Analyzing
Investment Products and Services
Summary of New Tax Act
The Truth on
529 Plans
What To Look Out For With 529 Plans
Variable
Life Insurance Trap
A Tough Lesson Learned
The Truth About Unit Investment Trusts
Simple vs. Compound Interest
Analyzing an Account's
Rate of Return
Analyzing Mutual Funds
Keys to Analyzing Any
Investment
Keys to Analyzing Any
Investment
Performance - This segment is
covered by everyone in the financial world. It is easy to promote since
there have been such successful markets over the past several years.
Risk - It is critical that
investors understand what they are investing in and why. Too many
unsophisticated investors bought global bond funds in 1993, only to lose
up to half their assets in 1994. These investors had no idea the risk
that they were taking, having simply purchased mutual funds as an
alternative to CD's.
Cost - Cost is another area not
covered by many brokers/advisors, but it is an important aspect of any
investment or financial plan. Most investors are not fully aware of
their initial costs, annual expenses, or total cost of each investment
before investing. Our advice is to get all expenses in writing before
you invest.
Tax Exposure - Once again, most
investors are not aware of what the inherent tax liability or future
potential tax costs are before they invest. Similar to the cost and risk
of a mutual fund, your tax exposure and the fund's tax efficiency are
integral components of any long term investment plan. For more
information on
tax strategies click here.
Analyzing Mutual Funds
Did You Know?
- You need more than just the
prospectus to analyze a mutual fund.
- The commonly used annual
expense ratio ignores a significant added cost.
Everyone has heard about the
prospectus, which has to be delivered as a part of each mutual fund
purchase. The prospectus is required as part of a disclosure rule which
is in effect to protect the investor, by permitting investors to see
more than those one-sided glossy brochures before making an investment
decision. But the mutual fund prospectus does not tell the complete
story. It does not cover the annual brokerage or transaction cost within
a mutual fund. In fact, the commonly used annual expense ratio also
ignores this key added cost. To obtain the brokerage cost of a mutual
fund you need the lesser known Statement of Additional Information (SAI).
To get the real cost of your mutual fund, you need to add the total
brokerage cost (found in SAI) to the published annual expense ratio.
Here is a breakdown of what is
found in a prospectus as well as in the Statement of Additional
Information. Investors should obtain both to properly analyze any mutual
fund.
|
PROSPECTUS |
STATEMENT OF
ADDITIONAL INFORMATION |
| INVESTMENT STRATEGY |
Covers basic fund strategy and risks. States which policies
can be altered without shareholder approval. |
Covers any and all investment strategies the fund could ever
use, however unlikely, and their risks. |
| FEES |
Details fund costs, including sales charges, management fees
and 12b-1 fees. |
Details how management fees are calculated and how 12b-1
fees are spent. Lists all brokerage fees (commissions and
transaction costs). |
| PERFORMANCE |
Lists 3, 5 and 10 year average annual returns and
year-by-year returns over the past decade. |
Describes how performance and yield numbers are all
calculated. |
| MANAGEMENT |
Discloses a fund's investment advisor and the basis for his
compensation. Names the fund's portfolio manager. |
Discloses the fund's directors along with their total
compensation. |
For more information on
mutual fund investing click here.
Analyzing an Account's Rate of
Return
|
|
Fund Performance |
Annual Gain |
| YEAR 1 |
Initial investment: $1,000 |
+100% |
$1,000 |
| YEAR 2 |
Subsequent investment: $8,000 |
- 10% |
-$1,000 |
Scenario:
Initial investment of $1,000 receives a 100% return in the first year to
build a $2,000 total value after year 1. An additional $8,000 investment
at the beginning of year 2, with a return for the year of -10%,
realizing a $1,000 loss on $10,000. What is your return?
