Everything You've Heard About Mutual Funds is Wrong

You can't get away from them. They're in newspapers and magazines, on TV and radio and the Internet, and they are a staple of workplace and cocktail party conversation. They're mutual funds, and, as with computers, if you don't own any, it's probably because you're paralyzed by the confounding complexity of it all.

Investing in mutuals isn't brain surgery. Brain surgery involves a manageable number of specific, dependable techniques that typically yield predictable results. Fund investing involves a seeming infinitude of factors, variables, statistics and technical analyses of varying and arguable worth, along with a host of assorted, and often conflicting, proven methods, prevailing wisdoms and winning strategies.

Fact: For virtually every timeless truth in fund investing, there's a data junkie somewhere who can refute it statistically.

I'm no professional investment counselor. I'm just a freelance writer trying to provide for my eventual retirement in an era when Social Security will be about as viable as unicorn breeding. Thus I've been investing in mutual funds for seven years now, and I have digested almost everything on the subject that has crossed my path. I have concluded that picking mutual funds is largely like picking horses at the track: It's as much a matter of luck and hunch as it is of empirically reliable methodology.

Even so, some rules and rationales are sounder and more sensible than others, some techniques more demonstrably successful than others, and some realities more relevant than others. Most important, the more I've learned, the better I've done.

Here's what I've learned.

I have one simple rule of thumb: Only invest what you could afford to lose without that loss having any effect on your daily life in the foreseeable future.---Peter Lynch

Your first and most important investing decision is asset allocation: how much to invest in funds. (By which I mean U.S. equity funds. There's probably room for fixed-income and international funds in your portfolio, but not in this article.)

Ignore such witless formulas as "the percentage of your savings to have in stock funds should equal 100 minus your age." This has nothing to do with individual financial realities. The axiom that "the younger you are, the more you can take risks and ride out down markets" overlooks the vastly different risk tolerances of a single, healthy 25-year-old with an MBA and a married 25-year-old with three kids, a mortgage, a vulnerable job and a bad back.

More germane to how heavily you invest are your personal financial condition (income, budget, job security), the size of your investment nest egg and how long you know you won't have to touch it---your time horizon.

Equity funds observe the law of risk and reward: the greater the former, the greater the latter, and vice versa. The more assets that you invest in equities, the higher your risk-reward potential.

Financial writer Jane Bryant Quinn's guidelines for risk are fairly typical: 100 percent in equities is high risk, 50 percent is medium risk, 20 percent is low risk. She defines low-risk indicators to include low earnings, big debts, poor health, a time horizon of four years or less and a tendency to fret over paper losses. A high-risk investor has hefty and reliable earnings, a comfortable net worth and a blithe indifference to down markets lasting up to two years.

Tip: Be brutally honest about your emotional fortitude. This is a roller coaster, and if turbulence in the market will produce turbulence in your gut, you're much more likely to make impetuous, and wrong, decisions.

Ninety percent of your investment success comes from picking the right types of funds, and only ten percent from picking the right funds.---William Donoghue

In choosing individual funds, don't start with proven winners as defined by various financial magazines' and services' performance ratings. Start by determining the kinds of funds that are best for you and in what proportions. Different fund types are designed to meet different goals, such as minimal risk (balanced), long-term capital growth (capital appreciation), maximum returns (growth, aggressive growth) or steady income (growth and income, equity income).

Conservative investing seeks decent gains with the least amount of risk. It emphasizes funds that capture dividends or concentrate on undervalued stocks. Dividend income is a quiet but formidable engine for robust longterm profits. Income funds tend to be more stable. Steady, reinvested dividends provide a superb cushion when the market is falling. Value funds buy bargain-priced stocks with good fundamentals. In theory, such stocks offer more growth potential and less ground to lose if the market sours.

Aggressive investing scoffs at risk and goes right for the gold. It emphasizes capital growth funds: growth, aggressive growth and small cap (smaller, often younger companies).

Note: Some aggressive growth funds sell stocks short. If you're bullish, write them off.

Your greatest friend and protector is time, which diminishes risk and virtually ensures reward. Had you invested entirely in equities in 1947 and held your portfolio intact until 1993, you would have taken some savage one-year hits (one as high as 26.5 percent), but you would have gained an average 13.4 percent annually. The longer your time horizon, the more the historical incline overcomes the hits.

