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The world of mutual funds: informed CPAs can help clients make better investment decisions.

For most of the last decade, mutual fund investors have been too busy counting their profits to worry about potential losses. While the average stock gained 11.6% over the last three years, the average mutual fund returned 14.2%. In 1993, some funds that invested in small company stocks or foreign securities climbed 30% or more. Even conservative investments, such as bond funds, have been surprisingly strong performers.

Currently, approximately 40 million people have invested over $2 trillion in more than 5,000 mutual funds. As public interest continues to grow, CPAs often are asked not only whether it's better to invest in mutual funds than in individual stocks or bonds but also what fund types are best. Many CPAs also are interested in mutual funds for their own portfolios. Many others, however, are increasingly called on to help clients make investment decisions. The burgeoning interest in individual mutual fund investing makes it important for CPAs to understand how the funds work to ensure they--and their clients--invest wisely.


A mutual fund pools many investors' monies and buys stocks, bonds and other investments on their behalf. Investors buy shares in the fund; each share represents proportionate ownership of the fund's assets. Mutual funds distribute dividends and capital gains to shareholders in proportion to the number of shares they own. Similarly, fund expenses are charged to shareholders on a per-share basis.

The basic characteristics of mutual funds account for much of their popularity:

Liquidity. With few exceptions, mutual fund shares can be redeemed easily at current market values. Any limits on the ability to redeem shares immediately are identified in a fund's prospectus.

Flexibility. Many mutual funds are part of a "family" of funds developed by a single sponsor. Shareholders in one fund can move their money from one fund to another in the family at little or no cost--often with just a phone call.

Accessibility. Many funds have low minimum initial investment requirements (some as low as $250), and subsequent investments can be even lower (as low as $50). This gives even small investors access to the benefits of mutual fund investing.

Diversification. Small investors generally are unable to acquire on their own investment portfolios as diverse as those of mutual funds.

Asset allocation. Asset allocation is the process of dividing a portfolio among available investment classes--stocks, bonds (domestic and international), cash, real estate, etc. Mutual fund investors can purchase a number of different funds to achieve their targeted allocation or invest in a single asset allocation fund that invests according to established asset allocation goals.

Professional money management. A mutual fund's day-to-day investment decisions are handled by professional money managers. Fund managers base their decisions on intensive ongoing research and up-to-date economic, market and financial information and ultimately are accountable to shareholders for their investment strategies.

Regulation and disclosure. Mutual funds are regulated by the Securities and Exchange Commission, which sees to it that irregularities are avoided or corrected and that appropriate disclosures are made to the public about a fund, its holdings and operations.


Each investor has unique needs and objectives limiting the number of funds he or she might consider. Before helping clients evaluate specific mutual funds, CPAs must help them address three issues:

1. Investment goals (reasons for investing).

2. Time horizon (when the invested funds might be needed).

3. Risk tolerance (how much of the investment can be lost).

Within these constraints, CPAs should consider a number of fund characteristics to help clients find the most appropriate fund or funds.

Investment objectives. Every mutual fund has specific objectives, ranging from earning current income to long-term appreciation. Investors must identify and establish priorities for their own goals and begin the selection process by identifying funds with investment objectives that match those goals. A summary of mutual fund types and their investment objectives is included in the sidebar on page 47.

Risk. Risk is the chance an investor might lose some or all of his or her money. Risk often is classified in two categories: inflation risk and the risk of uncertain investment returns. An investor's risk tolerance--the level of risk the investor is willing and able to assume--is important in making fund selections. Risk tolerance can be determined from a review of an investor's current investments, discussions about risk and investment preferences or from questionnaires designed to help evaluate risk tolerance.

Understanding a mutual fund's investment objectives is one way to determine the riskiness of its investments. Generally, funds that seek to maximize capital appreciation pick riskier investments with a potential for higher returns. Funds seeking to provide current income make somewhat safer investments that will minimize risk and maximize income.

Fund management. A mutual fund's manager or management team is responsible for making investment decisions that carry out its objectives. Even with this guidance, many funds give managers tremendous leeway in the decision-making process.

In evaluating a fund manager, factors that should be considered include the manager's experience in managing investment portfolios, whether that experience was with funds of similar size or investment objectives, the manager's performance in the current or a previous fund and his or her performance under difficult market conditions (the 1987 stock market crash, the recent stock market pullback in the face of rising interest rates). Exhibit 1, page 50, provides a checklist CPAs can use to evaluate fund managers.

