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Mutual Funds

Intro on Mutual Funds:
         Why Your Broker/Advisor May Be Pushing Class 'B' Mutual Funds
         Hiding The Load In Mutual Funds
         A Look into No-Load Mutual Funds
         Loads vs. No-Loads
         Index Funds

         Analyzing Mutual Fund Costs, Risk and Performance:

For more information on IRAs, mutual funds and distributions click here.

Hiding The Load In Mutual Funds

A "load' is simply the mutual fund industry's term for sales charge, which is a fee investors pay directly out of their investment. In recent years, as investors have become more sophisticated, there has been a trend toward devising various alternatives (methods for investors to pay the sales charge). These payment methods are referred to as multiple classes of shares, and have greatly added to the confusion of purchasing mutual funds. Multiple classes of shares are shares sold from the same fund with a different sales load charged for each share class. Here are the most common share classes currently sold with their pricing or cost structure:

• Class A Shares are sold with a "front-end" load. The sales charge is deducted directly off the top of your investment and paid to your broker with the remainder invested in the fund. This sales charge can be as high as 8 1/2%, but due to the market environment it has been averaging 4 - 4 1/2%.
• Class B Shares generally charge a "back-end" load for exiting a fund within 5-7 years of purchase. This fee is sometimes called a Contingent Deferred Sales Charge (CDSC) or a surrender charge. A back-end charge typically starts at 5-6% of the redeemed assets during the first year of purchase and declines by one percentage point each year until it reaches zero. However, since the broker must be compensated for selling the fund whether or not you redeem in the first several years, B shares often have higher annual expenses paid out in the form of a 12b-1 fee. After the back-end load expires (5-7 years), the 12b-1 fee is no longer deducted from the funds assets and the B shares convert to A shares.
• Class C Shares are often referred to as "level load" shares. While they do not charge either a front or back-end load, C shares deduct a 12b-1 expense each year for the life of the investment.
• Institutional Class Shares are available for the larger investments or through an advisor that has already established minimum criteria. The total expense ratio on these funds is usually significantly less than the same fund via other class shares. For example, the American Century Income and Growth Fund Advisor Class Shares have a competitive 0.94% total expense ratio, while the Institutional Class shares of the same fund total expense ratio is only 0.49%. It pays to check out all your options before you invest - as the above example illustrates a nearly 50% cost savings each year by purchasing the appropriate class shares of the same fund.

Most A shares offer reduced sales charges for large purchases at various breakpoints. An investor that purchases less than $10,000 in a typical Class A fund will pay a 5% sales commission. A purchase worth $50,000 may result in a 3.5% commission. Usually, the sales commission is waived at $1 M, but you still may pay a 12b-1 charge that is taken out internally each and every year.

It should be noted that B and C shares do not reduce commissions on large orders. The broker typically receives a flat commission of 4% for these orders. Similar to the 12b-1 extra fees, the client does not notice the commission because it is taken out internally from the annual expenses. Thus, class B and C shares are very expensive over time and should always be avoided for large sums. In fact, mutual fund companies are suppose to discourage large sales of B shares. Many have set limits of $200,000 for such shares, but brokers may still find funds that don't adhere to the rules or find ways around the limits. There are also virtually limitless combinations of the above charges, such as Class M shares having a smaller front-end charge than the Class A combined with a more modest 12b-1 charge than Class B or C.

There are two significant points investors should keep in mind when looking at different share classes of mutual funds. First and foremost, none of the above mentioned fees will add to your investment performance as the fees are deducted from the amount you invest simply to pay a broker. Secondly, it is the investor's responsibility to determine the fees (and hidden sales charges) on all mutual funds before they invest. While cost should not constitute your sole reason for purchasing a fund, it should play a critical role in your investment decision.

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A Look into No-Load Mutual Funds

First of all, lets discuss the cost equation of mutual fund investing. Total costs are often overlooked by investors many times due to confusing sales practices and overly creative marketing techniques. A variety of different sales charges and fees have been introduced over recent years that make cost analysis even more confusing to investors. In fact the term no-load can no longer be construed as meaning no sales charges or added fees as it has in the past. Currently, investors must look for "true" or "pure" no-load to assure themselves of not paying any of the following various charges:

• Front-end sales charge - an initial one time deduction from your investment made into the fund, usually ranging from 3.0-5.5% on each and every purchase.
• Back-end sales charge - a deferred charge imposed when you redeem shares of the fund. Typically this charge declines over time but an additional 12b-1 charge is also usually imposed every year.
• 12b-1 charge - an additional charge deducted from the fund each year to pay for distribution and marketing costs.
• Redemption fee - is the amount charged when money is withdrawn from the fund typically only applicable for short period of time, often 30, 60 or 90 days.

