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Carlson critiques funds: no-load stocks vs. no-load mutual funds.

THE FOLLOWING IS selectively excerpted from Charles R Carlson's new book, No-Load Stocks: How to Buy Your First Share and Every Share Directly from the Company--with No Broker's Fee. Carlson, a certified financial analyst is also the editor of Dow Theory Forecasts, a trade newsletter. In the third chapter, Carlson debunks some of the myths surrounding mutualfund investing.

The mutual-fund industry has done a masterful job at selling no-load funds as the only investment that makes sense for small investors. However, what the fund industry doesn't tell you is that mutual funds have their own imperfections that need to be considered by investors. Indeed, the attraction of no-load mutual funds--often at the expense of ownership of individual stocks--may not be all it's cracked up to be. (No-load stocks and mutual funds can be bought directly from some companies, allowing you to bypass a broker and avoiding the fees they charge.


Contrary to what many investors believe, mutual funds, including money-market mutual funds, are not federally insured investments. Even mutual funds sold by banks are not federally insured, although a study by the American Association of Retired Persons should that less than 20% of those surveyed understood that mutual funds bought at a bank are not federally insured. And if you use the word safe to mean that mutual funds are immune to sharp downturns, you're wrong as well. Just ask holders of the Steadman Oceanographic Fund, who saw their investment decline 62% for the 10-year period through 1993. Or the holders of the DFA Japanese Small Company Fund, who saw the value of their holdings drop nearly 17% in the five-year period through 1993. Or the Frontier Equity Fund, which posted a nearly 25% decline in 1993. Remember that mutual funds are only as safe as the securities in which they are invested.

From a No-Load Stock (NLS) Perspective. Are mutual funds safer than no-load stocks? I won't attempt to argue that diversification doesn't matter in limiting downside risk, and diversification is easier to achieve with no-load mutual funds than no-load stocks. Still, investors who choose no-load mutual funds over a portfolio of no-load stocks or stocks in general may be surprised to see how unsafe these funds are during declining markets.


You can expect above-average performance, but you probably won't get it. In any given year, it's not unusual for at least two-thirds of all mutual funds to underperform the market as measured by Standard & Poor's (S&P) 500. For the 10-year period ending 1993, only funds specializing in international, financial-services, and health-care equities outperformed the S&P 500. General equity funds in that period posted an average gain, including reinvested dividends, of 234.6% versus the return on the S&P 500 of 301.4%

Several factors account for the lackluster performance of most funds. First, many academics argue that the market is so efficient--in other words, stock prices reflect all that is known about a stock and discount information so quickly that finding mispriced stocks is very difficult--that it is extremely difficult to outperform the market on a consistent basis. Many practitioners in the investment field hold that markets are not as efficient as academics believe. Still, you probably won't find too many fund managers who won't acknowledge the difficulty in beating the market.

But even if you believe that it's possible to beat the market regularly, how many mutual-fund managers have the skill to do so? Very few. And the number of mutual-fund managers who truly add value is being spread thinner over an always increasing number of mutual-fund offerings. Indeed, there are now more than 5,000 mutual funds. Are all of these funds being managed by fund managers who add value? Of course not. Furthermore, performance may be even bleaker over the next decade if the financial markets turn more difficult. After all, it wasn't too hard to show double-digit gains during the last decade when stocks in general were rising at such a rapid rate. However, in an environment where market returns are more in line with historical averages of roughly 10% per year for stocks, the disparities between the few effective fund managers and the huge number of mediocre ones will be even more evident.

Also affecting mutual fund performance is that, in some instances, a mutual fund may have little incentive to go for above-average performance. For example, a fund that accumulates, say, $2 billion in assets may have much more of an incentive to maintain the status quo by focusing on conservative investments. That's because, with $2 billion in assets, fees to the mutual fund could be anywhere from $20 to $40 million every year, even if the fund doesn't make a dime for it's shareholders. Thus, preservation of capital rather than aggressive asset appreciation may be the primary objective of the fund manager.

One final factor causing subpar mutual fund returns has been the huge amounts of money flowing into funds in recent years. In many cases, such huge inflows have created problems for fund managers, who are pressured to put these funds to work in stocks. However, especially during periods when stocks are high, huge inflows may force fund managers to abandon investment strategies that were successful. when the mutual fund was small or to invest in stocks that may be overpriced and not offering the best upside potential. Some funds have closed their doors to new participants when they perceived fund assets were overwhelming the fund manager's strategy, but the temptation to take in more money because of the annual management fee has caused a number of mutual funds with stellar track records to join the ranks of mediocre performers. Bottom line: Keep your expectations in check when investing in mutual funds. That way you won't be too disappointed when your fund comes up short.

From an NLS Perspective. I won't say that no-load stocks, as a group, will outperform no-load mutual funds over time. I will say that investors who ignore no-load stocks for no-load mutual funds may be overlooking some attractive long-term capital-gains performers while relegating their investment funds to subpar performance.