There are three basic types of
return and each results in a far different answer, in regards to the
scenario described above.
| Time Weighted Return |
34.2% |
| Dollar Weighted Return |
00.0% |
| Arithmetical Average Return |
45.0% |
Time Weighted Average Return
or Total Return - also known as geometric return. It is important to
remember that time-weighted returns ignore cash inflows and outflows. So
$1.00 invested into the above fund scenario would grow to $2.00 after
one year, and then would have lost $0.20 at the end of the second year,
for a net result of $0.80 on your $1.00 investment. Since the
calculation is only weighted for the beginning and ending date, it is
called time weighted. It grew 80% over two years, for an annualized
return of 34.2%. In other words, $1.00 compounded at a return of 34.2%
over two years would result in an $0.80 gain. Time weighted return is
the appropriate measure for comparing fund performance, and under
security regulations, it is the only approved method of calculating
returns.
Dollar Weighted Average
Return or Internal Rate of Return - depends on the timing and the
amount of the cash flows in and out of the investment. In other words,
they are weighted for each dollar inflow and outflow. In the
aforementioned scenario, the initial investment grows from $1,000 to
$2,000 in the first year ( a 100% gain). One can imagine an investor
liking that return, and so they added $8,000 at the beginning of Year 2,
bringing their balance to $10,000. At the end of Year 2, the 10% loss
reduces their account by $1,000. Thus, their dollar-weighted return is
0%, since they invested $9,000 and ended with $9,000. Dollar weighted
returns are not relevant to fund evaluation (the fund is not responsible
for the timing and the amount of the investments), but they do answer
the important question "what is my account's rate of return?"
Arithmetical Average Return
or the Arithmetical Mean - is simply the average return of each of
the annual periods. In the aforementioned scenario, 100% -10% = 90% / 2
= 45%.
Generally, this is a dangerous
number to use because it is virtually always higher than the time
weighted return. It is only a worthwhile measure for projections, and
then only if the series of data is long and meaningful enough.
To learn about investment strategies and ideas click here.
Simple
vs. Compund Interest
SIMPLE INTEREST
In the case of simple interest, the amount of interest earned is
con- stant. A formula for simple interest could be expressed as
follows: a(t) = 1+it (where i is the interest
rate and t is time). For example, let's say you deposit
$1,000 earning 7% interest. What would be your accumulated value at
the end of three years? Using our formula, we see that the answer is
1,000[1+(.07*3)] = $1,210. Thus the amount of interest earned is
1,210 - 1,000 = $210. We also could have obtained this by taking
1,000*.07*3, which becomes the familiar formula we all learned in
elementary school: I = Prt which states that the amount of interest
is equal to the product of the amount of principal, the rate of
interest and the period of time. Thus we can see that the client
earns $70 per year for three years.
Simple
interest has the property that the interest earned is not
"reinvested" to earn additional interest. In our example we see that
the client earns $70 per year for three years. However, for the
second year the client had $1,070 that could have been "reinvested."
It would be more advantageous to the client if the $1,070 earned 7%,
since the client would then have $1,144.90 instead of $1,140. (This
is a small example, obviously the larger the premium, the greater
the advantage.) Compound interest handles this by assuming that the
interest earned is automatically "reinvested." The word "compound"
refers to the process of interest being "reinvested" to earn
additional interest. Let's see the effects of compound interest
using our example above.
COMPOUND INTEREST
Using compound interest, our first year figure of $1,070 would be
the same (1,000*.07 = $70). How- ever the second year interest would
be 1,070*.07 = $74.90, which gives us $1,144.90. And the third year
would be 1,144.90*.07 = $80.14, which gives us $1,225.04. Looking at
it another way, we could calculate this as 1,000*1.07*1.07*1.07 or
1,000*(1.07) 3 . Thus we have the formula a(t) = (1+i)
t (where i is the interest rate and t is
time).
It is
clear to see that simple and compound interest produce the same
result over one measurement period (the measurement period is one
year). It is important to note that for lengths of time greater than
one measurement period, com- pound interest produces a larger
accumulated value than simple interest, but the opposite is true for
time periods shorter than one measurement period. A quick example
may be helpful. Keeping our $1,000 deposit at 7% interest, how much
interest would you earn in five months? Using simple interest we get
1,000[1+(.07x5/12)] = 1,029.17. With compound interest we get
1,000[(1.07) 5/12 ] = 1,028.59. The following graph shows this
relationship.