EXHIBIT 1 Mutual fund portfolio manager evaluation checklist

Objective: To help compare mutual funds by analyzing their managers' investment objectives and strategies.
Client Date
Fund Name Yes No Comments
1. The fund's top management team has
substantial experience managing
investment portfolios. _____
2. Top management has experience
with funs of similar size. _____
3. Top management has experience with
funds with similar investment objectives. _____
4. Top management has substantial experience
managing investment portfolios with equivalent
investment strategies involving the industries
or companies included in the current portfolio. _____
5. Top management's previous achievements
are similar to the fund's expected results. _____
6. The fund's investment objectives are
compatible with the client's. _____
7. The fund's investment strategies allow
adequate flexibility to maneuver
successfully within the marketplace
(restrictions on the size of
companies in the portfolio and the
percentage of ownership in each company,
are not excessive). _____

Source: American Institute of CPAs Personal Financial Planning Manual

Current holdings. Reviewing a particular fund's holdings (as listed in a current prospectus) is a good indicator the manager is (or is not) adhering to the fund's investment objectives and what types of investments are necessary to achieve that objective. Potential investors--and their advisers--should be comfortable with the fund's current investments.

Expenses. Mutual funds sometimes charge an up-front fee, or load, when selling shares. A fund also may levy a fee--known as a back-end load or redemption fee--on an investor's subsequent sales of shares. With "no-load" funds, investors incur no sales charge when they buy shares. Instead of a front-end load, some funds charge a back-end fee known as a contingent deferred sales charge. The fee is contingent on how many years the investor holds the fund. With some funds, the sales charge can be as much as 7% on sales within the first year; the charge declines by 1% annually to encourage investors to hold the fund at least seven years.

Whether funds are load or no-load generally should not be a factor in selecting them. Investors who have the time and expertise to make their own investment choices typically favor no-load funds. Other investors may need to retain an intermediary to help in the selection process; he or she typically is compensated by recommending funds with sales loads that will in turn pay the intermediary a commission.

In addition to purchase-related fees, funds pass fees on to investors to cover administrative and management costs. A fund's expense ratio, expressed as an annual percentage of its assets, is a measure of its efficiency in controlling costs and should be considered when evaluating its performance. The average expense ratio for equity funds and taxable bond funds is 1.5% and 1%, respectively. Newer or smaller funds typically have higher expense ratios than larger, more established funds. While a higher-than-average expense ratio may be a red flag suggesting a fund is poorly managed, it may be justified if the fund is performing well.

A fund's turnover ratio--an indication of the volume of its trading activity--reflects potential hidden costs to shareholders. A fund that buys and sells securities quickly will have a high ratio, resulting in higher transaction or brokerage costs and capital gains and reducing the fund's net asset value. A 100% turnover ratio indicates the portfolio has completely turned over in a year. Frequent portfolio turnover also may result in recognized capital gains on which shareholders are taxed.

Performance. Many investors consider a fund's track record in making investment decisions. Performance information provided by mutual funds generally highlights their best time horizons. CPAs should help their clients track a fund's investment returns on a year-by-year basis. This is the best way for potential investors to know if the fund's performance in bear markets is within their risk tolerance.

Key criteria for evaluating a fund's performance include

* Performance in relation to other funds with similar investment objectives.

* Long-term profits--amount and consistency.

* Performance in relation to market indexes.

It's best to avoid chasing so-called hot funds (funds that performed exceptionally well over the preceding two or three years). As always, past performance is not a guarantee of future success. A fund's performance should be reviewed over at least a five-year horizon to evaluate how the manager performed in bull and bear markets. Some managers lack the skills to weather bear markets.

Industry experts expect the number of mutual funds to double in the next 18 months. New mutual funds typically have experienced exceptional growth in the number of investors. These funds may have no track records in weak markets or no track records at all. In analyzing new funds, investors can review specific holdings in the funds' portfolios and investigate the fund managers, including their performance in managing previous funds.