Investing in funds with any of the above charges only reduces the amount of your investment dollars at work for you. In addition, studies have shown that funds with 12b-1 charges have, on average, taken more risk in attempts to compensate for their added charges. It should also be noted that all mutual funds will have ongoing administrative fees (the cost of running the fund) and management fees (the cost for managing the fund's assets) in addition to the varied transaction expenses in managing the assets. We use over 20 investment criteria over and above, our low expense and no-load parameters in selecting the most appropriate fund for each investor's specific situation. Some of the most important aspects in the selection process will be the defensive measures that fund managers incorporate to preserve capital and reduce volatility. This analysis will be particularly important during more turbulent market environments as opposed to what we experienced in 1995. In other words, they are much more relevant now than they were last year. Other important variables to analyze in addition to the fund's investment and risk parameters, include turnover ratio and capital gains exposure. This will not only give you a good idea on the style of the fund manager, but also can limit the tax liability to the individual investor.

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The Real Cost of Mutual Fund Wrap Accounts, and "Fund of Funds"

The positive aspect in purchasing true no-load mutual funds can be totally negated if such purchases are made through "wrap" accounts or "fund of funds". Wrap accounts are brokerage accounts that purchase a variety of mutual funds under one (wrapped) account in your name. "Fund of funds" are mutual funds that pool investor's monies together to purchase a portfolio of various mutual funds. Both charge an annual fee of usually between 1-2%, on top of your ongoing cost of each and every mutual fund held. Instead of purchasing a low cost competitive group of mutual funds, investors typically get what turns out to be a high cost investment vehicle (similar to Class C mutual funds), with annual expenses as high as 4% or more.

The best way to illustrate the opportunity cost associated with such additional annual charges is to show the difference of a 1 or 2% lesser annual return equates to over time.

Example: Investor #1 and #2 invest $10,000 over a 25 year period. Both investors receive a return of 12% annually over this period, but investor #2 has a wrap account that charges an additional 2% each year. After the 25 year period, investor #1 has $61,654 more from his/her original $10,000 investment than investor #2.

$10,000 Grew To:

Investor #1: $170,001 @ 12% Annually
Investor #2: $108,347 @ 12% Annually minus 2% in additional charges

The total cost involved over a long period of time is even more dramatic for aggressive investors seeking a high total return. Even a more modest additional charge of 1% makes a dramatic difference. Example: Both investor #3 and #4 invest $10,000 over 25 years. Both investors average 21% a year, but investor #4 pays an 1% additional charge to a broker under a wrap fee arrangement. Investor #3 ends up with an astounding $120,000 increase in value solely by avoiding the additional 1% annual cost.

$10,000 Grew To:

Investor #3: $1,173,909 @ 21% Annually

Investor #4: $   953,962 @ 21% Annually minus 1% in additional charges

After looking at these examples, it is not hard to see the importance in avoiding added costs when it comes to long-term investments such as mutual funds. Make sure you are at least buying Institutional Class shares if you are investing in these types of programs. This way the added cost from these mutual fund programs or timing/advisory programs will be lessened. So there may be something even better than your typical no-load mutual fund out there. If you’re working on a fee basis now, your advisor should be suggesting lower cost institutional class shares, if available, for a good part of your mutual fund portfolio.

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Loads vs. No-Loads

According to the Investment Company Institute over $4.5 trillion of assets existed in mutual funds at the close of 1997. The popularity of 401(k) retirement plans in conjunction with the best bull market in history, has created an unprecedented thirst for mutual funds. Skilled sales people try to continue the debate on buying load or no-load funds, but to all except the most unsophisticated investor, the case is a mute point. Pure no-load funds have no up-front sales charge upon purchase (or hidden back-end charges for that matter). Also, they are the most cost efficient on an ongoing basis. The average annual expense ratio is 1.15% for no-loads, and an amazingly high 1.64% for loaded funds. This equates to the average load fund being 43% more costly to operate each year - these costs do not even include the initial sales charge. If loaded funds were better investments than no-loads, a case could be made for all the extra costs and sales charges, but the opposite is true. In each of the past four years, no-loads have outperformed loaded funds, and since 1995, no-loads have been increasing their performance advantage over load funds (see table below). Don't misunderstand, there are good load funds, but why pay the commission in the first place, in addition to the higher ongoing expense each year. Besides, most load funds can now be purchased on a no-load basis through the right sources.