Much of the popularity of no-load funds is the fact that they can be bought without a sales fee. However, to say that investing in no-load funds is "no-cost" investing is simply not. true. In many cases, the costs of. investing in no-load mutual funds are greater than the costs of investing in individual stocks, especially no-load stocks. The problem is that most investors don't realize it since funds deduct expenses from your holdings, which means you never actually write a check to pay expenses. This may be less obvious, but it is no less painful to portfolio performance.

The sales, or "load," fee is only the tip of the fee iceberg in terms of the costs of investing in mutual funds:

* Annual management and administrative fees. These are the fees that all no-load funds charge to manage and administer the assets. Rates differ from one fund group to another and across types of funds. However, it is not uncommon for equity funds, especially those investing in foreign securities, to have annual management fees of well over 1% and more than 2% in some instances. Administrative fees may include such things as account setup fees, annual account maintenance fees, telephone redemption fees, and check redemption processing fees.

* 12b-1 fees. A number of no-load mutual funds charge 12b-1 fees to help defray expenses. These fees have become more regulated in recent years, although 12b-1 fees can still consume up to 0.75% of your assets.

* Back-end loads. Since mutual funds realize that investors don't like up-front load fees, they have become adept at building less conspicuous fees into the system. One such fee is a "back-end" or redemption fee. Most back-end load fees apply if a fund holder sells shares within five years. The fees decline the longer the fund shares are held and usually disappear if the fund is held for longer than five or six years.

When you add all of these fees together, it's quite possible that a no-load mutual fund may be charging you 2% to 3% per year in fees. That translates to annual fees on a $10,000 investment of $200 to $300 per year. That's $200 to $300 on which you'll never earn a dime in the future.

While mutual funds have been dropping "load" fees, management and administrative fees are increasing despite record dollar amounts under management. Logic says that a larger amount of money in a fund would create economies of a scale in managing and administering funds, causing fee expense ratios to decline. However, the opposite has occurred. Why? Because fund investors, by and large, have no idea how much they pay in annual fees, thus allowing funds to raise these "hidden" fees aggressively.

Yes, you will avoid a sales fee when investing in no-load mutual funds. But don't believe for a second that investing in no-load mutual funds is truly "no-cost" investing.

From an NLS Perspective. How do the costs of investing in no-load stocks compare to the costs of no-load mutual funds? The clear winners are no-load stocks. Not only do you avoid any sales fees on the initial purchase of no-load stocks, but your annual costs to maintain your account are usually zero. All of your money works for you each and every year, making no-load stocks the only "no-cost" investing vehicle available to equity investors. Also keep in mind that the cost advantage of no-load stocks versus funds means that a typical no-load mutual fund must outperform a portfolio of no-load stocks by at least 2% every year in order to generate the same "after-fee" returns. That gives no-load stocks a big edge in terms of long-term performance.


Knowing what a mutual fund has in its portfolio, if you go solely by the name of the fund, is extremely difficult. A mutual fund can use a certain name if, under normal market conditions, as least 65% of its assets are invested in that category. However, that also means that 35% of the fund's assets may be invested in totally different instruments carrying perhaps more risk.

But what about the quarterly reports in which the fund lists its holdings? Isn't this a useful source to find out what a fund holds? Perhaps, although this information is often out-of-date and fairly meaningless. Indeed, in funds with high portfolio turnover, what was reported as a substantial holding in a fund two months ago may not even be in the portfolio today.

Well, can't I call the fund manager to find out the fund's top holdings at any given time? The fact is that you'll probably get the runaround if you call your fund to find out the biggest holdings. Most mutual funds are very close-mouthed about the securities they hold. Fund managers don't want others, especially big, institutional investors, to know what they are buying or selling because that information may affect prices.

Finally, even if you know what's in the portfolio, it may not help you to assess the real risk of the fund. Financial derivatives are a popular investment for funds. Derivatives are hybrid securities designed by Wall Street rocket scientists. Many fixed-income funds have been employing derivatives in their portfolios in order to boost returns. The problem is that these newfangled investments have tended to be extremely risky and volatile in the wrong hands. Therefore, even though the overall maturity of your bond fund may be very short--which would make it less susceptible to interest-rate movements--the inclusion of certain financial derivatives may actually make it riskier than you think.

The risks of financial derivatives were evident in 1994 when several money-market mutual funds registered losses due to derivatives. In a number of cases, the mutual funds, fearing a major backlash from investors who don't expect to see losses in "safe" money-market funds, kicked money into the funds to cover the losses. But investors shouldn't expect fund groups to always be this benevolent.

From an NLS Perspective. You never have to guess what securities are held in your portfolio of no-load stocks. And you can reach the "fund manager" any time you want.


