Welcome to Part III of MAXuniversity

February 14, 2007

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 Kate Moss 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.)