Learn your ABCs: Fun with Mutual Funds

Jay Gragg

With thousands of different mutual funds out there, where in the world does one start to pick out what is the best ones for you? Many people rely on a financial advisor, stockbroker, neighbor, friend or family member to help them out. Then others rely on the financial news shows, magazines or journals for assistance. Many people close their eyes and point their index finger at a chart and go from there. For some investors that I have seen that might have been a better route to go.

Let’s first start with the classes of mutual funds. This seems to confuse a lot of people so let’s look at some of the differences in classes. Really the only differences between A shares, B and C shares is how much you pay in expenses and how your broker will be paid for selling you the fund.

First and most common you see “A” shares. “A” shares typically charge a front-end sales charge (or “load”) that is deducted from your initial investment. An average percentage for a diversified stock fund is around 5.1%. Some funds offer breakpoints on these sales charges if you make a large enough purchase, but that is generally for $25,000 purchases or more, or if you own a lot of other funds in the same family.

Class A shares will also charge a 12b-1 fee. This is a fee that you do not directly pay, but they are taken out of a mutual fund’s assets each year to cover the costs of marketing and distributing the fund to the investors. They can also be used to compensate a broker. 12b-1 fees vary from fund to fund quite a bit.

Class B Shares do not charge a front-end sales charge but generally their 12b-1 fees are higher than the Class A shares. Class B shares also typically have a contingent deferred sales charge which you pay if you sell those shares within a certain number of years. This charge is reduced generally each year you hold the fund. For example if you sell within one year, your sales charge is 6%, 2 years 5%, and so on. So if you have purchased a B share, you’d better make sure that you hold on to it before that surrender period is up, otherwise you will significantly reduce your return on this investment. Some B shares will convert to A shares after a number of years, so again, if you have purchased these, you might want to find out when they convert to the A share class.

Class C shares generally do not charge a front-end load, but have higher expenses on an annual basis. Class C shares, if held for a long time, could seriously diminish your investment because you are paying more in annual fees. In my opinion, class C shares are for the short-term investor. If you read my articles, you may remember that “short-term investor” is an oxymoron. There is no such thing as a short-term investor, because investors actually invest, rather than trade and speculate.

Now that you know your ABC’s, let’s review No-Load Funds. These funds have no front or deferred sales charge, and the 12b-1 fees must not exceed .25% of the fund’s average annual net assets. You generally have to buy these directly through a mutual fund company, and you don’t receive the assistance of a broker.

Most brokerage houses maintain a preferred lists of funds they like to sell. How does a mutual fund company get onto a brokerage house’s preferred list? Simple. They pay the brokerage house to get on those lists. It is called revenue sharing, and it is perfectly legal to do so. It’s also perfectly legal to smoke cigarettes, but that doesn’t mean it’s good for you. The SEC is in the process of making rules where brokerage houses must better disclose these types of transactions. Let’s hope that they are successful in getting that worked out. So a firm could be selling you a poorer fund just because it gets paid better to do so. This is another reason that you need to do a little research on your own even before (and possibly after) visiting a “financial professional”. Remember an advisor should offer advice and not just push products. Bryon and I have always made jokes that we can tell which brokerage house someone comes from by simply looking at what mutual funds they own.

I’m a fan of mutual funds, but only for certain types of investors. My problem with them is threefold. First is simply the high cost of owning the things. With the annual fees and sales charges, it had better be a solid fund to reach or outperform any benchmarks year after year. Obviously you can’t predict nor control what the performance of the fund will be, but you can always count on those fees and expenses being there.

Second is funds are often incredibly inefficient. Many hold 5%-10% in cash. I believe in staying fully invested and not sitting on the sidelines in cash. Of course you can’t control what other holders of the same mutual fund are doing, so the fund has to pay out investors that leave the fund, so some cash has to be on hand, instead of being invested, so it’s an inefficient but almost unavoidable strategy.

Finally, many funds have high turnover ratios. Turnover represents how much of a fund’s holdings are changed over the course of a year through buying and selling. You’ve heard of the buy and hold mantra, of which I am a fan. However, you may own a mutual fund, think you are buying and holding, yet the funds turnover rate could be over 120%! This means that more than the entire portfolio is sold each year! Not exactly a buy and hold strategy is it?

What people don’t realize about timing the market is that you have to be right twice. First is when to buy and second is when to sell. They don’t exactly ring a bell to tell you when that is, and I don’t know anyone that smart. A friend of ours says buying and selling too much is like pushing the elevator button more than once.

I have heard people dismiss “buying and holding” as an outdated philosophy and I completely disagree with these people. Many feel that you should be “doing something” instead of just sitting on your hands while your investments go up or down. A part of my job is to let people know that sometimes, nothing is the best thing to do. Assuming of course you have a plan and a great portfolio set up. This is not as daunting a challenge as you would think. Warren Buffet, known as the world’s greatest investor, buys stocks when they are undervalued, and he plans to never sell them. That’s wise advice and something that should be heeded by more people.