Fund rating services. Instead of reading the prospectuses or annual reports of dozens of mutual funds, CPAs and their clients can use rating services to help make sense of the mutual fund universe and identify the right funds. While each service is different, all generally rate funds according to investment strategy and provide information on a fund's manager, performance history and fees. A list of rating services and other mutual fund resources is provided in exhibit 2, page 51.

EXHIBIT 2 Mutual fund rating services and resources

General information

Newsstand publications such as Worth, Forbes, Money, Barrons, Investors Daily, Business Week, Consumer Reports, Smart Money, Kiplinger's and Personal Finance Magazine typically give substantial coverage to mutual fund investing. There also are magazines covering different types of funds such as subscription newsletters and publications issued by mutual fund families. Local libraries are a good place to obtain these resources.

Specific resources

Business Week Mutual Fund Scoreboard Diskettes: Equity Income Mutual Fund Scoreboard

Fixed Income Mutual Fund Scoreboard

P.O. Box 1597

Fort Lee, New Jersey 07024

(800) 553-3575 FundScope

The Planner's Edge

1412 112 Avenue, N.E.

Bellevue, Washington 98004

(206) 451-8462 The Individual Investor's Guide to Low-Load Mutual Funds

The American Association of Individual


625 North Michigan Avenue

Chicago, Illinois 60611

(312) 280-0170 Investing in Mutual Funds (videotape) Tape: Product no. 180160JA ($129) Manual: Product no. 350160JA ($30)

American Institute of CPAs

Harborside Financial Center

201 Plaza lll

Jersey City, NJ 07311

(800) 862-4272 Directory of Mutual Funds

Investment Company Institute

1401 H Street, N.W.

Suite 1200

Washington, D.C. 20005-2148

(202) 326-5800 The Investor's Guide to Low-Cost Mutual Funds Mutual Fund Education Alliance

The Association of No-Load Funds

1900 Erie Street, Suite 120

Kansas City, Missouri 64116

(816) 471-1454 Lipper Analytical Services/Standard & Poor's Mutual Fund Profiles

25 Broadway

New York, New York 10004

(800) 221-5277 Morningstar Mutual Funds


225 West Wacker Drive

Chicago, Illinois 60606

(800) 876-5005 Mutual Fund Expert

Steele Systems

12021 Wilshire Boulevard, #407

Los Angeles, California 90025-1200

(800) 678-3863 Value Line The Value Line Mutual Fund Survey

220 East 42 Street

New York, New York 10017

(800) 634-3583 Wiesenberger Investment Companies

CDA Investment Technologies

1355 Piccard Drive

Rockville, Maryland 20850

(301) 975-9600


The first and most important service CPAs can provide to clients who are potential mutual fund investors is to help them identify and set priorities for their goals. Some CPAs' investment advisory services include developing asset allocation strategies, choosing specific securities and mutual funds and monitoring portfolios and money managers' performance.

Most CPAs providing investment advisory services are compensated on a feeonly basis, with arrangements ranging from hourly rates to flat fees. Other CPAs base their fees on the amount of a client's assets. As in any other professional engagement, it is always a good idea to establish the fee structure up front in an engagement letter.

CPAs must be knowledgeable about mutual funds before offering guidance on them. Initially, it may be best to stick with the educational aspects of mutual fund investing--the structure, the risks and the rewards--rather than helping clients identify specific funds. CPAs also need to educate clients about the emotional aspects of investing and the risks and opportunities market fluctuations present; otherwise, CPAs themselves risk being held responsible for inevitable market downturns. CPAs who expand their services to offering advice on the selection of specific mutual funds also must consider whether to register as investment advisers under the Investment Advisers Act of 1940 and applicable state securities laws.


Mutual funds present a number of income tax issues. In general, shareholders must report each year their share of the interest, dividends, gains and losses realized by the fund. This information should be readily ascertainable from the annual reporting documents the fund provides. When investors sell mutual funds shares, whether by redemption, exchange or use of check writing privileges, a taxable event has occurred unless a qualified transaction occured in a tax-deferred account such as an individual retirement account, an Internal Revenue Code section 401(k) retirement plan or a variable annuity.

Computing the taxable gain or loss when mutual shares are sold can be complex, particularly when shares are acquired over time. Internal Revenue Service publication 564 explains how to keep track of the cost of mutual fund investments and how to compute gain or loss on the redemption of shares.


