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Brokers & Advisors

Analyzing Investment Products and Services

Summary of New Tax Act
The Truth on 529 Plans
What To Look Out For With 529 Plans

Variable Life Insurance Trap
A Tough Lesson Learned
The Truth About Unit Investment Trusts
Simple vs. Compound Interest
Analyzing an Account's Rate of Return
Analyzing Mutual Funds
Keys to Analyzing Any Investment

Keys to Analyzing Any Investment

Performance - This segment is covered by everyone in the financial world. It is easy to promote since there have been such successful markets over the past several years.

Risk - It is critical that investors understand what they are investing in and why. Too many unsophisticated investors bought global bond funds in 1993, only to lose up to half their assets in 1994. These investors had no idea the risk that they were taking, having simply purchased mutual funds as an alternative to CD's.

Cost - Cost is another area not covered by many brokers/advisors, but it is an important aspect of any investment or financial plan. Most investors are not fully aware of their initial costs, annual expenses, or total cost of each investment before investing. Our advice is to get all expenses in writing before you invest.

Tax Exposure - Once again, most investors are not aware of what the inherent tax liability or future potential tax costs are before they invest. Similar to the cost and risk of a mutual fund, your tax exposure and the fund's tax efficiency are integral components of any long term investment plan. For more information on tax strategies click here.


Analyzing Mutual Funds

Did You Know?

  • You need more than just the prospectus to analyze a mutual fund.
  • The commonly used annual expense ratio ignores a significant added cost.

Everyone has heard about the prospectus, which has to be delivered as a part of each mutual fund purchase. The prospectus is required as part of a disclosure rule which is in effect to protect the investor, by permitting investors to see more than those one-sided glossy brochures before making an investment decision. But the mutual fund prospectus does not tell the complete story. It does not cover the annual brokerage or transaction cost within a mutual fund. In fact, the commonly used annual expense ratio also ignores this key added cost. To obtain the brokerage cost of a mutual fund you need the lesser known Statement of Additional Information (SAI). To get the real cost of your mutual fund, you need to add the total brokerage cost (found in SAI) to the published annual expense ratio.

Here is a breakdown of what is found in a prospectus as well as in the Statement of Additional Information. Investors should obtain both to properly analyze any mutual fund.

INVESTMENT STRATEGY Covers basic fund strategy and risks. States which policies can be altered without shareholder approval. Covers any and all investment strategies the fund could ever use, however unlikely, and their risks.
FEES Details fund costs, including sales charges, management fees and 12b-1 fees. Details how management fees are calculated and how 12b-1 fees are spent. Lists all brokerage fees (commissions and transaction costs).
PERFORMANCE Lists 3, 5 and 10 year average annual returns and year-by-year returns over the past decade. Describes how performance and yield numbers are all calculated.
MANAGEMENT Discloses a fund's investment advisor and the basis for his compensation. Names the fund's portfolio manager. Discloses the fund's directors along with their total compensation.

For more information on mutual fund investing click here.


Analyzing an Account's Rate of Return

Fund Performance Annual Gain
YEAR 1 Initial investment: $1,000 +100% $1,000
YEAR 2 Subsequent investment: $8,000 - 10% -$1,000

Initial investment of $1,000 receives a 100% return in the first year to build a $2,000 total value after year 1. An additional $8,000 investment at the beginning of year 2, with a return for the year of -10%, realizing a $1,000 loss on $10,000. What is your return?

There are three basic types of return and each results in a far different answer, in regards to the scenario described above.

Time Weighted Return    34.2%
Dollar Weighted Return    00.0%
Arithmetical Average Return    45.0%

Time Weighted Average Return or Total Return - also known as geometric return. It is important to remember that time-weighted returns ignore cash inflows and outflows. So $1.00 invested into the above fund scenario would grow to $2.00 after one year, and then would have lost $0.20 at the end of the second year, for a net result of $0.80 on your $1.00 investment. Since the calculation is only weighted for the beginning and ending date, it is called time weighted. It grew 80% over two years, for an annualized return of 34.2%. In other words, $1.00 compounded at a return of 34.2% over two years would result in an $0.80 gain. Time weighted return is the appropriate measure for comparing fund performance, and under security regulations, it is the only approved method of calculating returns.