Loads vs. No-Loads
Average Annual Returns

	1994	1995	1996	1997
No Load Funds	-1.04%	31.64%	20.26%	25.07%
Load Funds	-1.60%	31.41%	19.25%	23.65%
No Load Advantage	0.56%	0.23%	1.01%	1.42%

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The Components of a Stock Mutual Fund's After-Tax Returns

The after-tax returns that an investor receives from a stock mutual fund is a function of: the investor's tax circumstances, the fund's pre-tax returns, and the fund's tax-efficiency. A mutual fund's tax-efficiency, in turn, is determined by the specific components of the fund's return which include: realized short-term capital gains and investment income (all taxed as ordinary income), realized long-term capital gains (taxed at rates up to 20%), and unrealized capital gains (not taxed until realized).

How Taxes Can Hurt Returns?

For stock fund investors, distributions of net investment income and realized short-term gains are taxed at federal rates as high as 39.6%. For Example, a growth fund returns 20% in one year and derives 14% of that return from realized short-term gains and dividends, 4% of that return from realized long-term gains, and 2% from unrealized gains. The 20% annual gains turns out to be an actual 13.7% after-tax gain for a high tax bracketed investor. This equates to a loss of over 31% of the fund's total return due to taxes and this does not even take into consideration potential state tax liability as well.

When Is a 20% Gain Actually Less Than 13.7%

	Pre-tax Returns	Tax Rate	After-Tax
Short-Term Gains and Dividends	14%	39.6%	8.5%
Long-Term Gains	4%	20.0%	3.2%
Unrealized Gains	2%	0.0%	2.0%
Total Return	20%	--	13.66%

Over 31% of total return is lost to taxes!

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Taxes and Mutual Funds

By now most investors know to avoid purchasing mutual funds before their distributions, in regards to taxable accounts. Over the past ten years, approximately 20% of the investment return on the average equity mutual fund has been lost to taxes. On an initial investment of $100,000, the amount lost to taxes during those ten years would total over $65,000. This does not even include the added transaction and administrative costs for the fund, nor the additional state tax liability. Most mutual funds leave investors vulnerable to short-term trading which creates profits that are considered ordinary income taxed up to 39.6%. Taxes can be even more of a nemesis to your after-tax return than high fees and/or commissions. According to Morningstar, the least tax-efficient mutual fund of the largest fifty gave up nearly 50% of its return to taxes - that is a 9% cost per year! While some funds try to minimize taxes, this strategy eventually becomes a mixed blessing. The longer a fund has been managed in a tax efficient manner, the bigger the amount of unrealized capital gains it will have built up, exposing shareholders to a possibility of a huge future tax hit. For example, the well managed Sequoia Fund has a potential capital gains exposure of over 69% of its assets. If the market soured and shareholder redemption's soared, these and similar funds might have to sell long-term winners, triggering the tax. This is why it is important to research a funds tax efficiency and potential capital gains exposure, so you can maximize total after-tax returns for all of our taxable mutual fund investments.

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Index Funds

Taxing matters of index mutual funds:

It is not a secret that index funds which track the Standard & Poor's 500 have been the hottest mutual fund ticket on Wall Street. The out-performance of index funds of late has created an unprecedented surge of new investors into index funds. Through the first 75 days of 1999, for example, thirteen billion dollars out of the nineteen billion dollars that flowed into equity funds went into large-cap index funds. That is an amazing 68.4% of every dollar of equity mutual funds going into index funds! During the same period last year, just 16.4% of total equity fund flows went into large cap index funds, or only $6.8 billion of the $41.3 billion total. While index exposure should be a part of most mutual fund portfolios, some of the attraction (excellent recent performance and tax efficiency) of index funds would dramatically swing against investors with any prolonged market downturn. This same problem would be seen with tax managed funds, another currently popular mutual fund concept. Both index funds and tax managed funds accumulate large amounts of unrealized gains over time. Prospective investors should carefully consider the following when deciding whether to invest in an index or tax managed fund:

• the size of the fund's unrealized capital gains,
• the growth rate of the fund's embedded gains position,
• the likelihood of the fund realizing embedded gains during your anticipated investment period.

