Chapter 9: Mutual funds.
There are three basic types of investment companies: (1) unit investment trusts; (2) management companies; and (3) face amount certificate companies. Management companies are either "closed-end" or "open-end" companies, also known as mutual funds. Mutual funds are by far the most predominant form of investment company and are regulated under the Investment Company Act of 1940.
(1) Unit Investment Trusts (UITs). Also referred to as "unit trusts," UITs are registered investment companies that buy and hold a fixed portfolio of income-producing stocks, bonds, or other securities. For example, municipal bond unit trusts are an alternative to municipal bond mutual funds. They are attractive to the investor who wants diversification, relatively low costs, and initial portfolio selection, but not ongoing portfolio management. Unlike a managed company, a UIT does not have an actively managed investment portfolio. UITs are often structured as "contractual" or "periodic payment" plans. "Units" in the trust are sold to investors or "unit holders." Investment interest, principal repayments and accelerated payments are not retained and reinvested by the fund, but instead are paid out to the investors who receive their proportionate share of distributions. Unlike other investment companies, a UIT has a stated date for termination that varies according to the investments held in its portfolio. Prior to termination, investors may either redeem units from the trust for their net asset value (NAV) or resell units on the secondary market. At termination, investors receive their proportionate share of the net assets of UIT, and the trust ends.
(2) Face Amount Certificate Companies. These investment companies issue face amount certificates that have a fixed maturity value and a schedule of redemption values--much like a United States savings bond. The purchaser typically makes periodic payments through a program of installment purchases. However, they are not equity investments and are, therefore, sometimes used in funding annuities used in tax deferred annuity plans.
(3) Management Companies. Management companies are formed as corporations or trusts for the purpose of managing a portfolio of securities in accordance with specific investment objectives. They can function as "closed-end" or "open-end" companies.
(a) Closed-End Companies. Closed-end investment companies are not mutual funds. Rather, they are investment companies that issue a fixed number of shares in closed-end funds, which are actively traded on a stock exchange or in the over-the-counter market. Assets of a closed-end fund are professionally managed in accordance with the fund's investment objectives and policies, and may be invested in stocks, bonds, or a combination of both. Like other publicly traded securities, the market price of closed-end fund shares fluctuates and is determined by supply and demand in the marketplace.
(b) Open-End Companies. Better known as mutual funds, these companies are considered "open-end" investment companies under federal law for two reasons. First, they are required to redeem (or buy back) outstanding shares at any time upon a shareholder's request, and at a price based on the current value of the fund's net assets (see Net Asset Value on page 184). Second, although not required, virtually all mutual funds continuously offer new fund shares to the public.
STRUCTURE OF A MUTUAL FUND
Mutual funds are typically externally managed. Instead of functioning as an operating company with employees in the traditional sense, mutual funds rely upon third parties, either affiliated organizations or independent contractors, to carry out their business activities.
Like shareholders of other companies, mutual fund shareholders have specific voting rights, including the right to elect directors. Shareholders must also approve material changes in the terms of a fund's contract with its investment adviser, the entity that manages the fund's assets. When mutual funds desire to change investment objectives, or policies that are deemed fundamental, they must seek shareholder approval.
These relationships are summarized in the following diagram, showing the principal service providers to a mutual fund and its shareholders.
POPULARITY & ADVANTAGES OF MUTUAL FUNDS
According to the Investment Company Institute, in 2009 about 87 million individual investors and 43% of U.S. households owned mutual funds. (1) In the United States in 2010, there were 7,691 funds holding assets worth $11,120,730,000,000 (that's 11.12073 trillion dollars). Of these 7,691 funds, 4,659 were equity funds, 474 were hybrid funds, 1,853 were bond funds, and 705 were money market funds. (2) Interestingly, in 2009 the number of mutual funds exceeded the number of stocks listed on the New York, American, and NASDAQ exchanges. (3)
Mutual funds pool investors' funds to purchase a diversified portfolio of investments according to specified goals. Their investments can include stocks, bonds, and money market instruments. Through these collective investments, each investor shares in the returns from the fund's portfolio while benefiting from professional investment management, diversification, liquidity, and other services. The key advantages of mutual fund investing include: (4)
(1) Professional Management. Investors benefit from the knowledge and experience of professional investment managers who are dedicated to security analysis, evaluation and selection.
(2) Diversification. Because mutual funds invest in a variety of securities, they provide shareholders with investment diversification in stocks, bonds, or money market instruments. A diversified portfolio helps reduce risk by offsetting losses from some securities with gains from others.
(3) Liquidity. Since mutual funds are required by law to redeem shares on a daily basis, fund shares are very liquid investments. Most mutual funds also continually offer new shares to investors. Many fund companies allow shareholders to transfer money--or make "exchanges"--from one fund to another within the same fund family. Mutual funds process sales, redemptions, and exchanges as a normal part of daily business activity.
(4) Cost Efficiency. By investing in a mutual fund, the average small investor is able to purchase shares in an economical way and obtain the same kind of professional money management and diversification that is available to large institutions and wealthy investors.
(5) Service. Custody of assets, tax reporting and record keeping are among the many services mutual fund companies provide. Many mutual funds also provide investors with a wide array of other shareholder services, including quarterly reports, duplicate statements, fund performance updates and extended hours during tax season.
The Investment Company Institute offers an array of data and information about mutual funds, including investor awareness & educational resources, at: www.ici.org.
Key to understanding a mutual fund is knowing the fund's stated investment objective. Mutual funds offer investors a variety of goals, depending on the particular fund and its investment charter. For example, some funds seek to generate income on a regular basis. Others strive to achieve modest gains as they preserve the investor's capital, while others seek large gains by investing in companies that are expected to grow at a rapid pace. When a fund fails to invest according to its stated objectives, this is referred to as "style slippage" (see page 177).
CATEGORIES OF MUTUAL FUNDS
Categories By Risk. The type of fund and investment objectives are often classified according to the risk an investor assumes in relation to the potential for returns.
General Categories By Investment. Although there are many categories of mutual funds, the three main categories of mutual funds include:
(1) Stock Funds. Also called "equity funds," these funds invest primarily in stocks. Over time, stocks historically have performed better than other investments, such as bonds and money market instruments. When an investor purchases stock he or she accepts any number of risks (see Risks Associated With Investing, pages 16-18).
(2) Bond Funds. These funds invest primarily in bonds and other fixed-income securities. Bond funds tend to be less volatile than stock funds and typically produce regular income. For these reasons, investors often use bond funds to diversify, provide a stream of income, or invest for intermediate-term goals. Like stock funds, bond funds have risks (e.g., default risk and market risk, see pages 17-18) and can make or lose money (as was most vividly demonstrated by the WorldCom and Enron bond losses in 2002). As a result of the subprime meltdown in 2008, some intermediate-term bond funds with heavy exposure to subprime mortgages experienced substantial losses in values. However, it appears that most funds have either no or limited holdings of risky mortgage-backed securities. Many more bond funds are facing the indirect impact of a failing housing market, widening bid-offer spreads, and increased investor redemptions forcing fund managers to sell securities at depressed market prices. (5) Before investing in a bond fund, today's investor would be well advised to determine the fund's exposure to subprime mortgages.
(3) Money Market Funds. These funds invest in pools of short-term, interest-bearing securities. A money market instrument is a short-term IOU issued by the United States government, a U.S. corporation, or a state and local government. Money market instruments have maturity dates of less than 13 months, and are relatively stable because of their short maturities and high quality.
Money market funds seek a stable $1.00 net asset value (NAV). In the unlikely event that a fund's NAV falls below $1.00, it is said to have "broke the buck." Such an event is very rare, but it can happen. In the fall of 2008, the highly-regarded Reserve Primary Fund "broke the buck" after a number of its very large investors pulled out almost $40 billion of their money over a period of only two days. This modern-day run on the bank appears to have been triggered when it became known that the fund held substantial amounts of riskier asset-backed commercial paper, followed by the write-down of substantial Lehman Brothers debt. The ensuing market turmoil caused the U.S. Treasury to announce on September 19, 2008 that for a period of one year it would guarantee participating money market funds against losses up to $50 billion. The guarantee covers funds invested prior to September 19, 2008 and is available to any publicly offered eligible money market mutual fund--both retail and institutional--that pays a fee to participate in the program.
Specific Categories By Objective. When it comes to specific classifications according to investment objective, the combinations and permutations of available mutual funds are many and varied. For example, The Wall Street Journal Online, under "Closed-End Funds by Category," listed 48 categories of mutual funds. The Investment Company Institute categorized United States mutual funds into the following 13 broad investment classifications: (6)
* Capital appreciation funds seek capital appreciation; dividends are not a primary consideration.