As a rule of thumb, you can expect the market (for the purposes of this article, the Standard & Poor's 500) to rise about ten percent a year over the long haul. But, as the small print says, past performance is no indicator of future trends. Since 1970 the market has stagnated for periods as long as six years. In one 21-month thrashing in 1973 and 1974, it nose-dived 45 percent. Thus, Fidelity, the world's largest mutual fund manager, suggests you use your time horizon to determine how you should allocate your assets. If you don't expect to need your mutual-fund money for ten years, you can be 100 percent in equities. If your time horizon is seven years, 65 percent; four years, 40 percent; two years, 20 percent. If you'll need your money in less than two years, stay out. Mind you, these are simply guidelines; your own mileage may differ.

Generally, aggressive funds perform best in up markets. But in bear markets aggressive funds can hemorrhage while the conservative funds merely cough. In seven bear markets since 1961, balanced and equity income funds lost an average 17 percent in value and took just nine months to recoup their losses. But growth and small cap funds lost 29 percent and spent 16 months in recovery. The lesson: The shorter your time horizon, the better off you'll be with conservative funds. Brokerage firm Charles Schwab recommends conservative funds for investment periods of two to five years, and aggressive funds if you intend to be in for five years or more.

Caveat: Lately, the difference in risk and reward between conservatives and aggressives hasn't been that impressive. From 1985 to 1995, aggressive growths returned 205 percent versus equity incomes' 188 percent. In flat-line 1994, the former lost 5.8 percent and the latter 3.5 percent, and in white-hot 1995's first 11 months, growth funds gained 27 percent, equity incomes 25.7 percent. Bear market safety may be the conservatives' primary edge.

Tips: Skip asset allocation funds, which combine stocks, bonds, cash, international funds and other investments. Most balanced funds do likewise, but without making speculative plays in gold or real estate, and they virtually tied general equity funds' returns from 1983--1992. Also, rebalance your fund mix every year as your various categories' values grow or shrink, You'll lock in profits from winners and add to laggards that may be prime for a move.

You've decided which fund types to buy; now you have to evaluate and identify the best prospects in each category. This is roughly as simple as finding an honest mechanic. For example, Mutual Funds magazine polled 100 so-called experts about their primary criterion for evaluating funds. The runaway leader was consistently above-average returns over time, preferably ten years.

As we noted before, past performance tells you only what has happened, not what will. Even funds with sterling long-term records can and do tank. Still, historic performance is what the experts look at. So it is a logical place for you to start. Look for funds whose total returns are routinely in the top 25 percent to 30 percent of their categories. Most magazines' performance ratings compare funds with their peers (growth to growth, balanced to balanced). But be careful---definitions vary, and one magazine's capital appreciation fund may be another's aggressive growth. When rating systems disagree, call the fund and ask how it categorizes itself, and why.

Caveat: Small cap is notoriously subjective and can mean companies with an average market capitalization of $500 million, $750 million or $1 billion. My bias is that small should mean $500 million or less. Also, many "domestic" funds include foreign holdings, sometimes up to 50 percent. If this troubles you, pass them up.

Then compare funds over the same time. Some people will tell you market trends are so transitory that anything beyond one year is meaningless. But many analysts want at least ten years in order to include the bear market of 1987 and factor in how a fund (continued on page 92)Mutual Funds(continued from page 82) weathers bed times. Alas, if you require more than five years you'll have to rule out a huge number of newer funds---many of them with excellent results and perhaps brilliant futures.

A possible tactic is to use time as a conservative variable. The lower your time horizon or risk tolerance is, the more "past" you want. The more risk you're willing to assume, the less history you'll need. But heed Eric Tyson, author of Mutual Funds for Dummies: "What happens to the value of equity funds in the short term is largely a matter of luck."

More important than overall past performance is consistency. Whatever your time frame, check the fund's year by year returns to see if its superior record was produced by one killer year and several mediocre ones. Of funds that grew an average of, say, 13 percent annually over time, give the edge to those whose individual years were fairly close to that average. That indicates a fund manager's ability to adapt to shifting market conditions. Funds that rise or fall widely may just be beneficiaries (or victims) of chance.

Tips: Within your time span, focus on funds that beat their peers' average two out of every three periods (quarters or years). And note the fund's worst down year; if you can't live with a similar falloff, stay out.

