. If you can afford to lose a whole lot of a particular mutual fund investment, go ahead and take a risk. If you can't, you had better find a safer fund.
On the data page you will find every funds risk level expressed as a number from 1 through 5. A fund with a 1 rating is about as safe as equity investing gets, with the likelihood of losing more than 15-20% being pretty remote. A fund with a 5 rating is very risky, with loses of over 40% being relatively common. Of course, funds with risk levels of 5 can go up more in the right market than a 1 fund. (Keep in mind these rankings were developed for equity funds. Most bond funds are safer than even a 1 ranked equity fund – there is a certain, unavoidable degree of risk in investing in equities.)
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