* Total return funds seek a combination of current income and capital appreciation.
* World equity funds invest primarily in stocks of foreign companies.
* Hybrid funds may invest in a mix of equity and fixed-income securities.
TAXABLE BOND FUNDS
* Corporate bond funds seek current income by investing in highquality debt securities issued by U.S. corporations.
* High-yield funds invest two-thirds or more of their portfolios in lower-rated U.S. corporate bonds (Baa or lower by Moody's and BBB or lower by Standard and Poor's rating services).
* Government bond funds invest in U.S. government bonds of varying maturities. They seek high current income.
* Strategic income funds invest in a combination of U.S. fixed-income securities to provide a high level of current income.
* World bond funds invest in debt securities offered by foreign companies and governments. They seek the highest level of current income available worldwide.
TAX-EXEMPT BOND FUNDS
* National municipal bond funds invest primarily in the bonds of various municipal issuers in the United States. These funds seek high current income free from federal tax.
* State municipal bond funds invest primarily in municipal bonds issued by a particular state. These funds seek high after-tax income for residents of individual states.
MONEY MARKET FUNDS
* Taxable money market funds invest in short-term, high-grade money market securities and must have average maturities of 90 days or less. These funds seek the highest level of income consistent with preservation of capital (i.e., maintaining a stable share price).
* Tax-exempt money market funds invest in short-term municipal securities and must have average maturities of 90 days or less. These funds seek the highest level of income--free from federal and, in some cases, state and local taxes--consistent with preservation of capital.
Source: 2004 Mutual Fund Fact Book, pp. 14-15. Copyright [C] 2004 by the Investment Company Institute (www.ici.org). Reprinted with permission.
Target Date Mutual Funds (TDFs). Also referred to as lifecycle funds, these are a type of mutual fund that automatically rebalances to a more conservative asset allocation as the investor approaches a retirement target date. These funds have experienced substantial growth in recent years. Key to this growth has been Department of Labor issued regulations allowing them to be designated as qualified default investment choices in 401(k) plans. TDFs can help eliminate the confusion felt by the less financially-sophisticated participant when faced with the many mutual fund choices offered by the typical 401(k) plan. They also relieve investor/participants of the need to constantly monitor their investments.
Similar to balanced funds, TDFs are comprised of a broad spectrum of stocks, bonds and cash. The asset allocation path that changes over time is referred to as the glide path, which is based on the number of years to and beyond the target date. TDFs are designed around a particular year and typically contain the expected date of retirement in their name (e.g., the "2025 fund").
With the collapse of the financial markets in 2008, significant losses were experienced by investors in TDFs who were close to retirement. This has raised concerns about the transparency and design of these funds, particularly regarding the target date. There is inconsistency between funds as to exactly what a target date represents. Some funds seek to deliver the participant to retirement, while others seek to deliver the participant through retirement. At actual retirement age, the "to retirement" funds are far more conservatively invested than the "through retirement" funds, as the latter are more aggressively invested to provide for the participant in retirement. There are also significant differences in the asset allocations and equity holdings among target date funds with the same target retirement date, with select firms' 2010 target date funds' equity holdings ranging anywhere from 24 to 68 percent. (7) Plan sponsors and participants must understand the underlying assumptions, fees, and risk associated with these products. Despite these challenges, the popularity of TDFs have remained relatively unaffected by the recent economic downturn, as demonstrated by the fact that more than $140 billion has entered into TDFs since the start of 2007. (8)
SELECTION OF MUTUAL FUNDS
Passively Managed vs. Actively Managed Funds. Investment managers, who oversee "passively managed" funds, generally try to track a market index--such as the S&P 500--by buying and holding all, or a large representative sample, of the securities in the index. Investment advisers who oversee "actively managed" fund portfolios base their investment decisions on extensive knowledge and research of market conditions and the financial performance of individual companies and specific securities in the effort to meet or beat average market returns. As economic conditions change, the fund investment adviser may adjust the mix of the fund's investments to adopt a more aggressive or a more defensive posture in meeting its investment objectives. Typically, the fees charged by actively managed funds exceed those charged by passively managed funds.
An excellent resource providing investment education programs and information about index funds is made available by Index Fund Advisors at: www.ifa.com.
Style Slippage. Also referred to as "style drift," this occurs when the active management of a fund portfolio changes from its stated investment purpose by investing in a different asset class or different ratios of assets within the same class. For example, an investor may invest in a fund that is expected to produce long-term gain through growth investing. If the fund manager invests a large portion of assets in large money market funds and bonds there is style slippage that reduces the investor's risk and potential for gain. Alternatively, an investment manager may drift from mid-cap growth value to small-cap growth, thereby increasing the investor's risk exposure. Style slippage is often difficult for the investor to detect without diligently monitoring the holdings of the fund in relation to the stated objectives of the fund. See the discussion of Morningstars Style Box on page 198.
Portfolio Turnover Rate. Also known merely as the "turnover rate," or a fund's "turnover ratio," this is a measure of the frequency with which securities are bought and sold during a year. For example, if a fund's assets totalled $100,000,000 and the fund bought and sold $100,000,000 worth of securities during the year, its turnover rate would be 100%. The lower the turnover rate, the better the opportunity for tax deferral. A higher turnover rate will generally add to the fund's expenses, and in strong markets can increase the likelihood that a fund will realize gains that will be distributed to shareholders (see Tax Issues on page 188). The turnover rate is an indication not only of the fund's trading activity, but also of the fund manager's investment philosophy. Aggressively managed funds generally have higher portfolio turnover rates than do conservative funds that invest for the long term. The turnover rate is provided in the fund's prospectus.
Share Classes. Funds that charge a front-end load typically offer shares with different sales charges, or "loads," and different fee structures. In effect, the investor who desires to purchase a particular mutual fund has a choice of how he or she will pay the sales charge. ("No-load" funds do not have share classes and are offered for sale without brokerage fees or sales loads.) Although there is currently no standardized method of classification, the following basic definitions of share classes appear to have gained some industry acceptance: (9)
A Shares--typically called "load funds," these are offered through brokers and sold with an initial, or "front-end," sales charge (usually 3%-6%) that is deducted from the initial investment. In addition, these funds usually charge a 12b-1 marketing fee (averaging around 0.25%), which is deducted from the fund's assets each year.
B Shares--have no front-end sales charge, but carry a redemption fee, or "back-end" load that is paid when shares are redeemed within a certain number of years. This load (called a "CDSC" or "contingent deferred sales charge") declines every year until it disappears--usually after six years. B share funds also carry a 12b-1 marketing fee that is typically higher than the 12b-1 fee of A shares. After the time period ends, some funds will convert B shares to A shares so these fees are reduced.
C Shares--known as "level-load" shares, C shares have no front-end sales charge and no redemption fee, but they carry a 12b-1 marketing fee that is paid each and every year. This load is similar to no-load funds that charge 12b-1 fees.
D Shares--are offered by some funds, most of which are variations of A, B and C Shares.
PURCHASE OF MUTUAL FUNDS
Prospectus. A mutual fund's prospectus describes the fund's goals, fees and expenses, investment strategies and risks, and provides information on how to buy and sell shares. Recent changes by the SEC now require that every prospectus include a summary section at the front of the prospectus, consisting of key information about the fund, including investment objectives and strategies, risks, costs, and performance. Also available are new means of satisfying the prospectus delivery obligations by sending or giving the key information directly to investors in the form of a summary prospectus and providing the statutory prospectus on an Internet Web site. The Securities and Exchange Commission (SEC) requires that the prospectus delivery obligation be satisfied either before an investment is made, or with the confirmation statement for the initial investment. In addition, periodic shareholder reports, prepared at least every six months by funds, discuss the fund's recent performance and include other important information, such as the fund's financial statements. By examining these reports, an investor can learn if a fund has been effective in meeting the goals and investment strategies described in the fund's prospectus.
Statement Of Additional Information (SAI). The SAI provides detailed information that expands upon the information provided in the fund's prospectus. Although most SAIs are lengthy and fairly technical, they do include many additional details about the fund that should be of interest to investors. For example, the SAI will give more information about the fund's: management; securities, risks, and policies; past investment performance; audited financial statements; portfolio securities as of the date of the SAI; and information about anyone who owns 5% or more of the fund's shares. Generally the SAI must be specifically requested, but once requested will be provided by the fund without charge.