Bear in mind that a fund's past performance is meaningful only if the same manager still runs the fund, and in the same way. Length of tenure at the helm is important: The number of equity funds has increased since 1989 and, as with baseball, expansion brings a host of untested and marginal players into the game. Most of the new managers don't have experience with bear markets or 1987-style debacles.

Even superior funds can slip after a star manager leaves. Be wary of funds that have recently changed managers. However, if the new manager will continue the fund's successful objectives and strategy and has managed, with good results, a similar fund elsewhere, you needn't worry too much. (But remember: A small cap genius who takes over a utilities fund can perform like Michael Jordan in a baseball uniform.)

Tip: Funds run by individual managers tend to outperform those managed by teams.

Some analysts feel that smaller funds are better. Funds with huge assets to invest may not be able to respond quickly to hanging markets, or may be forced to buy their favorite stocks to the point of dangerous overexposure. They may even buy marginal stocks they would otherwise pass on.

There's some truth to this, but rapid asset growth is more suspect than mere size, and a warning sign, not a curse. Berger 100 was a ten-year superstar when it managed $100 million to $300 million. Since it passed $1 billion, it's been an also-ran. But many people predicted unpleasantness for Fidelity Magellan and for 20th Century Ultra, with similar growth. Both were among 1995's highfliers. The old familiar lesson: It's not the size that counts but what you do with it.

Tip: Give points to fund families that offer telephone redemption---allowing for a quick bailout---and allow you free transfer into their other funds.

Because certain types of funds (such as equity income and balanced) predictably create more taxable income than others, some fund analysts make a big deal about tax liabilities. But this is like worrying about the tax consequences of getting a raise. Unless you're already in or near the highest bracket, taxes are a nonissue.

Two more meaningful factors in fund evaluation are risk and expenses. Let's consider them in order. The problem with risk is that it's hard---perhaps impossible---to measure. First, calculations of risk, like those of performance, are based on past realities. Some funds with seemingly bulletproof, low-risk ratings in 1993 (Vanguard Wellesley, Stratton Monthly Dividend) were ravaged in 1994.

Second, most risk measurements simply reflect the volatility of a fund. That tells you only how wildly a fund's returns have fluctuated in good and bad periods. It doesn't necessarily predict anything about your likelihood of losing money. Moreover, a fund that holds relatively few stocks or plays a narrow market sector can be low in volatility but still high in risk.

Still, volatility is important. A mercurial fund needs significantly more big upswings to succeed. The math is simple: Put $1000 into a fund that rises 50 percent one year and falls 50 percent the next and you will wind up with $750. A fund that nudges steadily upward or vacillates narrowly will beat one that whipsaws.

Your two major risk reducers are time and diversification. Given time, the market has never lost money over the long haul. (But that has sometimes meant riding it out for ten years or more.) Diversification addresses the fact that individual funds and fund types rise and fall at different times and rates, and for different reasons. The more you spread your money across a variety of funds and fund types and avoid concentration in isolated segments, the more you moderate your overall risk.

Diversification can be achieved by owning several funds in your chosen categories or by owning index funds, which buy hundreds of stocks in their particular category (small cap, balanced, value, etc.). Different indexes march to different drummers; large cap and small cap---and value and growth---tend to move in and out of favor inversely to each other. Your desired result, says Morningstar vice president Don Phillips, is analogous to "pistons in an engine, elements that are going to hit at different times and succeed in different environments to get smooth performance in a variety of markets."

How many fund types you should own is a matter of opinion, goals and capital. Nest egg permitting, most experts advise at least four: large cap, small cap, value and growth. I would add equity income and aggressive growth and, if you're investing more than $50,000, I'd recommend two or even three funds of each type. More than that is probably excessive---you could get about the same results with less expense in an index fund of each category. And the more funds you own, the more you must monitor and make decisions about. If you start losing track of what you own, and why, and how it's doing, you're overextended.

Remember that broad diversification is inherently conservative. If you're aggressive and want real action, you'll find it at the other end of the risk-reward spectrum: sector funds. These are niche investments concentrated in specific industries---in energy, health, technology, etc. They're often labeled "select" or "strategic" and are as much speculation as investment.

Any given year's top funds are usually sectors, but so are its dead-dog losers. And they're volatile enough to give you the bends. Fidelity Select Energy roared up 59 percent in 1989 and sank 23.5 percent in 1991. Sector funds require close and constant scrutiny and a "no guts, no gravy" temperament. Experts recommend them only if you know the industry well and are already broadly diversified. Failing (continued on page 161)Mutual Funds(continued from page 92) that, consider buying a general fund that is heavily into the sector without being formally committed to it.