Investing in mutual funds is easy. With most no-load funds, investors can call or write a fund with an admirable track record and ask for a prospectus and application; all they have to do is read the former and fill out the latter. Then (and only then) should they send money. For load funds and large no-load fund families, commissioned sales representatives generally are available to answer questions and assist with obtaining a prospectus and application and making the actual purchase.

In the past, investors sometimes had difficulty obtaining the information needed to decide whether to invest in particular mutual funds. Today, the problem is sorting through and making sense of an overload of confusing information. CPAs can and do play an important role in the process of gathering and assimilating information about mutual funds.


* MUTUAL FUND INVESTMENTS continue to grow. Approximately 40 million people have invested over $2 trillion in more than 5,000 funds. CPAs can play a valuable role in educating clients on how mutual funds work and in some cases helping them select specific mutual funds.

* THE BASIC CHARACTERISTICS of mutual funds--liquidity, flexibility, accessibility, diversification, asset allocation, professional money management and regulation and disclosure--account for their popularity.

* SELECTING THE RIGHT MUTUAL fund involves a review of both available funds and the investor's goals and objectives. Focusing only on funds that meet these goals and objectives will significantly narrow the investment choices.

* CPAs CAN ASSIST CLIENTS in many facets of the mutual fund selection process but may be particularly helpful to clients who need to assess their investment objectives. Some CPAs will choose to assist clients in selecting specific funds and may need to consider the consequences of registering with the Securities and Exchange Commission as investment advisers.

* AS THE NUMBER OF MUTUAL funds grows, investors are faced with an overload of information. CPAs can help clients sort through this information and assist them in selecting funds whose investment objectives most closely match their own.


A mutual fund manager's job is to carry out the fund's objectives. The investor's job is to select funds to match his or her needs. And the CPA's job is to bring the two together. Understanding some of the available mutual fund types can make everyone's job easier.

Capital appreciation funds. This kind of stock mutual fund has as its goal maximizing capital growth. These funds, which also are called aggressive growth funds, invest in stocks of smaller companies or companies that have fallen out of favor. They may use specialized investment techniques such as option writing, selling stock short and borrowing money to buy additional stocks. These funds may do well in bull markets but do poorly in bear markets. They generally will be rewarding for long-term investors who hold the funds for five years or longer.

Growth funds. Generally more patient than aggressive growth funds, growth funds seek long-term capital appreciation. These funds buy stock in well-established companies whose profits are expected to grow for at least the next few years or companies whose stock is selling for significantly less than the fund manager thinks it is worth. The primary goal is to produce an increase in value (capital gains) rather than a flow of income (dividends).

Growth and income funds. These funds invest in common stocks of companies that pay steady and rising dividends but also have growth potential. These typically are established companies with a history of steady growth (such as public utilities). The goal is to combine long-term capital growth with a steady stream of income.

Income funds. The objective of these funds, which appeal to more prudent investors, is to make investments that will preserve principal at low risk yet provide steady income and, secondarily, increase capital. Also known as equity income funds, these funds invest approximately 50% of their assets in income-producing stocks and the other 50% usually in convertible stocks and conventional debt instruments.

Balanced funds. A high priority for balanced funds is to conserve capital by investing in a mix of stocks and bonds. These funds also aim for rising income and, in the process, long-term growth.

Precious metals funds. These funds keep most of their investments in securities associated with gold, silver and other precious metals.

International funds. Unlike global funds, which hold U.S. securities, these funds invest only in the securities of companies or governments outside the United States.

Fixed-income funds. This broad category of funds invests primarily in bonds and related securities such as preferred stocks and mortgage securities. Fixed-income funds may specialize in high-grade corporate bonds, high-yielding junk bonds, tax-free municipal bonds, government-backed mortgage certificates, government bonds and notes or money-market securities. These funds seek to maximize income with the least amount of volatility and risk commensurate with the aim of conserving capital.

The chart on page 48 summarizes mutual funds' characteristics by fund category, portfolio makeup, investment objective and risk.
COPYRIGHT 1994 American Institute of CPA's
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Article Details
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Title Annotation:includes definitions of mutual fund types and directory of mutual fund information services
Author:Rojas, Stephen J.
Publication:Journal of Accountancy
Date:Nov 1, 1994
Previous Article:Determination letters for pension plans.
Next Article:The big chill.

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