Letter Of Intent. This is an assurance by a mutual fund shareholder that in exchange for lower sales charges, a certain amount of money (the target amount) will be invested over a specific period of time (not to exceed 13 months). The letter of intent is binding only on the mutual fund. Although not binding on the investor, if the target amount is not purchased by the end of the specified period, the sales charge on prior purchases is adjusted upward to reflect the amount that would have been paid absent the letter of intent program.
Fees, Costs & Expenses. The fees must be listed in the fund's prospectus and are typically categorized according to whether they are paid directly by the investor or paid from fund assets.
(1) No-Load. Mutual funds that do not charge any sales or transaction fees are known as "no-load" funds. With a no-load fund, the purchase price of the fund's shares is equal to its "net asset value," or NAV (see page 184). Likewise, redemption of shares is also done at the NAV. Like all mutual funds, however, no-load funds charge for annual operating expenses.
(2) Front-End Load. This is the fee (or commission) charged by some funds at the time of the initial purchase (i.e., a sales charge). Funds that impose these fees are known as "load" funds. This fee may also be charged on reinvested distributions and is sometimes referred to as a "re-load." As the size of the purchase increases, these fees are typically reduced at set "breakpoints." Sales charges can also be reduced by "letters of intent" and "rights of accumulation" (see above and page 183). The amount of the load is equal to the difference between the "offering price" and the "net asset value" (see page 184). If a load is charged upon the initial purchase, normally upon the subsequent redemption or sale there is no charge (i.e., there is no back-end load). See A Shares on page 178.
(3) Back-End Load. Also referred to as a "contingent deferred sales charge (CDSC)," a "back-end" load is the commission charged for redeeming mutual fund shares. These fees typically range from 4% to 6% and are levied in order to discourage an investor from frequent buying and selling of fund shares (i.e., "in-and-out trading"). Generally, backend fees decrease over time, with the time period varying from 90 days to 5 years. See B Shares on page 178.
(4) 12b-1 Fee. Also referred to as a "distribution and service fee," "marketing fee," or "trailer," this fee is intended to cover marketing and advertising costs, and sometimes sales commissions and employee bonuses. Under SEC Rule 12b-1, this annual fee cannot exceed a maximum of 1.25% of the fund's "net asset value" (see NAV on page 184). Both "load" and "no-load" funds can impose 12b-1 fees, but if a fund charges an annual 12b-1 fee of more than 0.25%, it cannot advertise itself as a no-load fund (i.e., a true "no-load" fund cannot charge more than 0.25%). Funds that impose these fees are sometimes known as "12b-1 funds."
(5) Level Load. This is an annual fee that is charged, typically in lieu of front-end and backend loads (e.g., the mutual fund does not charge an up-front or back-end commission, but instead deducts up to 1.25% of average daily fund assets).
(6) Management Fee. This fee is assessed annually and represents the cost of the professional money managers who manage and invest the fund's portfolio. Typically this fee is graduated. Both load and no-load funds impose management fees.
(7) Operating Fees & Expenses. These fees pay the operating costs and expenses of running the fund and include items such as employees' salaries, phone lines, marketing expenses, printing, and mailing costs. Both load and no-load funds impose operating fees.
(8) Exchange Fee. Also referred to as a "transfer fee," this is the fee that is charged when money is shifted between funds within the same mutual fund company.
(9) Overall Maximums Allowed. Total sales charges and fees cannot exceed 8.5% of the net asset value. Note that this 8.5% limitation does not include annual management and operating fees. Despite these maximums, since the 1980s there has been a substantial downward tread in mutual fund fees and expenses. Factors contributing to this include a growth of sales through employer-sponsored plans, increased availability of no-load funds, and intense competition within the mutual fund industry.
The actual percentage sales charge is higher then the load percentage when determined with respect to the net amount actually invested. For example, assume an investor purchased fund shares that imposed the maximum 8.5% load. Investing $10,000 would result in a load of $850 (10,000 x .085 = 850). Therefore the net amount actually invested is $9,150 (10,000 - 850 = 9,150). The shares of the fund owned by the investor have a NAV of $9,150. Taken as percentage of the NAV the sales charge is 9.3% (850 / 9,150 = 9.3%).
Expense Ratios. The "expense ratio" is the ratio of total fund expenses to net assets of the fund. If a fund has $890,000 of expenses and $100,000,000 of net assets, then its expense ratio is 0.89 of one percent (890,000 / 100,000,000 = .0089). This ratio includes management fees, 12b-1 fees if any, transaction costs, the cost of shareholder mailings and other administrative expenses. A fund with an active management style and high turnover rate will generally have a higher expense ratio than a fund with a passive management style and low turnover rate. The ratio is often a function of the fund's size, rather than the operating efficiency of the fund management, but can also depend on the nature of the investments in the fund. Although 12b-1 fees are included in the expense ratio calculation, sales and commission expenses are not included.
Mutual Fund Expense Disclosure Tables. The SEC requires that a summary of fees and costs appear in the prospectus. The following is an example of such a table from a no-load fund. Note that the shareholder fees are transaction costs, whereas the annual fees are operating costs.
The following table describes the fees and expenses that are incurred when you buy, hold, or sell shares of the fund.
The following table describes the fees and expenses that are incurred when you buy, hold or sell shares of the fund A. Shareholder fees (paid by the investor directly) Sales charge (load) on purchases None Sales charge (load) on reinvested distributions None Deferred sales charge (load) on redemptions None B. Annual fund operating expenses (paid from fund assets) Management fee 0.66% Distribution and Service (12b-1) fees None Other expenses 0.23% Total annual fund operating expenses 0.89%
C. Example of fund expenses over time. The following example helps you compare the cost of investing in the fund with the cost of investing in other mutual funds. It assumes a hypothetical annual return of 5% and that shareholder fees and annual fund operating expenses are exactly as described above. For every $10,000 you invested, here's how much you would pay in total expenses if you sell all of your shares at the end of each time period indicated:
1-year 3-years 5-years 10-years $91 $284 $493 $1,096
The following tables provide examples of the expenses for a load fund:
Annual Fund Operating Expenses (deducted from fund assets) Class A Class B Class C Management Fees .29%% .29% .29% Distribution and/or Service .25%% 1.00% 1.00% (12b-1) Fees (1) Other Expenses .11%% .12% .22 Total Annual Fund .65%% 1.41% 1.51% Operating Expenses (1) Class A and 12b-1 fees may not exceed .025% and .50%, respectively, of the class' average net assets annually. Fees Paid Directly from Shareholder's Investment Class A Class B Class C Maximum sales charge 5.75%1 None None imposed on purchases (expressed as a percentage of the offering price) Maximum sales charge None None None imposed on reinvested dividends Maximum deferred sales charge None (2) 5.00% (3) 1.00% (4) Redemption or exchange fees None None None (1) Sales charges are reduced or eliminated for purchases of $25,000 or more. (2) A contingent deferred sales charge of 1% applies on certain redemptions made within 12 months following purchases of $1. (3) Deferred sales charge is reduced after 12 months and eliminated after six years. (4) Deferred sales charge is eliminated after 12 months.
Example Of Fund Expenses Over Time: The following examples are intended to help the shareholder compare the cost of investing in the fund with the cost of investing in other mutual funds. The examples assume that: the shareholder invests $10,000 in the fund for the indicated time periods; the shareholder's investment has a 5% return each year; all dividend and capital gain distributions are reinvested; and the fund's operating expenses remain the same as above. The examples assume redemption, and do not reflect the effect of any taxable gain or loss at the time of the redemption.
One Three Five Ten Year years Years years Class A (1) $638 $771 $916 $1,339 Class B (2) $644 $846 $971 $1,483 Class C (3) $254 $477 $824 $1,802 (1) Assuming redemption. Reflects the maximum initial sales charges in the first year. (2) Assuming redemption. Reflects the applicable contingent deferred sales charges through year six, and Class A expenses for years nine and ten (because Class B shares automatically convert to Class A shares after eight years). (3) Assuming redemption. Reflects contingent deferred sales charge during the first year.