Caveat: If you're conservative, be aware that some nominally diversified funds may have 65 percent or more of their assets in a specific sector, with all the attendant risk. Read the quarterly, semiannual or annual fund report.

All funds have expenses in varying amounts. But the rule is simple: The less money the fund deducts, the better your probable return. Resist the argument that top-performing funds are worth the extra cost. Even usually dependable winners have occasional bad years, but their expenses are unremitting.

Expenses come in many guises. The most conspicuous are loads---sales commissions deducted up front when you buy into a fund. Avoid load funds. First, you're not buying better performance: For five years through 1994, pure noload funds rose 52.4 percent, load funds 50.8 percent. Some of the individual load funds are admittedly stellar, but for almost every one there's a no-load look-alike somewhere.

Second, loads are understated. On $1000, a "five percent" load takes $50, which is actually 5.26 percent of your net $950 investment. Thus the fund must earn 5.26 percent in the first year to break even. And loads compound with returns---if the fund doubles in value, a $100 load becomes $200 in lost value. Finally, by skipping load funds---of which there are a multitude---you expedite, shorten and simplify your selection process, especially since loads aren't normally factored into performance figures, making comparisons of loads and no-loads needlessly laborious.

Caveat: There are also back-end loads, or "redemption fees," which are deducted when you sell shares. Many of these fees decline to zero over a few years, but if you have to sell before then, the effect can be similar to a front-end load.

Then there are management fees, charged by every fund to cover investment expenses. These generally range from 0.5 percent to 2.5 percent yearly. A Morningstar study found little or no correlation between higher (or lower) fees and better (or worse) performance. More significant, steeper fees can, over time, bite you harder than the stiffest loads. An example: Fund A is no-load, with a 2.1 percent annual fee; Fund B has a 5.75 percent load but just 0.7 percent in fees. Over the course of five years, Fund B is a better deal.

High fees also make bad times worse. If your return is low, the fees will really hurt. A two percent fee cuts a ten percent gross to eight percent---still decent---but slices a slack year's six percent gross to four percent, less yield than from a certificate of deposit.

Tip: Check a fund's prospectus for notations that fees have been waived, enhancing the return. If so, and the enhancement is significant, make sure the waiver isn't just temporary.

A true no-load fund charges only management fees. But many technically no-load funds also deduct (sometimes inconspicuously) distribution fees, administrative charges, sales expenses and 12b-1 fees. These don't pay for money management per se but are used to cover the fund's business operations, some of which return no benefit to you. (Most notable is the 12b-1, which pays for the fund's advertising and marketing. It's often buried in the prospectus as sales expenses.)

The critical number is the fund's total expense ratio. The more it exceeds the management fee, the more you're subsidizing the fund. And in the words of American Association of Individual Investors president John Markese, "If your fund has an above-average expense ratio, in the long run you're going to pay dearly." And not just that extra one percent or so, compounded annually, but probably in performance as well. The No-Load Fund Investor found that of funds with expense ratios of two percent or more, only one third ranked in the top 60 percent over five years. Case closed.

The average expense ratio for stock funds is 1.4 percent. Most no-load advocates recommend you avoid anything over 2 percent, and many would cut that to 1.5 percent. But small-asset-base funds have necessarily greater expense ratios, so make allowances. Also, average fees vary by category: aggressive growth, 1.51 percent; small cap, 1.33 percent; growth, 1.19 percent; equity income, 1.05 percent; growth and income, 1.04 percent. Compare accordingly.

Tip: Check the prospectus for trends. Have expense ratios been rising, or falling, the past few years?

There are thousands of equity funds, so the key to making fund selection manageable lies in your ability to narrow the field to a short list of finalists. Eliminate all funds with loads, or expense ratios more than 0.5 percent above the category's average. Forget those that have trailed their category's average return in two of the past five years, and those that require such large initial investments that it skews your asset allocation.

If you're conservative, omit aggressive and sector funds, funds more volatile than a S&P 500 Index fund, those that yield under three percent and those with below-average returns in down markets. Lean toward value-oriented funds. If you're aggressive, scratch those that don't perform in the top 30 percent of their categories in bullish years, those with rookie managers, those that didn't gain at least 30 percent in 1995 and those that keep more than 7 percent of their assets in cash.