Perhaps the biggest downside to investing in mutual funds is that, in many cases, buying a mutual fund means buying a tax liability. Investors in funds, especially those with high portfolio turnover, are likely to incur a tax liability at some point in the year. This occurs when the fund manager sells issues that have appreciated, thus turning an "unrealized" gain into a "realized" gain. Since funds with high turnover do a lot of selling, these funds generate a lot of realized gains each year, and these realized gains are distributed to fund holders. When this occurs, current shareholders of the fund incur a tax liability. The bad part is that all fund holders must pay the tax on realized gains that are distributed to them each year. That means that even if you bought the fund in the last month of the year and weren't holding the fund when the big gains were achieved, you still must pay a capital gains tax on the realized gains if you received them. In fact, even if the value of the fund has dropped since your investment--in other words, you're holding a paper loss in the fund--you still have to pay taxes on realized gains distributed to you.

Even funds with low portfolio turnover cannot escape the tax issue. Mutual funds with low turnover have large unrealized capital gains. While a fund that has huge unrealized gains is an indication of a fund that has been successful in picking winners, it also poses potential bomb-shells for new investors in the fund. At some point, the fund will sell these stocks and distribute the "realized" gains to current fund holders. Thus, buying a fund with low turnover may mean that you are also buying a fund with potentially huge "hidden" tax liabilities.

Keep in mind this tax burden is aside from the usual taxes you have to pay on dividend distributions the fund makes during the year as well as taxes you must pay when selling fund shares at a profit.

The tax issue concerning mutual funds is especially significant at this time given that the markets have been strong for so many years, and a plethora of funds have large unrealized gains. Should fund managers sour on the market and begin selling stock, the size of the distributions of realized gains--and therefore the size of your tax headache--could grow.

What if you invest in a tax-exempt mutual fund? This is one way to dodge the tax liability. But even this strategy may not be bulletproof when it comes to taxes. For example, a tax-exempt fund that has realized capital gains on its bond holdings that aren't off-set by losses may pay out those realized profits in the form of taxable dividends. This scenario would be most likely to occur following a strong advance in the bond market and in a fund with high turnover. Some tax-exempt mutual funds handed their fund holders taxable distributions in 1993, which came as a big surprise to many investors who thought that tax-exempt funds were just that--tax exempt.

Frequent switching among mutual funds within the same fund family and liberal check-writing privileges for some bond funds also present potential tax problems. Being able to switch from one fund to another with just a phone call is a major advertising point of the big fund families. Worried about the stock market? No problem. Just switch your funds from an equity fund to the fund family's moneymarket fund. Want more exposure to international markets? Simply take some of your money out of that bond fund and invest in the fund family's Pacific rim fund. The problem from a tax standpoint, is that every time you switch funds, you incur a tax liability. Indeed, switching money from one fund to another is the same as selling shares in the fund and buying shares in the new fund. If you have a gain on the shares in the fund from which you are switching, you'll have to account for the gain at tax time. Thus, switching privileges are a double-edged sword for investors--more flexibility, but more tax headaches.

And those bond funds that have liberal check-writing features present another taxing problem. Investors who write checks against their holdings in a bond fund--not a money-market fund, mind you, but a bond fund--are, in effect, selling fund shares. Anytime you sell an investment that is held outside an IRA or other retirement-type account, you incur a potential tax liability. To illustrate the problem, I once knew an investor who was writing checks against his bond fund for everything--groceries, gifts, you name it. You can imagine his shock when he learned that each time he wrote a check against his bond fund, he had to account for the transaction to the IRS.

From an NLS Perspective. Fund investors are at the mercy of fund managers when it comes to incurring an unwanted tax liability. The fund managers decide when and how much realized gains to distribute. Fund managers also determine what types of stocks to purchase-high dividend-paying stocks to which create additional tax liabilities for fund holders, or low-dividend-paying stocks. The fact is that fund managers don't necessarily manage the fund based on tax considerations. That's because mutual funds don't pay taxes--you do. Furthermore, the generous switching and checkwriting features have tax consequences as well. However, with no-load stocks, you control your tax destiny. You decide when to realize capital gains. You decide if you want to invest in high-dividend-paying stocks--and incur the tax liability for dividend income--or low-paying or no-paying dividend stocks. You decide when to offset capital gains by taking losses. In short, no-load stock investors control when and how much to pay in taxes on their investments. This control, which is not available in mutual funds, can have huge implications in terms of after-tax investment returns over time.

Excerpted from No-load Stocks: How to Buy Your First Share and Every Share Directly from the Company--With No Broker's Fee by Charles B. Carlson copyright [C] 1995, McGraw, Hill Inc. Reprinted by permission of the publisher.
COPYRIGHT 1995 Earl G. Graves Publishing Co., Inc.
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1995, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.

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Title Annotation:excerpt from 'No-Load Stocks: How to Buy Your First Share and Every Share Directly from the Company - With No Broker's Fee'
Author:Carlson, Charles B.
Publication:Black Enterprise
Date:Oct 1, 1995
Previous Article:Recipe for a rich retirement.
Next Article:Making a fuss and getting results.

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