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Taking Time to Learn Online

soundinvesting.org has always stressed researching a mutual fund's risk level and total expenses as much (if not more so) than its past performance. By doing this, investors can buy the best performing funds (in accordance to their risk level) that have the lowest cost. Thus, capitalizing on a "dual" play for one's mutual fund investment by combining solid performance with low cost. There is no better way to invest in mutual funds over the long term. The Securities and Exchange Commission has added a mutual fund cost calculator on its website (www.sec.gov), available to the public. This calculator features the total cost (you must know the fund's expense ratio and sales commission), in addition to the "foregone earnings" (what you lost in future earnings with the money you paid out in costs). For example, a $10,000 investment in a mutual fund with a 3.5% load and 1.25% annual expense ratio that earns 12% per annum would cost $101,364 over 30 years. The same return and time period with a no-load fund having a 0.37% annual expense ratio would cost $31,531. This represents a total cost differential of $69,883 on an initial $10,000 investment over the hypothetical 30 years. This cost calculator is an excellent way to see the true cost, over time, between loaded funds and no loads, plus the difference between high cost versus cost efficient funds.

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Why Your Broker/Advisor May Be Pushing Class 'B' Mutual Funds

Their is a common misconception that Class 'B' shares of mutual funds are a better alternative for investors because the front end load (commission) is not immediately taken out. The truth is Class 'B' funds tend to reward the broker with higher total commissions/fees over the long term. The broker or advisor not only receives an upfront commission (typically 4 or 5 percent) but in addition the commission on Class 'B' shares are not discounted for larger deposits like they are in Class 'A' shares. The chart below is the best illustration in showing why you should avoid class 'B' shares at all costs. A broker/advisor that sells $1M worth of Class 'B' funds a year for 10 years (assuming a conservative 8% annual return of assets) will net $2,896,985 commission/fees over the next twenty years. In comparison, a 5% Class 'A' loaded fund with no 12b-1 fees or trailers would net the broker/advisor a total of $500,000. This $2,396,985 of addition compensation is all internally generated from your pooled mutual fund assets, and thus, unless you read the prospectus you don't even know it is being taken out. Some brokerage firms are actually using similar illustrations to what is seen below to motivate brokers to push Class 'B' mutual funds, particularly in circumstances where the initial investment is rather meaningful.

Class 'A' Commissions
Year	Mutual Fund Sales	Up Front 5% Commission (First Year)
1	$1,000,000	$50,000
2	$2,080,000	$50,000
3	$3,246,400	$50,000
4	$4,506,112	$50,000
5	$5,866,601	$50,000
6	$7,335,929	$50,000
7	$8,922,803	$50,000
8	$10,636,628	$50,000
9	$12,487,558	$50,000
10	$14,486,562	$50,000
11	$15,645,487
12	$16,897,126
13	$18,248,897
14	$19,708,808
15	$21,285,513
16	$22,988,534
17	$24,827,422
18	$26,813,616
19	$28,958,705
20	$31,275,402
TOTALS		$500,000

Class 'B' Commissions
Year	Mutual Fund Sales	Up Front 5% Commission (First Year)	.25% Trail Commission (Years 2-6)	1% Trail Commission (years 7+)	Total Compensation
1	$1,000,000	$50,000			$50,000
2	$2,080,000	$50,000	$2,700		$52,700
3	$3,246,400	$50,000	$5,616		$55,616
4	$4,506,112	$50,000	$8,765		$58,765
5	$5,866,601	$50,000	$12,167		$62,167
6	$7,335,929	$50,000	$15,840	$15,869	$65,840
7	$8,922,803	$50,000	$15,480	$33,007	$81,709
8	$10,636,628	$50,000	$15,480	$51,516	$98,847
9	$12,487,558	$50,000	$15,480	$71,506	$117,456
10	$14,486,562	$50,000	$15,480	$71,506	$137,346
11	$15,645,487		$15,480	$93,096	$108,935
12	$16,897,126		$13,140	$116,412	$129,552
13	$18,248,897		$10,244	$141,594	$151,817
14	$19,708,808		$7,075	$168,790	$175,864
15	$21,285,513		$3,673	$198,162	$201,835
16	$22,988,534			$229,884	$229,884
17	$24,827,422			$248,274	$248,274
18	$26,813,616			$268,136	$268,136
19	$28,958,705			$289,587	$289,587
20	$31,275,402			$312,754	$312,754
TOTALS		$500,000	$158,398	$2,238,586	$2,896,985