Rights Of Accumulation. These rights use breakpoints to reduce sales charges. Rights of accumulation differ from a "letter of intent" (see page 179) in that they do not require any stated amount to be invested over any particular period of time, and such rights only apply to cumulative purchases above the break points. For example, assume the following breakpoints applied:
Cumulative Purchase Sales Charge Under 10,000 3.0%% 10,000 to 25,000 2.5% 25,000 to 50,000 2.0% 50,000 to 75,000 1.5% 75,000 to 100,000 1.0% 100,000 to 250,000 0.5% Over 250,000 NAV (i.e., no sales charge)
Based upon these breakpoints, an investor who made purchases under rights of accumulation would pay the following sales charges:
Purchase Calculation of Cumulative Date Amount Sales Charge Purchases Sales Charges 1/20/03 $8,000 $8,000 x .03 = $240 $8,000 $240 3/3/03 $8,000 $2,000 x .03 = 60 $6,000 x .025 = 150 Total = $210 $16,000 $450 4/14/03 $44,000 $9,000 x .025 = $225 $25,000 x .020 = 500 $10,000 x .015 = 150 Total = $875 $60,000 $1,325
This result can be compared with an investor who received a reduced sales charge of 1.5% based upon a letter of intent to purchase $60,000 of mutual funds over a 90-day period:
Cumulative Purchase Calculation of Sales Date Amount Sales charge Purchases Charges 1/20/03 $8,000 $8,000 x .015 = $120 $8,000 $120 3/3/03 $8,000 $8,000 x .015 = $120 $16,000 $240 4/14/03 $44,000 $44,000 x .015 = $660 $60,000 $900
VALUATION & MEASURING RETURN
Net Asset Value (NAV). "NAV" is the current market value of all the fund's assets, minus liabilities, divided by the total number of outstanding shares (see formula below). The price at which a fund's shares may be purchased is its NAV per share,plus any applicable front-end sales charge (thus, the offering price of a fund without a sales charge would be the same as its NAV per share). For example, assume Mutual Fund X owns a portfolio of stocks worth $6,000,000; its liabilities are $60,000; and its shareholders own 500,000 shares. The NAV of $11.88 is calculated as follows:
NAV = Market Value Of Fund's Securities--Liabilities / Number of Investor Shares Outstanding
NAV = $6,000,000--$60,000 / 500,000 = $11.88
The NAV must reflect the current market value of the fund's securities, as long as market quotations for those securities are readily available. Other assets are priced at fair value, determined in good faith by the fund's board of directors. The Investment Company Act of 1940 requires "forward pricing," meaning that shareholders who purchase or redeem shares receive the next computed share price following the fund's receipt of the transaction order (typically computed at the end of each trading day). Income and expenses (including fees, if any) must be accrued through the date the share price is calculated. Fund share prices appear in the financial pages of most major newspapers. A fund's share price can also be found in its semiannual and annual reports. Funds typically value exchange-traded securities using the closing prices from the exchange on which the securities are principally traded, even if the exchange closes before the fund's daily pricing time (which occurs with many foreign securities).
Yield. "Yield" is the measure of net income (dividends and interest less the fund's expenses) earned by the securities in a mutual fund's portfolio during a specified period. Yield is expressed as a percentage of the fund's NAV at the beginning of the period (including the highest applicable sales charge, if any). For example, assume a fund's purchase price (NAV) was $50 at the beginning of the year and ended the year at $53. Also assume that the blended fund of stocks and bonds paid out $1.50 in dividend income, $2.75 in interest earnings, and had $.50 in expenses during the year. The yield of 7.5% would be calculated as follows (note that the yield calculation does not take into consideration the appreciation in NAV from $50 at the beginning of the year to $53 at the end of the year):
Yield = Dividends + Interest--Expenses / NAV At Beginning Of Year
Yield = $1.50 + $2.75--$.50 / $.50
Yield = 7.5%
Total Return. This is the percentage of gain or loss a fund has provided, assuming that all distributions have been reinvested. It is generally regarded as the best and most comprehensive measure of fund performance. Total return includes dividend and capital gain distributions along with any changes in the fund's share price. A dividend distribution comes from the interest and dividends earned by the securities held by a fund; a capital gain distribution represents any net gains resulting from the sale of the securities held by a fund. For example, assume a fund's purchase price (NAV) was $50 at the beginning of the year and $53 at the end of the year (an increase of $3.00 per share). Also assume that during the year the fund paid out $1.25 in dividend distributions and $2.00 in realized capital gain distributions (both long-term and short-term).10 The total return of 12.5% would be calculated as follows:
Total Return = Dividend Distributions + Capital Gains Distributions + Increase In NAV / NAV At Beginning Of Year
Total Return = $1.25 + $2.00 + $3.00 / $50
Total Return = 12.5%
Risk Adjusted Rates Of Return. These measures of performance are potentially useful because they may give investors a tool for balancing the potential returns of a fund against the risks of the fund. For instance, if a fund has historical annual returns which are 2% above a market index, historical risk measures may provide some indication of the risks that were taken to produce the increased returns. However, use of these measures is not without controversy. (11)
(1) Beta. "Beta" is generally used in connection with equity securities, but is also used with respect to equity funds (see also, the discussion of beta on page 21). Beta measures the sensitivity of a security's, or portfolio's, return to the market's return. The market's beta is, by definition, equal to "1." Portfolios with betas greater than 1 are more volatile than the market, and portfolios with betas less than 1 are less volatile than the market. For example, if a portfolio has a beta of 2, a 10% market return would result in a 20% portfolio return, and a 10% market loss would result in a 20% portfolio loss (excluding the effects of any firm-specific risk that has not been eliminated through diversification). The calculation of a fund's historical beta requires the selection of a benchmark market index, such as the S&P 500 (see the discussion of "Other Measures" in the Morningstar report on page 195). With many funds it may be difficult to find an appropriate index. For example, since a gold fund has very little correlation with an index such as the S&P 500, a gold fund might compute its beta with respect to a gold index, but this would be useless when making a comparison to other types of funds.
(2) Standard Deviation. This is a statistical measure of the range of a fund's performance. A high rating means that there is greater potential for volatility. See expanded discussion on page 38.
(3) Sharpe Ratio. Also known as the "Sharpe index," or the "reward-to-variability ratio," this ratio is computed by dividing the fund's return minus a risk-fee return (such as that obtainable with a T-bill) by the fund's standard deviation (i.e., it is the ratio of a fund's average return in excess of the risk-free rate of return, or average excess return). A higher ratio means that the fund offers a better trade-off between risk and reward. A Sharpe ratio over "1.0" is generally considered "pretty good," but anything over "2.0" is likely to be considered "outstanding."
(4) Treynor Ratio. Also known as the "Treynor index," or "reward-to-volatility ratio," this is the ratio of a fund's average excess return to the fund's beta. It measures the returns earned in excess of those that could have been earned on a riskless investment per unit of market risk assumed. Unlike the Sharpe ratio, the Treynor ratio uses market risk (beta), rather than total risk (standard deviation), as the measure of risk. It is an attempt to remove from the fund's return that portion due to market risk, leaving only the portion of the return attributable to other factors, such as the skill of the portfolio manager.
(5) Jensen's Alpha. Also known as "Jensen's measure," this is the difference between a fund's actual returns and those that could have been earned on a benchmark portfolio with the same amount of market risk (i.e., the same beta as the portfolio). Jensen's alpha measures the ability of active management to increase returns above those that are purely a reward for accepting market risk. A portfolio having consistently positive excess returns (adjusted for risk) will have a positive Jensen's alpha, whereas a portfolio with consistently negative excess returns (adjusted for risk) will have a negative Jensen's alpha.
MUTUAL FUND LISTINGS
The daily performance of mutual funds is reported in many places, to include major newspapers throughout the country and various online sources. The following is a brief explanation of the information reported by The Wall Street Journal's online Markets Data Center regarding Fidelity's Dynamic Capital Appreciation Fund on December 28, 2007.
Unlike most corporations, a mutual fund generally distributes all of its earnings each year. Because of the specialized "pass-through" tax treatment of mutual fund income and capital gains, fund investors are ultimately responsible for paying tax on a fund's earnings, whether or not they receive the distributions in cash, or reinvest them in additional fund shares.
Taxable Distributions. Mutual funds make two types of taxable distributions to shareholders every year: dividends and capital gains.
(1) Dividend Distributions. Dividend distributions come primarily from the interest and dividends earned by the securities in a fund's portfolio, after expenses are paid by the fund. These distributions must generally be reported as dividends on an investor's tax return. Dividends paid by a mutual fund may be taxable at favorable capital gains rates (see next paragraph) if the income being passed from the fund to the investors is "qualified dividend income" (i.e., corporate stock dividends) in the hands of the fund, and not short-term capital gains or interest from bonds (which is taxed at ordinary income tax rates).