Another
thing we can observe is that in the case of simple interest, the
amount of growth is constant; under compound interest, it is the
rate of growth that is constant. We might say that simple
interest is linear, while compound interest is exponential. You saw
in our example that with simple interest you would never earn more
than $70 per year, but with compound interest you earn $70 in year
one, $74.90 in year two and $80.14 in year three.
Understanding these differences between simple and compound interest
is key in understandingthe importance of how your CD or other
guaranteed type of investment compares.
The Truth About Unit Investment Trusts
Soundinvesting.org has plenty of material on what to focus on in
regards to analyzing mutual funds, but many brokers are selling Unit
Investment Trusts (UIT) and we wanted to touch on that subject. Both
mutual funds and UITs are baskets of securities pooled together and
purchased by investors that either go or down based on the value of
their underlined securities. Both are also regulated by the
investment company act 1940. In contrast, the Unit Investment Trust
portfolio is fixed meaning that once the securities are filled,
securities are generally not bought or sold. Closer to the passive
investing of index mutual funds, UITs are even more passive in that
they generally do not make any changes. (Index funds will change
positions based on specific changes noted that occur in their
specific index). Opposed to mutual funds UITs also have expiration
dates, generally 1-5 years. When the trust expires, investors either
take their money or roll it over into another UIT.
There
are several drawbacks to UITs that once again are usually not
detailed to investors by those selling these investment vehicles.
The first being the inability of the UIT to protect, adjust, or vary
the portfolio based on market expectations or conditions. Secondly,
considering these passive restrictions UITs are still very costly
many with high sales charges in addition to annual administration
charges. The typical five year UIT charges 4.5% partly paid up
front. If you sell the shares before expiration, you still pay the
full sales charge. The average annual administration charge is 1.1%
very high when you figure that no actual money management acitivity
has taken place once the initial portfolio is established. UITs are
also hard to compare since no formal performance figures are kept by
third party sources. They are more like sector funds and should be
compared to mutual funds since no-loads, sector or even index funds
may be better alternatives.Brokers like UITs for their high
compensation combined with locked in commissions and lesser
performance scrutiny. UITs have grown 906% from $7.49B in 1990 to
$75.31B in 1999, according to the Investment Company Institute. In
comparison, mutual funds sales have soared 27,000%, from $4.63B to
$1.273 trillion during the same period. The aforementioned drawbacks
are the main reasons the recent UIT growth pales in comparison
mutual funds. Just like with loaded mutual funds and funds with
ongoing 12b-1 fees, it is best to be wary in regards to the vast
majority of Unit Investment Trusts.
A Tough Lesson Learned
Those
investors who did not heed our words of warning regarding internet
stocks early in 2000 have found themselves with some painful losses.
Another pitfall with the recent market rebound is feeling complacent
and not understanding how hard it is to rebound from huge losses.
Investors must realize that it will take years to recover 50-80%
losses of the past. It is critical to understand the math in trying
to overcome such losses. For example, the average tech fund suffered
70.1% losses from March 10, 2000, through April 4, 2001. Many
experts are receiving accolades on the financial networks on their
recent rebounds that may give investors a false sense of security.
The average tech fund gain of 38% since April 4th yet this still
settles investors with a 60% loss from March 2000 highs, as once you
lose so big it becomes increasingly problematic to recoup your
losses. When a fund loses 10% it takes an 11.1% advance to get back
to its original value. This is all because investors have less money
working for them after the initial drop. The recovery percentage
grows exponentially as the magnitude of the drop increases. After a
50% drop on an investment, a fund must double in value (+ 100%) just
to get back even. With an 80% drop, however, the percentage explodes
to an amazing 400% just to get to break even. The best real life
example is from the actual results of the Profunds Ultra OTC Fund
which lost 94.71% between March 2000 and April 4, 2001. In the month
since, the fund actually rose by a larger percentage soaring 95.6%
through May 2, 2001. The bottomline is that investors in the fund
from March 2000 still are sitting on an 89.7% net loss even after
its most recent 95.6% gain. A $10,000 investment in March equated to
a paltry $1,035 total value on May 2, 2001. So the next time you
hear or read about the company success and recovery of these popular
tech stocks, look at it from a minimum 1 or 2 year perspective
before patting the manager on the back (like much of the media is
eventually doing).