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Mutual Fund Update

The divergence in the market has never been greater between the haves and the haves not. The heroes of yesterday in the investment world finished their worst year in history both of a relative and absolute basis. Warren Buffett, the Oracle of Omaha, has had the best investment record of our time but his Berkshire Hathaway holdings finished down 49% in 1999. This was his first down year ever. Another past investment star was manager of the Oakmark Fund - Robert Sanborn. Mr. Sanborn was on the cover of Barron's as the best money manager in the country just four years ago. His fund has lost an average of 4.4% per year the past three years culminated by a drop of nearly 30% in 1999. So how did these stars fall from grace after years of outperforming their peers? Better yet, what about those new funds that specialize in high tech, biotech and telecom stocks that have averaged triple digit percentage returns? The divergence is absolutely incredible, and investors that have not invested in the above three sectors can attest to not enjoying this great bull market of late. Investors should remain flexible and invest in lower cost mutual funds that match your risk tolerance. Chasing those high double digit or even triple digit percentage returns is not the most prudent thing to do with your monies currently. Investing in funds that held companies like Coke and Procter & Gamble should also be avoided because those stocks have been overpriced for several years in comparison to their growth rates. So it is critical to differentiate the fund managers that were buying Procter & Gamble, for example, over $100 a share from those that may be accumulating now at 1/2 that price. Investors are best served by investing in funds that participate in the high growth areas without paying the exorbitant prices. There are always bargains to be had - it is just that during times like these they are much more difficult to uncover. We suggest if you are invested in these high flying mutual funds (and have a long term horizon) then you may wish to hold and ride the volatile waves. If you are thinking about getting in, it is better to limit your allocation in such funds so that the market swings don't force you to get out at the wrong time. At times like these it is best to err on the side of caution. We would adjust some of the excessive gains made last year in the high tech sector back into the more conservative side. This way investors high tech exposure does not become too concentrated. After all, the average high tech fund was up 187% in 1999 and is already up 36.4% the first ten weeks of 2000. Investors were too scared about Y2K six months ago - now they may be just too euphoric particularly regarding the high techs, biotechs and telecoms.

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Bank-Run Mutual Funds

The Wall Street Journal recently featured an article on the poor performance of bank-run mutual funds. (W.S.J. 8/14/00) Banks are getting aggressive in their marketing of such funds to offset relatively flat deposit and loan growth. The strategy was to increase the more consistent fee generated income to stabilize earnings and cash flow during times of decreased economic certainty. According to the Wall Street Journal, the typical bank-run U.S. mutual fund has badly lagged the mutual fund averages last year, and continue to dramatically underperform this year as well. Two examples where the outflow of money (despite banks' strong marketing tactics) has been especially bad include Sun Trust Banks of Atlanta and First Union of Charlotte. Like many banks, which have never before emphasized the money management arena, bank funds have typically not attracted the high quality money managers and instead always seem to be following one or two steps behind. The best example of this is with Sun Trust as they did not even have a technology related fund until late 1999 after many high tech funds actually recorded triple digit annual returns. Of course, establishing such a fund after such amazing returns only set up Sun Trust fund investors for the major NASDAQ plunge this spring - taking the blunt force of the losses without the preceding positives. It is no wonder that Sun Trust experienced $800m of the net overflows from its stock and bond funds over the first half of 2000, while First Union fund investors bailed out of $1.3b of fund assets during the same six month period. Again according to the Wall Street Journal, almost all banks have suffered as the overall tally would have been in the red had it not been for Bank of America's Nations Funds Unit which benefited by capturing hot growth manager Tom Marsico from the Janus Funds.

Such dismal showings were definitely not what the banks had in mind when they put this emphasis on the fee based side of money management. When customers yank their monies, the banks not only give up all current and future fee revenue streams, but also lose the opportunity to sell other even higher margin products into the future. Many of the bank mutual funds also have sales charges and/or added annual costs to compensate your private banker/representative. (See other SoundInvesting.org mutual fund articles for specifics on what to analyze and research before you purchase any mutual fund.) So the next time your banker suggests a new investment for your retirement or savings/checking account assets, make sure you investigate all your options (including no loads outside of the bank) before you give your "okay".

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