(2) Capital Gain Distributions. Capital gain distributions represent a fund's net gains, if any, from the sale of securities held in its portfolio for more than one year. When gains from these sales exceed losses, they are distributed to shareholders. Distributions of these gains are taxed as long-term capital gains. For taxpayers in the 25 percent tax bracket and higher, the rate on long-term capital gains is 15 percent through 2012. For taxpayers in the 15 percent and 10 percent tax brackets, the rate on long-term capital gains is 0 percent through 2012.
Share Sales & Exchanges. An investor who sells mutual fund shares usually incurs a capital gain or loss in the year the shares are sold. (For the method of determining gain or loss upon the sale or exchange of shares, see page 189). The exchange of shares between funds in the same fund family also results in either a capital gain or loss (see Tax-Deferred Retirement Accounts on page 190 for exceptions to these rules). Investors are liable for tax on any capital gain arising from the sale of fund shares, just as they would be if they sold a stock, bond, or any other security. Capital losses from mutual fund share sales and exchanges (just as capital losses from other investments) may be used to offset other gains in the current year, and thereafter.
Tax-Managed Funds. When a mutual fund is owned outside of a tax-deferred retirement account, it is important to consider how a fund's investment activity will result in taxation of the fund investor. Tax-managed funds attempt to minimize dividends, interest, and realized capital gains. Dividends are minimized by emphasizing investments in long-term growth stocks rather than dividend-paying stocks. Interest is avoided by investing in equities in preference to fixed-income securities. Capital gains are minimized by taking a buy-and-hold approach to investing. If capital gains are realized, the fund is likely to sell other stocks that may generate offsetting capital losses. When stocks must be sold in order to meet redemptions, or for investment purposes, the fund sells stocks with the highest cost basis. To discourage investors from forcing sales, redemption fees are often assessed for funds that have been held for less than two years.
DETERMINING GAIN OR LOSS UPON SALE
The amount of a shareholder's gain or loss on fund shares is determined by the difference between the cost basis of the shares (generally, the purchase price for shares, including those acquired with reinvested dividends) and the sale price.
Cost Basis In Shares. Many funds provide cost basis information to shareholders or compute gains and losses for shares sold. When funds are acquired over a period of time, and for different prices, the investor has some flexibility in determining his or her income tax basis according to one of the following methods:
(1) Specific Identification Method. If the shareholder can adequately identify the group from which the shares came, that basis and holding period can be used.
(2) First-In, First-Out Method (FIFO). Under the FIFO method, it is assumed that the first shares purchased are sold. If the shareholder is unable to adequately identify when the shares were purchased, he or she will usually be deemed to have sold or transferred the shares in the order in which they were acquired using the FIFO method. Assuming an appreciating market, this may result in a low cost basis, high realized gain, and increased taxes.
(3) Average Basis Methods. The shareholder may elect to use either one of two average basis methods if the shares are held in a custodial account maintained for the acquisition or redemption of fund shares and the shareholder purchased or acquired the shares for different bases.
(a) Single Category. Under the single category method, all shares in the mutual fund account are added together. The basis of each share in the account is the total cost (or other basis) of all the shares in the account, divided by the total number of shares.
(b) Double Category. Under the double category method, all shares in the mutual fund account are divided into two categories--those with a holding period of more than one year, and those with a holding period of one year or less. The basis for each share in either category is the total cost (or other basis) of all the shares in that category, divided by the number of shares in that category. The shareholder can then elect to have the shares being sold to come from either one of the categories.
Tax-Exempt Funds. Tax-exempt bond funds pay dividends earned from municipal bond interest. This income is exempt from federal income tax and, in some cases, state and local taxes as well. Tax-exempt money market funds invest in short term municipal securities and also pay exempt-interest dividends. Even though income from these two types of funds is generally tax-exempt, investors must report it on their federal income tax returns. Tax-exempt mutual funds provide investors with this information in a year-end statement. They typically explain how to handle tax-exempt dividends on a state-by-state basis. For some taxpayers, portions of income earned by tax-exempt funds may also be subject to the federal alternative minimum tax. Even though municipal bond dividends and interest may be tax-free, an investor who redeems tax-exempt fund shares may realize a taxable capital gain. An investor may also realize a taxable gain from a tax-exempt fund if the fund manager sells securities during the year for a net gain.
Tax-Deferred Retirement Accounts. No tax is incurred as a result of the sale of mutual fund shares within retirement accounts. Generally, any mutual fund capital gains in retirement accounts accrue tax-deferred until they are distributed to the account holder (i.e., taxation is delayed until the funds are distributed). Distributions from tax-deferred accounts are treated as income subject to the individual's federal income tax rate at the time of distribution, except for nondeductible (after-tax) contributions that are not subject to taxation upon distribution, and most distributions from Roth IRAs. For most individuals, distributions from tax-deferred accounts begin at or near retirement age, at which time the individual may be in a lower income tax bracket. Individuals who receive proceeds from tax-deferred accounts prior to age 59^ may incur a tax penalty in addition to federal, state, and local income taxes.
Digging Deeper An excellent resource for information about the use of mutual funds in retirement accounts is made I available by the Mutual Fund Investor's Center[TM] at: www.mfea.com.
FUND COMPARISONS & SELECTION
Sorting through the more than eight thousand mutual funds can be a daunting task. Making "apples to apples" comparisons of mutual funds, their past performance and future potential, requires use of a rating service offering comprehensive, independent, and accurate mutual fund information. The primary services include Value Line Mutual Fund Survey (www.valueline. com), Lipper Performance Reports (www.lipperweb.com), Morningstar Mutual Funds, and an abridged version available as Morningstar FundInvestor (www.morningstar.com). (12)
Morningstar Mutual Funds. (13) The comprehensive report produced by this service is generally recognized as the leader in its field. Key features of this product include full-page reports on 1,500 mutual funds, twice-a-month analysis sections with updated reports for up to 150 funds, twice-a-month summary sections with updates on key data points, editorial analysis, Morningstar's proprietary style boxes and star ratings, commentary on the fund industry, tax analysis, and aggregate performance data for categories of funds. The following examination of the specific information presented in the single-page stock-fund report provides an overview of the essential information that is required in comparing and selecting mutual funds. (14)
Manager Strategy. This section explains what criteria a manager uses in selecting stocks, and how risky a given approach may be. It may often focus on what size and type of company a manager prefers, together with a discussion regarding how growth and value factors are balanced.
Call it forced evolution. As this fund has grown into a behemoth, with nearly $30 billion in assets, manager Will Danoff has had to move away from mid-caps and small caps and adopt a growth-at-a-reasonable-price philosophy. He still continues to keep a big part of the fund in mid-caps, but the fund is now dominated by larger fare. The fund tends to be more conservative than most of its large-blend rivals, with a big underweighting in
Portfolio Manager(s). This section provides a profile of the portfolio manager, including a listing of any other funds the manager runs. To determine how much of the fund's record is attributable to the manager, check the start date (e.g., since September 1990).
William Danoff. Since 09-90. BA'82 Harvard U., MBA'86 U. of Pennsylvania; MA'86 University of Pennsylvania, Wharton School.
Performance. This section gives the quarterly returns over the past five years. Morningstar suggests that this is a good place for the investor to quickly test his or her risk tolerance.
Quarterly returns are compounded to obtain the year-end total shown on the right.
Trailing returns provide performance over short and long periods with comparisons against appropriate benchmarks and peers. Total Return % is calculated by taking the change in net asset value, reinvesting all income and capital gain distributions during the period, and dividing by the starting net asset value. The measure of the difference between the stock fund's total return and the total return of the S&P 500 Index is +/-S&P 500 (see page 65). The measure of the difference between the fund's total return and the total return of the Russell 1000 Index is +/-Russ 1000 (see page 67). With both of these measures, the minus sign ("-") means that the fund underperformed the index, and the plus sign ("+") means that the fund outperformed the index. For example, a listing of -1.23 means that the fund underperformed the S&P 500 Index by 1.23 percentage points. Another performance measure, %Rank All/Cat, provides two total return percentile rankings for each fund for the periods indicated. The first compares a fund with all funds in the Morningstar database (% Rank All), while the second compares the fund's total return for that period against the funds in the same Morningstar Category (% Rank Cat). With both rankings "1" is the highest or best percentile and "100" is the lowest, or worst.