Variable Life Insurance Trap
The
media has finally picked up on the excessive compensation for those
brokers who sell class B type mutual funds. After discussing how
such funds for large investors are sold mainly for the sake of
increasing the compensation (and therefore your total costs!) for
those brokers selling them to you, it was good to see recent Wall
Street Journal* and Barron's** articles discuss this fact
in great detail. In fact, Pru Bache has gone so far as to restrict
any of its brokers from selling B shares for any accounts over
$100,000.
The
next area that we see of growing concern is the deceptive
illustration and aggressive forecast used in selling variable life
policies. Many such policies were sold under the assumptions that
the contract values would rise substantially, thus lowering the cost
of the overall insurance. As it turns out, decreasing values
increase the actual cost of the insurance, thus hindering potential
future growth even more so. Many times due to the cost of these
policies it may be better to buy term and invest the difference in
low cost/no load mutual funds. In other words, try to keep your
investment portfolio seperate from your life insurance holdings.
If you
are not getting such objective alternatives from your life insurance
agent or financial planner, it may have something to do with the
outrageous commissions of up to and over 90% of first year premiums
that they have on the line (plus the continuous renewal and trailing
compensation).
*Wall Street
Journal article "Prudential Limits Broker Sale of Class B
Shares"
**Barron's
article "Second Class", 7/9/01
TOP
The
Truth on 529 Plans
Named after the section
of the federal tax code that governs them, 529 plans are tax advantage
programs that help families save for college. College savings plans are
for students of all ages and cover all college costs including tuition,
fees, room & board, textbooks, computers and supplies. All 50 states
have 529 plans which can be used at most colleges and universities
throughout the country, including graduate schools. Some foreign
education institutions also may be eligible. Many states have plans with
no residency restrictions so you can live in New York contribute to a
plan in Maine and send your child to California for college. Please note
that certain state tax advantages to residents who participate in a
local plan may be lost if one opts out for another states plan. The
other big negative to these plans is expenses which in some states can
run as high as nearly 11% annually. It is vital to check all expenses
before committing to a 529 plan. Here are some of the most common fees,
charges, and expenses found in college savings plans:
- Enrollment Fee.
Several college savings plans charge a minimal enrollment fee.
Currently, the highest enrollment fee is $90. Most enrollment fees
are under $50.
- Annual
Maintenance Fee. Most college savings plans charge annual
maintenance fees. These fees usually range from $10 to $50. Many
plans reduce or eliminate this fee for residents, if you make
automatic contributions, or if you maintain a certain balance,
typically $25,000.
- Sales Charge
(Load). Several college savings plans charge a sales charge when
you buy certain investment options within a plan or purchase a plan
through a broker or investment adviser instead of directly from the
state. Generally, you can determine the sales load by looking at the
fees and expenses section of the offering circular or prospectus.
Not every plan has a sales load. The load also may differ between
classes in a single plan.
- Deferred Sales
Charge. A deferred sales charge or contingent deferred sales
charge (CDSC) is a charge you pay when you withdraw money from an
investment option or college savings plan. It is sometimes referred
to as the back-end load. The charge may start out at 2.5% for the
first year, and get smaller each year after that until it reaches
zero. Generally, you can determine the deferred sales charge by
looking at the fees and expenses section of the offering circular or
prospectus. Not every college savings plan has a deferred sales
charge. In some plans, a deferred sales charge also may be levied on
certain classes of the plan.
-
Administration/Management Fee (Expense Ratio). This is the total
annual college savings plan operating expenses expressed as a
percentage of the plan's assets. For example, an expense ratio of 1%
represents an annual charge to the plan's assets - including your
proportional interest in those assets - of 1% per year.
