Advantages and Disadvantages of Mutual Funds

As a general rule, the first palce to start analyzing a fund is by by comparing its expense ratio to similar funds. All funds have fees and expenses, but the amounts vary. In addition to sales and redemption fees, the mutual fund’s prospectus indicates the fund’s management and administration expenses. The fund’s investment advisor generally receives 0.5 to 1.0 percent of the fund’s average daily net assets. Administrative expenses include legal, auditing, and accounting costs, along with the fees for directors and the costs of preparing the annual report and proxy statements. These administrative expenses are added to the investment advisory fee. The total costs often average between 0.75 percent and 1.25 percent of fund assets. Savvy mutual fund investors are wary of funds with expense ratios that are more than 1.25 percent.

In 1980, the SEC passed Rule 12b-1, which allows mutual fund companies to charge advertising and marketing expenses. These costs typically range from 0.25 percent to 0.30 percent and can be as high as 1.25 percent. Some mutual funds charge these fees and others don’t, so read the mutual fund’s prospectus carefully.

The Mutual Fund Education Alliance (www.mfea.com) is a not-for-profit trade association of the no-load mutual fund industry. The Web site’s Mutual Fund Investor’s Center is designed to serve investors who want to use mutual funds to reach their financial goals. The site provides links to profiles on performance data for no-load mutual funds, lists of funds with the lowest initial minimum deposit, lists of funds with the lowest expenses, comparative indexes, and other relevant mutual fund information.

Comparing costs and return

PersonalFund.com (personalfund.com) and the premier features of Morningstar (www.morningstar.com) allow you to investigate fund alternatives that have similar characteristics but lower costs. The returns of the mutual fund you select can be radically reduced by hidden costs. When evaluating a mutual fund, consider the following:

Returns: Keep in mind the power of compounding, which can be used against you. For example, say that you select a fund that has a return of 8 percent when a similar fund has a return of 10 percent. Over your lifetime, that two percent difference can be the difference between retiring in luxury and living in fear that you will outlive your retirement funds.

Costs: Predicting the cost of owning your mutual fund is easier than predicting future market activity and the performance of your mutual fund. Keep in mind that mutual funds charge

• Management fees: Shareholders are charged management fees by the company that manages the fund.

• Transaction fees: Shareholders are charged transaction costs when fund managers buy or sell shares of the mutual fund. If the mutual fund has a high rate of turnover, the fund’s returns are less than a similar fund with low turnover.

• Taxes: Shareholders are charged taxes on distributions (dividends and capital gains) from the fund. Fund distributions look good to potential shareholders. Unfortunately, current shareholders have to pay taxes at their ordinary tax rate on the short-term gains, which reduces the return of the mutual fund.

At PersonalFund.com, you can personalize your analysis by using Personal Fund.com’s questionnaire to indicate how much you’re investing, whether the account is taxable or nontaxable, how long you expect to hold the fund, and your required rate of return (before costs). If the fund is in a taxable account, enter your tax bracket for ordinary income and the tax bracket for long-term capital gains. Click the Calculate Costs button to get an analysis of the total cost of ownership.

PersonalFund.com can provide an analysis of your fund and suggestions for three similar funds. All four funds are fully analyzed. Click the Go button to determine whether it makes sense to sell your shares in your fund and replace them with a different fund.

The new analysis looks at the trade-offs (out-of-pocket costs, taxes, commissions, and loads) and future returns, shows you how much better the new fund must do to justify making the switch, and gives you the opportunity to change your assumptions and recalculate. A recent analysis, based on the assumption that the Wilshire 5000 Index Portfolio (WFIVX) has a 0.15 percent higher net return than Matrix Advisors Value (MAVFX), indicates that you wouldn’t break even within ten years before taxes, nor would you break even net of taxes. In other words, you wouldn’t receive any benefit from replacing the MAVFX fund unless you plan to hold the new WFIVX fund for more than ten years. That’s certainly something to think about!

Experienced mutual fund investors typically avoid funds with expense ratios greater than 1.25 percent.

Some mutual fund companies may have low up-front fees but charge high rates for managing fund operations. The prospectus details whether the mutual fund charges these fees. I give you details on prospectuses in the section “Locating and Reading the Prospectus.”

Understanding mutual fund risks

Smart investors select opportunities based on their risk return. For example, the promise of a big return may not be worth the level of risk. Conversely, investing in a security with a low guaranteed return (such as a savings bond) may not keep up with inflation. In this situation, you lose money because you didn’t take enough risk.

Different investments have different types of risks. You can minimize your risk by investing in different types of securities. RiskGrades (www.risk grades.com) uses scores that are based on statistical analysis of historical price fluctuations of stocks and bonds (and foreign exchange rates and commodity prices). Large price fluctuations are an indication of high uncertainty, or risk. With your free registration, you can measure the risk of a single security or your entire portfolio. For example, imagine two large cap mutual funds that have the same costs and returns. The first fund has a risk grade of 72, and the second fund has a risk grade of 57. All things being equal, you should select the mutual fund that has less risk (or lower risk grade). Mutual funds provide statements about their objectives and risk posture (which is briefly explained in qualitative terms in the prospectus). Rather than provide precise information to help you evaluate the riskiness of a mutual fund, however, these statements typically offer vague, general explanations of a fund’s approach to risk. For more precise, statistical evaluations of a fund’s risks, you can turn to independent mutual fund rating services, such as Morningstar (www.morningstar.com).

Morningstar and other independent mutual fund rating services calculate such statistics as the standard deviation of a fund’s return. I don’t want to turn this article into an introductory statistics course, but I can tell you that standard deviation helps you judge how volatile, or risky, a fund is. This statistic shows you how much a fund has deviated from its average return over a period of time. Standard deviation offers a clear indicator of a fund’s consistency over time. A fund’s standard deviation is a simple measure of a fund’s highest and lowest returns over a specific time period. Just remember this point: The higher the standard deviation, the higher the fund’s risk. For example, if the 3-year return on a fund is 33 percent, that statistic may mean that the fund earned 11 percent in the first year, 11 percent in the second year, and 11 percent in the third year. On the other hand, the fund may have earned 28 percent in the first year, 5 percent in the second year, and 0 percent in the third year. If your financial plan requires an 11-percent annual return, this fund isn’t for you!