Performance 01-31-03 1st Otr 2nd Otr 3rd Otr 4th Otr Total 1998 12.28 4.48 -9.36 23.73 31.57 1999 5.79 5.51 4.66 17.50 25.03 2000 5.56 -6.58 1.13 -6.54 -6.80 2001 -13.18 3.47 -8.80 6.70 -12.59 2002 2.88 -3.68 -9.86 1.18 -9.63 Trailing Total +/- +/- Russ % Rank Growth of Return * S&P 500 1000 All Cat $10,000 3 Mo 4.17 -1.23 -1.61 85 80 9,583 6 Mo -5.09 0.16 0.21 61 27 9,491 1 Yr -11.90 11.11 10.66 43 3 8,810 3 Yr Avg -9.57 4.26 4.09 62 16 7,394 5 Yr Avg 3.32 4.64 4.53 43 5 11,773 10 Yr Avg 10.82 1.86 1.98 5 5 27,926 15 Yr Avg 15.56 4.59 4.57 2 1 87,509
Tax Analysis. This section lists the fund's tax-adjusted returns (Tax-Adj Rtn%) and the percentage point reduction in annualized returns that results from taxes (Tax-Cost Rat). Each figure is then given a percentile rank (%Rank Cat) in the fund's category ("1" is the best, "100" is the worst). Morningstar warns that high tax-adjusted returns do not necessarily mean that a fund is tax-efficient; a very tax-efficient fund with poor returns may result in low after-tax results. This section is probably best used in determining whether a fund should be held in a tax-deferred or taxable account.
Tax Analysis Tax-Adj % Rank Tax-Cost %Rank Rtn% Cat Rat Cat 3 Yr Avg -11.37 18 0.99 41 5 Yr Avg 0.96 7 1.68 66 10 Yr Avg 8.16 7 2.09 67 Potential Capital Gain Exposure: -10% of assets
Morningstar's Take. This section reflects the interpretation by Morningstar's analysts and is based upon the data displayed and an interview of the fund's manager, which is designed to uncover those strategies guiding investment decisions. The "how and why" of a fund's success or failure is provided and recommendations are made regarding inclusion in the investor's portfolio.
Morningstar's Take by Christopher Traulsen 02-03-03 Fidelity Contrafund's manager still hasn't found much to like in the technology sector. Will Danoff has been skeptical of the technology sector since early 2001, when he sold down most of the fund's holdings in the area. Put simply, he didn't think the sell-off made tech stocks much more attractive from a valuation perspective, as their earnings had shrunk along with their share prices. As of late 2002, tie remained skeptical of their earnings power, and that apparently hadn't charged by year-end. As of Dec. 31, 2002, Contrafund had just 3.1 % of its assets in the technology sector, according to Fidelity's numbers. In contrast, tech stocks were 14.3% of the S&P 500 index on the same date. Instead of tech, Danoff continued to favor steadier financials, consumer staples, and health-care names at year-end. In addition, he maintained a significant overweight in materials issues relative to the S&P 500 Index, and bad also stashed a large percentage of the fund's assets in mid-caps and overseas stocks. With the exception of a notable blowup at Tenet Healthcare, Danoff's positioning and stock-picking was spot-on for most of 2002. Strong showings from top holdings such as Lockheed Martin, Avon Products, and Newmont Mining helped limit the fund's 2002 loss to 9.2%. No one likes to lose money, but the fund beat the S&P 500 Index and the average large-blend offering by 12.5 percentage points on the year--a huge margin. Danoff's bets carry risk: The fund isn't likely to participate much in a rally driven by the tech sector. Indeed, it badly lagged its peer group and the S&P 500 in 2002's buoyant fourth quarter. That said, we think the true measure of a fund's worth is its strength over time. On that score, Contrafund excels: Its three-, five-, and 10-year returns all best the category average and the S&P 500 by sizable margins, and it has been less volatile than both benchmarks. Investors seeking a core holding should find much to like here.
Operations. This section lists the mailing address, phone number and web address of the fund. Also listed are the inception date, advisor, minimum initial purchase, and breakdown of the fund's expenses into its components, including projections of the funds total costs, such as load, and annual expense ratio, based on a $10,000 investment over different periods of time. Lastly, the fund's total costs are given relative to its category.
Address: 82 Devonshire Street Boston. MA 021 OS 600-544-8888 Web Address: www.fidelity.com Inception: 05-17-67 Advisor: Fidelity Management & Research Subadvisor: FMR (Far East), FMR (U.K.) NTF Plans: Commonwealth NTF, Fidelity Instl-NTF Minimum Purchase: $2500 Min Auto Inv Plan: $2500 Sales Fees: 3.00%L Management Fee: 0.30%. 0.20P Actual Fees: MgtO.45% Expense Projections: 3Yr:$502 Income Distrib: Annually Total Cost (relative to category): Add: $250 IRA: $500 Add: $250 Dist:-- 5Yr:$651 10Yr:$1086 Below Avg
Morningstar Category. This is the first stage in understanding a fund's portfolio. Morningstar sorts funds into 50 peer groups based on the types of securities held by the funds. Each category is assigned using a fundamental analysis of a fund's portfolio over a 3-year period. This portfolio analysis and the fund's category tell a great deal about a fund's performance and future volatility. These categories are also helpful in selecting funds with a view toward diversifying a portfolio.
Investment Style. (15) These boxes indicate whether the fund manager sticks with a consistent style from year to year, or whether there is "style slippage" (see page 177). Purchase of a fund to fill a particular investment need in a balanced portfolio requires that the fund maintain that position if the investor is to achieve his or her goal. See the expanded illustration of this unique Morningstar feature on page 198. The figure below the boxes is the percentage of stock holdings. If there has been a change of manager, that occurrence is indicated by a "[nabla]" placed over the quarter of change.
Fund Performance vs. Category Average. This graph compares a fund's quarterly returns with its category average. It indicates the volatility of a fund compared with others in the same category.
Performance Quartile. This graph shows in which quartile a fund's calendar-year returns finished relative to its category. Again, this is an indication of how consistent the fund has been from year to year.
History. (16) This table can be used to spot trends over the years. NAV is the fund's "net asset value" and represents its per-share price (see page 184). Total Return % includes income (in the form of dividends or interest payments) and capital gains or losses (the increases or decreases in the value of a security). Total return is calculated as a percentage by taking the change in a fund's NAV, assuming the reinvestment of all income and capital gain distributions during the period, and then dividing by the initial NAV. The measure of the difference between the fund's total return and the total return of the S&P 500 Index is +/-S&P 500 (see page 65). The measure of the difference between the fund's total return and the total return of the Russell 1000 Index is +/Russ 1000 (see page 67). With both measures, the minus sign ("-") means the fund underperformed the index, and the plus sign ("+") means the fund outperformed the index. For example, a listing of 12.26 means that the fund outperformed the S&P 500 Index by 12.26 percentage points. Total Rtn % Rank Cat measures the fund's total return compared to funds in the same Morningstar Category ("1" is the highest or best percentile, and "100" is the lowest, or worst). Income $ is the fund's yearly income distribution expressed in per-share dollar amounts (dividends and interest). Capital Gain $ is the fund's yearly capital gain distributions expressed in per-share dollar amounts (i.e., the profits received and distributed from the sale of securities within the portfolio). Expense Ratio % is the percentage of assets deducted each fiscal year for the fund's expenses, including 12b-l fees, management fees, administrative fees, operating costs, and all other asset-based costs. Income Ratio % is the percentage of current income earned per share, and is calculated by dividing the fund's net investment income by its average net assets (net investment income is the total income of the fund, less expenses). Turnover Rate % is then determined by dividing the lesser of purchases or sales (expressed in dollars and excluding all securities with maturities of less than one year) by the fund's average monthly assets. This provides a rough estimate of the fund's level of trading activity (i.e., the percentage of the portfolio that has changed over the past year). Net Assets $mil is the fund's asset base in millions of dollars, net of fees and expenses.