- Underlying Fund
Expenses. Because college savings plan portfolios typically
invest in a number of mutual funds, they bear part of the fees and
expenses of these underlying funds. This expense is expressed as a
percentage of a mutual fund's assets. Because college savings plan
investment portfolios sometimes invest in a number of mutual funds,
the offering circular or prospectus may contain fund expenses
percentages for each of these funds.
If you don't think fees
can make such a difference in your child's total net proceeds for
college, they make more of a difference than the cost differential of
mutual funds.
- Fees, Charges,
and Expenses
All 529 plans have various fees and expenses. Not only do these
charges vary among 529 plans, but also they can vary within a single
529 plan. With college savings plans, there are an even wider
variety of fees and expenses. Like mutual funds, some college
savings plans have different classes. Often referred to as Class A,
B, or C shares, units or fee structures, each class has different
fees and expenses. You can look at the offering document to see if a
particular college savings plan offers more than one class.
It is very important to take fees and expenses into account when
selecting a college savings plan. Slightly larger fees and expenses
can make a big difference in the value of your investment over time.
Let's say you invest $10,000 in a college savings plan with a return
of 10% before expenses. With a plan that had annual operating
expenses of 10.97% (Yes, one plan has expenses that can be this
high!), after 18 years, you would end up with only $6,866. That's
over $3,000 less than you started with. If the college savings plan
had expenses of 0.85%, you would end up with $47,680 - an 85%
difference!
So review all details
of each specific plan because the costs can be prohibitive. Austan
Goolsbee, professor of economics at University of Chicago Graduate
School of Business says that not only are the long run benefits of 529
plans "seriously compromised" by excessive management fees added by
states but also most of these plans limit investors to a single
financial firm that offers only 2 or 3 investment options. Between the
high costs and limited investment options many early investors in 529
plans are finding themselves hopelessly underwater in their accounts,
especially if they made one large lump sum deposit initially. While the
tax benefits of 529 can be worthy, please realize that if you buy into a
high expense plan the tax benefits will merely be neutralizing the high
costs. Utah currently has the cheapest plan, but it even adds 0.25% of
state fees to Vanguard's low 0.07% annual costs while expense wise
TIAA-CREF is the next lowest cost plan... but make sure you research and
get details on all costs not just the mutual fund component's
annual expenses. Also, keep in mind that 529 plan's tax-free withdrawals
are now slated to expire in 2010 (even though there is talk that such
benefits will be extended there is no certainty of this right now).
WHAT TO LOOK OUT FOR WITH 529 PLANS
College tuition
savings plans were named after "529" the tax-code section that
sanctioned them back in 1996. Major dollars were not put into them
until last year when Uncle Sam made withdrawals from 529 plans tax
free when used for college expenses. These plans allow parent,
grandparents and others to fund college education on a tax deferred
basis with potnetial state tax benefits if participating in a state
sponsored plan. However many investors are buying heavily loaded
plans (even though they work) when less costly, no load identical
plans are available. Over forty states have plans and there are
substantial variances among investor choices. Brokerage firms are
putting a full court press on in the marketing of 529 plans and this
is the main reason 70% of Rhode Island participants are paying up to
4 1/4% sales charge even though an identical no load version is
available. Annual expenses can even have a greater impact than the
initial sales charge.. For example, if you invest $10,000 in
TIAA-CREF's plan and it earns 7% over 18 years you would have
$30,288, the same money at 7% in an American Express plan in
Wisconsin would return 24% less solely becasue of higher costs. The
other negative in regards to 529 plans that is beginning to improve
is the limited investment choices in the early plans. Many were
skewed toward higher risk (technology/selective and other aggressive
growth equities), so be very careful with your investment selection
process. For more specifics on 529 plans, please refer to
http://savingforcollege.com.
