Can Mutual Funds Still Provide a Safe Haven for Diversity?

At this time last year, the mutual fund industrywas unknowingly standing on the brinkof its largest scandal ever. On September 3,New York Attorney General Eliot Spitzerannounced a complaint that Canary Capital Partnershad engaged in late trading and market timing. Duringthe following months, a number of prominent companieswould be touched by the probe into illegal andunethical behavior, including Bank of America, BankOne, Janus, Strong Financial Corp, and PutnamInvestments, among many others. The investigationwould dominate headlines and give investors one morereason to lose faith in Wall Street.

Today, the implications are still trickling through. OnJune 23, the SEC voted to adopt changes to its rulesregarding short selling, its requirements for disclosuresby investment companies concerning board approval ofadvisory contracts, and its investment company exemptionrules, which were designed to improve fund governancepractices. But what does it all mean to investors?

Scandal Aftermath

Luckily, many funds were not affected by the scandal.And of those funds that did overcharge shareholders,none folded, taking investors' money with them."While we recognize that this is a serious situation in theindustry, suggestions that the fund industry is unsafe, orthat investors should redeem funds or bail out of long-terminvestments without careful evaluation, is unfairand misleading to investors," commented MichelleSmith, director of the Mutual Fund Education Alliance(MFEA), the nonprofit trade association of the no-loadmutual fund industry.

US News & World Report

Many investors are still investing in funds. "Wereally don't hear about the scandals from clients. Itdoesn't come up," comments Richard Krasney ofKrasney Financial Inc, in Brookside, NJ. According toa recent article, in the firstquarter of this year, a record $135 billion was investedin stock mutual fund holdings, compared to just $8billion last year.

Indeed, mutual funds now represent a $7-trillionindustry with over 10,000 funds available and roughlyone of every two American households investing. Whilefunds have been around since the 1920s, their popularityover the past 20 years has soared by a staggering1787%, rising from $371 billion in 1984, according toan MSN Money article.

"With 95 million Americans relying on mutualfunds as the core of their financial plans, funds clearlyhave been recognized for their many advantages,"Smith says. "Mutual funds offer broad diversification,professional investment management, flexibility, andliquidity, often at a very low cost. Mutual funds makeit possible for anyone to participate in the success ofthe financial markets."

Fund Recipes

Krasney agrees that mutual funds are one of thebest ways to achieve diversification quickly. However,he says that some investors operate under a false senseof security. "We find people taking risks more thanthey should…. I think there's a misconception thatmutual funds are less risky than stocks." A key lies inunderstanding the investment objective of a fund.

Obviously, the more concentration you have in onearea, the more risk you have. Krasney explains, "Duringthe frenzy of the late '90s, many mutual fund companiesbegan offering funds specializing in hot startup technologyand Internet companies. When the bubble burst,these funds got destroyed and people came looking forhelp after they lost 90% of their portfolio. The concentrationis what killed them, and the bottomline is that you can get into trouble witha mutual fund. The first questionyou need to ask yourself is, ‘Am Idiversified?' (ie, ‘How much riskam I taking?')"

For investors whodon't want muchinvolvement, agood place tostart is a balancedfund that investsin a mix of equityand fixed income."You can buy just onefund and be more diversi-fied," Krasney says. Beyond that, it'sabout finding the right asset allocation. This not onlyhelps safeguard your investment, but it's also "goodfor building in predictability" as to potential gainsand losses, according to Krasney.

The following are a few fund recipes he offers:

• Conservative—60% bond, 30% large cap, 5%small cap, and 5% international funds. This mix, hesays, has a 1-year loss threshold of –5%. In other words,approximately 95% of the time, this portfolio won't losemore than 5% of its value in any 1-year period. "Thiswas true even in 2002, one of the worst years ever," hesays. On average, the investors he knew who invested inthis type of a mix finished the year down 4.87%, comparedto the S&P 500, which was down 22.1%.
• Balanced growth—40% bond, 40% large cap,8% small cap, and 12% international funds. The thresholdKrasney found here in 2002 was –10%.
• Growth—25% bond, 50% large cap, 10% smallcap, and 15% international funds. The threshold in2002 of this mix was –15%.
• Aggressive growth—65% large cap, 15% smallcap, and 20% international funds. The loss threshold inthis case was –20%.

While these mixes include bonds, it's important tonote that long-term bonds are very interest rate–sensitive.With interest rates going up, longer-term fixedincome investments will likely get hurt. "We're not a bigfan of long-term bonds, or especially bond funds rightnow—with some exceptions," Krasney adds.

Instead, choose shorter-term individual investment-gradebonds with a fixed maturity date of less than 5years. You can also set up a bond ladder with staggeredmaturities starting in 2005, and then some every yearuntil 2010. This allows you to reinvest money at the topof the ladder as rates climb, thus taking advantage of therise in rates. One short-term bond fund he recommendsis the Pimco Low Duration fund.