2000 2001 2002 01-03 History 49.18 42.77 38.60 37.42 NAV -6.80 -12.59 -9.63 -3.06 Total Return % 2.30 -0.71 12.46 -0.44 +/-S&P 500 0.99 -0.14 12.02 -0.64 +/-Russ 1000 0.41 0.45 0.12 0.00 Income Return % -7.21 -13.04 -9.75 -3.06 Capital Return % 46 56 3 81 Total Rtn % Rank Cat 0.24 0.22 0.05 0.00 Income $ 6.62 0.00 0.00 0.00 Capital Gains S 0.84 0.91 -- -- Expense Ratio % 0.45 0.49 -- -- Income Ratio % 166 141 -- -- Turnover Rate % 40,285 32.321 27,695 26.729 Net Assets $mil
Rating and Risk. This section provides the funds' risk, returns, and overall star rating over the 3-, 5-, and 10-year time periods. Load-Adj Return % provides the percentage returns by adjusting downward to account for sales charges (the calculation is adjusted for deferred and back-end loads that decline or disappear). Morningstar Rtn vs Cat indicates how the fund's returns compare with those of its peer group (High = top 10%; Above Average = next 22.5%; Average = middle 35%; Below Average = next 22.5%; Low = bottom 10%). Morningstar Return is an assessment of a fund's excess return over a risk-free rate (the return of the 90-day Treasury bill) in comparison to similar funds, after adjusting for all applicable loans and sales charges. Morningstar Risk vs Cat ranks a fund's historical volatility versus that of its peer group (Low Risk = 10% of funds with lowest measured risk; Below Average = next 22.5%; Average = middle 35%; Above Average = next 22.5%; High = top 10%). Morningstar Risk is an assessment of the variations in a fund's monthly returns in comparison to similar funds (the greater the variation, the larger the risk score). Morningstar Risk-Adj Rating is derived by weighting and averaging the separate measures, and provides some idea of the consistency of the fund's historical risk-adjusted performance (Highest = 5 stars; Above Average = 4 stars; Neutral = 3 stars; Below Average = 2 stars; Lowest = 1 star).
Rating and Risk Time Load-Adj Morningstar Morningstar Morningstar Period Return % Rtn vs Cat Risk vs Cat Risk-Adj Rating 1 Yr -14.54 3 Yr -10.49 +Avg Low **** 5 Yr 2.69 High -Avg ***** 10 Yr 10.48 High -Avg ***** Incept 12.63
Other Measures. These all provide additional views of risk. Alpha measures the difference between a fund's actual returns and its expected performance, given its level of risk as measured by "beta" (see page 21). A positive alpha figure indicates the fund has performed better than its beta would have predicted, and a negative alpha indicates that the fund has underperformed in light of the expectations established by the fund's beta. Beta is a measure of a fund's sensitivity to market movements (see pages 21 and 185). Morningstar calculates beta using excess fund returns against excess index returns (some other methodologies use regression against raw returns). R-Squared is a measure of the performance patterns of the fund compared to the index. For beta and alpha to be reliable measures of risk, a fund must have a high correlation with its index. A high R-Squared (from 85 to 100) indicates that the fund's movements are in line with the benchmark index. A fund with a low R-Squared (70 or less) does not move with the index (e.g., an R-Square measure of 30 indicates that only 30% of the fund's movements can be explained by movements in the benchmark index). Standard Deviation is a statistical measure of the range of a fund's performance (see page 38). A high standard deviation indicates that the fund has a greater potential for volatility. The Mean is the annualized average monthly return from which the standard deviation is calculated (i.e., since the standard deviation is based upon 36 monthly returns, the mean is the same as the annualized trailing 3-year return figure; -9.57 in this example). The Sharpe ratio is a risk-adjusted measure that is calculated using standard deviation and excess return to determine reward per unit of risk (see page 186). The higher the Sharpe ratio, the better the fund's historical risk-adjusted performance. The Best Fix Index is the index that has the highest correlation with the fund; in this case the S&P Mid 400 Index (Standard and Poor's Mid-Cap 400 Index, see page 65).
Other Measures Standard Best Fit index Index S&P S&P 500 Mid 400 Alpha -4.3 -11.4 Beta 0.51 0.54 R-Squared 57 77 Standard Deviation 11.42 Mean -9.57 Sharpe Ratio -1.20
Portfolio Analysis. This section provides information regarding the fund's holdings that help in understanding performance and potential volatility. Included are the fund's total holdings (Total Stocks), each stock's sector, price earnings ratio (PE), year-to-date returns (YTD Ret %), and percentage of fund assets devoted to the stock (% Assets). An increase in stock holdings is indicated by a plus sign ((+)) and a decrease is indicated by a minus ((-)) sign. New additions are indicated by a star burst (a).
Portfolio Analysis 10-31-02 Total Stocks: Share change 446 YTD % since 12-01 Sector PE Ret % Assets Lockheed Martin Ind Mtrls -- -13.16 3.39 PepsiCo Goods 23.0 4.74 2.68 Colgate-Palmolive Goods 24.4 -1.57 2.68 Berkshire Hathaway CI B Financial 32.0 -10.69 2.40 3M Company Ind Mtrls 26.7 -0.23 2.26 Avon Products Goods 27.5 -4.14 2.10 Encana -- -- -- 1.89 BP PLC ADR Energy 18.3 -7.33 1.87 Johnson & Johnson Health 26.0 -2.96 1.77 Tenet Healthcare Health 7.5 6.40 1.77 UnitedHealth Grp Health 23.1 0.62 1.65 Fifth Third Bancorp Financial 19.8 -9.89 1.43 Pfizar Health 23.4 -2.10 1.23 American Intl Grp Financial 20.4 -16.68 1.21 HCA- The Healthcare Com Health 24.1 -2.07 1.15 First Data Business 22.8 -4.66 1.14 Newmont Mng Ind Mtrls 78.2 -1.48 1.12 ExxonMobil Energy 23.2 -3.15 1.04 Gillette Goods 29.6 4.99 0.96 Fannie Mae Financial -12.1 -1.47 0.92
Current Investment Style. This is the Morningstar style box for the current period (see page 198). Also shown is the Market Cap % giving a view of the different size companies in the fund's portfolio based upon percentiles (Giant = 1% of U.S. largest companies; Large = next 4%; Mid = 15%; Small = next 30%; Micro = bottom 50%). Median $mil gives the median market capitalization of the portfolio in millions of dollars.
Current Investment Style Market Cap % Giant 25.1 Large 40.1 Mid 29.9 Small 4.5 Micro 0.3 Median $mil: 15,620
Value Measures. This section provides key indicators of value (see Value Investing on page 20 and Value Stocks on page 135). Price/Earnings is the weighted average of the price/ projected earnings ratio of all stocks in the fund's portfolio (see page 33). Price/Book is the weighted average of the price/book ratios of all the stocks in the fund's portfolio. Price/Sales is the weighted average of the price/sales ratios of all the stocks in the fund's portfolio. Price/Cash Flow is the weighted average of the price/cash-flow ratios of all the stocks in the fund's portfolio. Dividend Yield % is the weighted average of the dividend yield for each stock in the fund's portfolio (see page 137). To provide perspective the column entitled Rel S&P 500 compares these measures with the figures for the broad-based S&P 500 Index.
Value Measures Rel S&P 500 Price/Earnings 25.4 1.5 Price/Book 3.7 1.7 Price/Sales 1.6 1.5 Price/Cash Flow 10.3 1.8 Dividend Yield % 0.8 0.4
Growth Measures. This section provides key indicators of the potential for growth. Long-Term Erngs is the weighted average of the projected growth in earnings for each stock in the fund's portfolio, as derived from polled analysts' estimates. Book Value is the weighted average of growth rates in book value for each stock in the fund's portfolio. Sales is the weighted average of the sales-growth rates for each stock in the fund's portfolio. Cash Flow is the weighted average of the growth in cash flow for each stock in the fund's portfolio. Historical Erngs is the weighted average of the growth in earnings for each stock in the fund's portfolio. Rel S&P 500 column compares these measures with the figures for the broad-based S&P 500 Index.
Growth Measures % Rel S&P 500 Long-Term Erngs 17.4 1.1 Book Value 9.0 1.1 Sales 8.5 1.0 Cash Flow 13.3 1.6 Historical Erngs 12.8 2.1
Profitability. This section provides key indicators of the potential for increased profitability. Return on Equity (ROE) is the weighted average of the fund's individual holdings' ROE. Return on Assets (ROA) is equal to the weighted average ROA of the fund's individual holdings. Net Margin represents the weighted average of the individual stocks' net margins.
Rel S&P Profitability % 500 Return on Equity 17.8 1.1 Return on Assets 9.3 1.1 Net Margin 7.2 na
Sector Weightings. Morningstar divides the stock market into three broad "economic spheres": Info (information); Service; and Mfg (manufacturing). Each of these spheres is in turn divided into four specific industry sectors. The column headed % of Stocks gives the percentage of the fund's assets in each sphere and sector. The column headed Rel S&P 500 gives the weightings relative to the S&P 500 Index. The last two columns give the fund's historical (3-year) range of the percentage of assets held in each sphere and sector.