Then seriously research the survivors. Read the fund prospectus for the fund's investment objectives and policies and what proportion of its assets is allotted to stocks, bonds, cash and other investments. Find out its requirements and which restrictions it's bound by. Look closely at year-by-year expenses, volatility and total return (dividends and capital gains). And take note of the declaration of risk and the shareholder privileges and services. Read the semiannual reports for a review of fund performance over time, year by year and compared with various indexes. Also look at a list of the fund's current holdings broken down by dollar amount allotted to each and its percentage of total assets.

Of course, some advisors feel that all of the above is unnecessary, that your easiest, safest and best-performing play is simply to buy an S&P 500 Index fund. These are 100 percent invested in Standard & Poor's 500 leading American companies in major industries and are considered a proxy for the U.S. stock market. The "index versus managed" debate is one of the most heated and contradictory in fund investing.

Historically, an S&P 500 Index fund beats 50 percent to 75 percent of all actively managed U.S. equity funds, depending on your time frame. But it does so inconsistently---it topped managed funds in the Eighties but often lagged them in the preceding two decades.

An index fund buys and holds stocks. By not trading, it minimizes taxes on capital gains that managed funds incur. But it pays considerable dividends, often taxed at higher rates than capital gains. The tax factor will probably just be a wash.

An S&P 500 Index fund stays fully invested and thus gets maximum benefit from rising markets, which historically occur more often than falling ones. But if the market does take a prolonged dive, index funds can't retreat into cash or bonds to cut their losses. That means they'll take the maximum whack.

In the ten years ending January 1994, the 500 Index' total return of 258 percent beat 80 percent of all U.S. diversified stock funds. But that was partly because the 500 Index became a favorite play with institutional investors, who plowed money in, thus boosting the prices of the 500 stocks. That's a self-fulfilling tactic. Many pros, including former Vanguard chief executive John Bogle, who virtually invented the index fund, feel this trend will reverse, to the benefit of managed funds.

Partisan statistical rhetoric aside, the 500 Index fund does have clear-cut advantages. Over the past decade, its 15 percent average annual return bested the average general equity fund's 12 percent, and it beat over half of those funds in seven of ten years. Since it always buys the same 500 stocks, the Index' fund manager is irrelevant and the management fees and trading commissions are minuscule. Several index funds have expense ratios that are a full one percent below the managed-funds average. That's a significant long-term edge.

And finally, the Index fund is composed of 500 of America's largest, most stable and most powerful companies. It will never finish in the top 50 funds, but not in the bottom 50, either. It won't always be a winner, but it will be more often than not. And it will always be competitive, with comfortably moderate risk.

On the downside, it fails to provide true diversification---it holds no small cap stocks, and, because of the companies' size, few growth stocks. It can't dump poor stocks and snap up hot ones, or buy low and sell high.

And managed funds have their own virtues. In bullish markets, they generally outpace the 500 Index funds. Managed funds can buy stocks that feature superior growth potential or bargain prices. And even in the 500 Index' best years, 25 percent of the managed funds top it.

Financial columnist John Waggoner found that of 1093 funds with a five-year record through September 1995, 43 percent beat the S&P Index. That's 470 funds. Waggoner located about 45 of them just in the five largest no-load fund families. In that period, while the S&P Index rose 121 percent, the diversified funds at Fidelity rose an average of 163 percent, at Vanguard 139 percent, at T. Rowe Price 148 percent and at 20th Century 201 percent.

But managed funds also have drawbacks. While many top the S&P Index in any given year, far fewer manage to do so significantly and consistently. More often, the winners are either temporary streakers or volatile funds, are riding bandwagon sectors or are just lucky. Even consistent winners come loaded with uncertainty: Their annual returns are less predictable than the 500's and their holdings change constantly. The skill and experience of their managers are absolutely vital. They also must maintain cash reserves---money that's not working for you.

Bottom line, a 500 Index fund probably shouldn't be your only play. It may not even be your best play. But it's an excellent first fund and core holding if you're just getting in, and a solid foundation to build on with more aggressive or conservative funds of your choice. And it enjoys perhaps the single greatest virtue in the world of mutual funds: absolute, brain-dead simplicity.

Final tip: All 500 Index funds are identical, hence no-loads with the lowest expense ratios are the best, period.

The number of equity funds has increased, and expansion brings marginal players into the game.