SAMPLE 529 COSTS
| Provider (State) |
Total Annual Expenses |
Growth of $10,000 |
| TIAA-CREF (NY) |
0.65% |
$30,288 |
| T. Rowe Price (Alaska) |
0.96% |
$28,738 |
| Alliance Capital No-Load (Rhode Island) |
1.00% |
$28,543 |
| Manulife Financial (Alaska) |
1.97% |
$24,190 |
| Alliance Capital Loaded Class C (Rhode
Island) |
2.00% |
$24,066 |
| Strong-American Express (Wisconsin) |
2.27% |
$22,976 |
Based on $10,000
investment earning a hypothetical 7% annual return for 18 years.
The primary change in The Jobs & Growth Tax Relief Reconciliation Act of
2003 was the reduction of the tax on dividends to 15% from 38.6%. Other
major points of this tax package included:
-
A decrease in tax rates from 28, 31, 36, and 39.6 percent to 25, 28,
33, and 35 percent by 2006. The lowest bracket, 10 percent, will be
expanded.
-
The child tax credit will be raised to $1,000 per child.
-
The marriage penalty will be reduced by expanding the 15 percent
bracket and increasing standard deduction.
-
Taxes on capital gains will be cut from 20 to 15 percent and the tax
paid by individuals on corporate dividends will decrease to the same
rate. These new rates apply to capital gains realizes on or after
May 6.
-
The IRA contribution limit increases from $2,000 to $5,000 per year
and the 401k plan contribution limit increases from $10,500 to
$15,000 per year.
-
The equipment investment that small businesses can write off
increases from $25,000 to $100,000 (plus potential bonus
depreciation benefits).
AVERAGE ANNUAL SAVINGS WITH THE NEW TAX ACT
$41,000 INCOME
• Single: $211
• Married couple with two children under 17: $1,208 |
$126,000 INCOME
• Single: $1,827
• Married couple with two children under 17: $3,028 |
$63,000 INCOME
• Single: $551
• Married couple with two children under 17: $1,100 |
$170,000
INCOME
• Single: $2,743
• Married couple with two children under 17: $3,148 |
(Source:
AP/Deloitte & Touche)
Investment & Tax Strategy
Dividends have just become a whole lot more valuable to individual
investors. This is because dividend distributions from U.S. and
qualified foreign corporations are generally taxed at the same rate
as capital gains. Many experts feel that high income investors will
now be more inclined than ever to consider selling their mutual
funds and buying a portfolio of quality stocks with solid dividended
histories. This is because with an individual portfolio of stocks an
investor is in total control of when to realize capital gains - such
flexibility will prove to be incredibly valuable. Mutual funds on
the other hand must pay out 100% of both short and long term
realized gains each year. In addition, mutual fund investors can not
be certain that all of their dividends paid out will qualify for the
new lower tax rate. For example, dividends paid by companies
domiciled in certain overseas countries as well as dividends by any
securities exclusively traded on foreign exchanges do not qualify.
Other key points to consider in regards to the new tax act include
the following:
-
If you are a retiree you should recalculate your quarterly
estimated taxes. There is an excellent chance you should pay
much less if the majority of your income comes from dividends.
-
This may also be an excellent time to rebalance your portfolio
and coordinate any capital losses carry forwards with the new
lower rate for capital gains as just one example.
-
Real Estate Investment Trusts (REITs) and bond investments
should be part of your qualified or retirement assets since
their dividend distributions do not participate in the lower tax
rates.
-
Taxable portfolios should concentrate in taking advantage of the
lower tax placed on capital gains (growth) as well as dividends
(income from equities).
-
Mutual fund investors must coordinate tax efficient funds that
take advantage of the lower rates on dividends and capital gains
into taxable accounts while placing income funds that invest in
REITs, bonds, as well as funds with short holding periods, into
their retirement plans. Comprehensive analysis of each fund's
tax efficiency is critical to take advantage of the new law.
-
Finally, interest bearing accounts such as money market funds
and checking accounts, as well as variable annuities, did not
obtain benefits within this tax package. Thus they join the
ranks of REITs and bonds in not maintaining parity when compared
to an individually managed stock portfolio.
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