Rel 3 Year Sector % of S&P Weightings Stocks 500 High Low Info 4.8 0.2 15 5 Software 1.6 0.3 6 2 Hardware 1.1 0.1 5 1 Media 2.0 0,5 3 2 Telecom 0.1 0.0 2 0 Service 56.0 1.1 71 43 Health 19.2 1.3 21 16 Consumer 11.5 1.3 11 7 Business 8.7 2.2 11 5 Financial 16.7 0.8 28 15 Mfg 39.1 1,3 46 20 Goods 20.2 2.2 20 9 Ind Mtrls 13.8 1.3 14 5 Energy 5.0 0.8 10 5 Utilities 0.1 0.0 3 0
Composition. This section shows the percentage of assets devoted to cash, stocks, bonds, and other, along with the percentage of stock assets invested in foreign securities.
Composition Cash 7.3 Stocks 92.1 Bonds 0.4 Other 0.2 Foreign 22.3 (% of Stock) Note: Table made from pie chart.
Morningstar Style Box. The investment style box has been designed by Morningstar to provide a visual tool for better understanding a fund's true investment strategy. The following is the style box for funds falling within the Morningstar Category for domestic-stock funds, defined as those with at least 70% of their assets in domestic stocks (there is also an international-stock style box and a bond style box). Within the stock style box grid, nine possible combinations exist, ranging from large-cap value for the safest funds to small-cap growth for the riskiest. For stocks and stock funds, it classifies securities according to market capitalization (the vertical axis) and growth and value factors (the horizontal axis). Large-cap stocks are defined as the group that accounts for the top 70% of the capitalization of the Morningstar domestic-stock universe (representing about 99% of the United States market for actively traded stocks); mid-cap stocks represent the next 20%; and small-cap stocks represent the balance. A fund's horizontal placement--value, growth, or blend--is determined by an asset-weighted average of the stocks' net value/growth scores (the scores include value measures such as price-to-projected earnings and dividend yield, and growth measures such as long-term projected earnings growth and book value growth).
Exchange-Traded Funds (ETFs). While exchange-traded funds are typically registered investment companies--as unit investment trusts or open-end funds--they differ from traditional mutual funds both in how their shares are issued and redeemed, and in how their shares or units are traded. Unlike traditional mutual funds, or unit investment trusts, ETF shares are generally created by an institutional investor depositing a specified block of securities with the ETF. In return, the institutional investor receives a fixed amount of ETF shares, which may then be sold on a stock exchange. Retail investors buy and sell these ETF shares after they are listed on an exchange, much as they can buy or sell any listed equity security. (The retail investor does not purchase or redeem shares directly from the ETF, as with a traditional mutual fund or unit investment trust.) Shares are priced and traded throughout the day on national stock exchanges at market-determined prices. In contrast, mutual funds are bought or sold directly from the fund at net asset values determined upon the close of the market each day.
Unlike mutual funds, ETFs have no investment minimums (i.e., a single share can be purchased), and there are no sales charges other than the cost of the stock transaction. Because exchange-traded fund shares can be sold short and bought on margin, they are often promoted as offering the benefits of index investing, but at a lower cost, and with greater trading flexibility in comparison to mutual funds. When compared to mutual funds, ETFs are also often promoted as offering the benefits of index investing, but with less exposure to capital gains taxation (i.e., sales by mutual funds to generate cash for shareholder redemptions often produce realized capital gains that must be reported by mutual fund shareholders). Exchange-traded funds offer the individual investor a very wide range of investments. For example, there are broad-based ETFs that track the S&P 500 index, sector-based ETFs that track specific industries, and international ETFs that track various groups of overseas stocks. There are also ETFs that track REITs, bonds, and commodities such as gold, oil, and wheat. Just like publicly traded stocks, ETFs have ticker symbols (e.g., QQQQ, referred to as "cubes," which allows investors to invest in all of the companies represented in the NASDAQ-100 Index). Commission-free ETFs have recently been offered by two of the larger mutual fund management companies. There were 920 ETFs in the United States in November of 2010, of which 489 were domestic equity funds, 296 were global equity funds, 129 were bond funds, and 6 were hybrid funds. (17)
Stock Style Box Average Weighted Market Risk Investment Style Capitalization Value Blend Growth Low Large-cap Large-cap Large-cap large Value Blend Growth Moderate Mid-cap Mid-cap Mid-cap Mid Value Blend Growth High Small-cap Small-cap Small-cap Small Value Blend Growth
CROSS REFERENCES TO TAX FACTS ON INVESTMENTS (2011)
Q 7886. How are dividends received from a mutual fund taxed?
Q 7895. How is a shareholder taxed when he or she sells, exchanges, or redeems his or her mutual fund shares?
Q 7899. What is a closed-end fund? How are shareholders in a closed-end fund taxed?
Q 7900. What is an exchange-traded fund? How are shareholders in an exchange-traded fund taxed?
Q 7902. What is a unit trust? How are unit holders taxed?
Donald F. Cady, J.D., LL.M., CLU
(1) See 2010 Investment Company Fact Book, p. 80, (www.icifactbook.org/pdf/2010_factbook.pdf).
(2) Ibid. pp. 126 and 128.
(3) In November of 2009 there were 7,704 funds, as compared to a total of 6,811 stocks on the three exchanges at the beginning of 2010 (3,276 stocks listed on the NYSE, 2,951 on the NASDAQ and 584 on NYSE Alternext U.S.). The American Stock Exchange (AMEX) was acquired in 2008 by NYSE Euronext and renamed NYSE Alternext U.S.
(4) The advantages of mutual fund ownership were obtained from the Investment Company Fact Book, a very useful publication of the Investment Company Institute. The Investment Company Fact Book is an annual compilation of facts and figures on the United States mutual fund industry, to include information about the industry's history, regulation, taxation, and shareholders. The full text of this publication can be accessed at: www.ici.org.
(5) For a brief explanation of how subprime mortgage problems have impacted both stock and bond mutual funds, see Paul Herbert, CFA, "Subprime and the Impact on Bond Funds," (August 15, 2007) at: htttp://news. morningstar.com/articlenet/article.aspx?id=203764.
(6) As listed in the 2004Mutual Fund Fact Book, Copyright [C] 2004 by the Investment Company Institute Reprinted with permission.
(7) See Target Date Retirement Funds: Lack of Clarity Among Structures and Fees Raises Concerns; Summary of Committee Research prepared by the Majority Staff of the Special Committee on Aging, United States Senate, page 8, October 2009.
(8) See Morningstar, Target-Date Series Research Paper: 2009 Industry Survey, page 5, September 9, 2009.
(9) The following definitions of share classes are based upon materials made available by the Mutual Fund Education Alliance[TM] in its online Mutual Fund Investor's Center (www.mfea.com). This web site is an excellent resource offering a large collection of mutual fund companies, website links, fund listings and exclusive planning, tracking and monitoring tools. The Mutual Fund Education Alliance is the not-for-profit trade association of the no-load mutual fund industry.
(10) Note that only realized capital gain distributions are considered. Any appreciation in price is derived from unrealized capital gains.
(11) See Paul Schott Stevens and Amy Lancellotta, Improving Mutual Fund Risk Disclosure, 2nd (Investment Company Institute Perspective, Vol. 1, No. 2, November 1995).
(12) Morningstar also offers a software product entitled Morningstar Principia Mutual Funds, providing the ability to analyze and construct portfolios by sorting and selecting funds using a variety of parameters.
(13) The information on pp. 191-198 was reprinted with permission of Morningstar, Inc.
(14) Morningstar Mutual Funds consists of a stock-fund report and a separate, but similar, bond-fund report. The following material is based upon information set forth in the Morningstar Mutual Funds Resource Guide, (Morningstar, Inc., 2003), provided as a supplement to subscribers to the Morningstar Mutual Funds service. The current edition of this publication can be purchased by calling 312-424-4288.
(15) Morningstar provides style boxes for the current year plus the prior eight years, if available. To conserve space, only the prior three years are shown.
(16) Morningstar provides data for the current year plus the prior eleven years, if available. To conserve space, only the prior three years are shown.
(17) As reported in a monthly statistical release by the Investment Company Institute, Exchange-Traded Fund Assets, November 2010, at www.ici.org.
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|Title Annotation:||2011 FIELD GUIDE TO FINANCIAL PLANNING|
|Author:||Cady, Donald F.|
|Publication:||Field Guide to Financial Planning|
|Date:||Jan 1, 2011|
|Previous Article:||Chapter 8: Stocks.|
|Next Article:||Chapter 10: Tangible assets.|