Other picks on the equity side include, for large capfunds, Oakmark I fund (OAKMX), for small capfunds, Third Avenue Value fund (TAVFX); and forinternational funds, Julius Baer Fund (BJBIX).

Going Fund Picking

Important:

Once you know the mix that meets yourneeds, you need to find the right funds. Greatinformation is available through the MutualFund Investor's Center (MFEA; www.mfea.com). It offers practical advicealong with a listing of the topfive funds by category andmarket indexes. Krasneyoften uses Yahoo! Financefor quick fund information.In addition, there arealways the reliable Morningstarratings (www.morningstar.com). Compareapples to apples (ie, a large cap fundto other large caps, etc).

But don't look just at performance. "People tend tochase returns," Krasney insists. He calls Morningstarratings "a good starting point," but adds, "then youneed to do your own due diligence." Particularly important,he says, is evaluating fees and finding funds withlow expense ratios. It's the total annual expenses for afund that will eat at long-term returns. But how do youknow whether a no-load fund with yearly expenses of1.75% or a fund with a front-end sales charge of 3.5%and a yearly sales charge of 0.9% is better? Luckily, Websites can help again here. MFEA's site offers a cost calculatoras well as a recommended selection of low-feefunds. Mentioning that you can get hit with back-endfees on a load fund, Krasney says, "We like no-loadfunds because they don't tie your hands."

US News &World Report

When it comes to low fees, Vanguard and Fidelityfunds may deserve a thorough look. The article states that these two "giants" haveattracted 38% of investments since the scandals and"are among the lowest-cost providers of asset managementservices." The article points out that the averagedomestic stock fund charges annual expenses of 1.5% ofassets, while Fidelity comes in at 1.3%. The article goeson to say, "Equity funds at Vanguard, the industry'sabsolute cost leader, charge just 0.3% on average."

Dealing with Taxes

But fees aren't the only drag on your return. Taxescan play a large role—as much 2% to 3% annually,according to Vanguard. Appreciating funds held intaxable accounts are subject to a capital gain tax,which can be particularly costly if the fund has beenheld for less than a year.

Luckily, there are ways to reduce tax implications.The following are a few suggestions from Vanguard andAmerican Century:

• Take advantage of tax-deferred accounts, suchas 401(k), IRA, and Section 529 plans. According toMSN Money, they account for about one third ofmutual fund assets.
• Buy and hold. Selling shares frequently createsmore taxable events.
• Be wary of the distribution date. Consider puttingoff buying a new fund until after this date to avoid taxeson a recent investment.
• Consider tax-managed funds, which use beneficialtax-reducing strategies.
• Invest in index funds that typically have a lowerturnover. This tactic generates fewer taxable gains.

For more tips on reducing your capital gains tax burden,visit the Tax Center at www.mfea.com. Severalsources recommend index funds, which seek to track aparticular market index. With no active fund managers,many investors think they have lower expenses and,thus, better-performing portfolios. An article from theMotley Fool Web site (www.fool.com) states, "By purelyquantitative measures, there is no reason to buy anythingbut an index fund…. It is quite simply, handsdown, no questions asked, your best bet."

Krasney also likes exchange-traded funds for their"easy liquidity and very low expense ratios," pointingout that they're growing in popularity. He mentionsthe Russell 3000 fund from iShares.com, which is atotal market fund index. "With one purchase, you'vebought 3000 stocks for $15. That's broad and cheapdiversification."

Fund Downsides

Of course, not everyone is a fan of mutual funds. TheMotley Fool article reports that, "Approximately 80%of mutual funds underperform the average return of thestock market." The article stresses that the averageactively managed stock mutual fund returns approximately2% less per year to its shareholders than thestock market returns in general.

Worry-Free Family Finances

In their new book, (McGraw-Hill; 2003), Bill Staton, MBA, CFA, andMary Staton also make a case against stock mutualfunds, citing fees, taxes, and other detractors. Theythen describe a scenario depicting an investment in theS&P 500 index vs a stock mutual fund over 20 years.With transaction costs, management fees, marketing,and taxes, they calculate that the fund would return40% less than the index.

Here's a summary of a few of the Statons' "Top 10Reasons to Never Own a Stock Mutual Fund":

• In any given year, 75% to 85% or more of stockmutual funds fail to equal, much less exceed, the market.
• Why would you pay someone else for what youcan do better and cheaper?
• Fees and other expenses are generally outrageousand continue to rise.
• Taxes eat up a sizable chunk of annual returns—as much as 55% for wealthy investors.
• Fund managers generally invest for the short term.
• It is often difficult to find out what kind of investingphilosophy a fund really has.
• The choices are overwhelming.
• More funds are increasing their minimums.

Love them or hate them, whether or not mutualfunds work for you depends on your investmentstyle.