Dollar Weighted Average Return or Internal Rate of Return - depends on the timing and the amount of the cash flows in and out of the investment. In other words, they are weighted for each dollar inflow and outflow. In the aforementioned scenario, the initial investment grows from $1,000 to $2,000 in the first year ( a 100% gain). One can imagine an investor liking that return, and so they added $8,000 at the beginning of Year 2, bringing their balance to $10,000. At the end of Year 2, the 10% loss reduces their account by $1,000. Thus, their dollar-weighted return is 0%, since they invested $9,000 and ended with $9,000. Dollar weighted returns are not relevant to fund evaluation (the fund is not responsible for the timing and the amount of the investments), but they do answer the important question "what is my account's rate of return?"

Arithmetical Average Return or the Arithmetical Mean - is simply the average return of each of the annual periods. In the aforementioned scenario, 100% -10% = 90% / 2 = 45%.

Generally, this is a dangerous number to use because it is virtually always higher than the time weighted return. It is only a worthwhile measure for projections, and then only if the series of data is long and meaningful enough.

To learn about investment strategies and ideas click here.


Simple vs. Compund Interest

In the case of simple interest, the amount of interest earned is con- stant. A formula for simple interest could be expressed as follows: a(t) = 1+it (where i is the interest rate and t is time). For example, let's say you deposit $1,000 earning 7% interest. What would be your accumulated value at the end of three years? Using our formula, we see that the answer is 1,000[1+(.07*3)] = $1,210. Thus the amount of interest earned is 1,210 - 1,000 = $210. We also could have obtained this by taking 1,000*.07*3, which becomes the familiar formula we all learned in elementary school: I = Prt which states that the amount of interest is equal to the product of the amount of principal, the rate of interest and the period of time. Thus we can see that the client earns $70 per year for three years.

Simple interest has the property that the interest earned is not "reinvested" to earn additional interest. In our example we see that the client earns $70 per year for three years. However, for the second year the client had $1,070 that could have been "reinvested." It would be more advantageous to the client if the $1,070 earned 7%, since the client would then have $1,144.90 instead of $1,140. (This is a small example, obviously the larger the premium, the greater the advantage.) Compound interest handles this by assuming that the interest earned is automatically "reinvested." The word "compound" refers to the process of interest being "reinvested" to earn additional interest. Let's see the effects of compound interest using our example above.

Using compound interest, our first year figure of $1,070 would be the same (1,000*.07 = $70). How- ever the second year interest would be 1,070*.07 = $74.90, which gives us $1,144.90. And the third year would be 1,144.90*.07 = $80.14, which gives us $1,225.04. Looking at it another way, we could calculate this as 1,000*1.07*1.07*1.07 or 1,000*(1.07) 3 . Thus we have the formula a(t) = (1+i) t (where i is the interest rate and t is time).

It is clear to see that simple and compound interest produce the same result over one measurement period (the measurement period is one year). It is important to note that for lengths of time greater than one measurement period, com- pound interest produces a larger accumulated value than simple interest, but the opposite is true for time periods shorter than one measurement period. A quick example may be helpful. Keeping our $1,000 deposit at 7% interest, how much interest would you earn in five months? Using simple interest we get 1,000[1+(.07x5/12)] = 1,029.17. With compound interest we get 1,000[(1.07) 5/12 ] = 1,028.59. The following graph shows this relationship.

Another thing we can observe is that in the case of simple interest, the amount of growth is constant; under compound interest, it is the rate of growth that is constant. We might say that simple interest is linear, while compound interest is exponential. You saw in our example that with simple interest you would never earn more than $70 per year, but with compound interest you earn $70 in year one, $74.90 in year two and $80.14 in year three.

Understanding these differences between simple and compound interest is key in understandingthe importance of how your CD or other guaranteed type of investment compares.


The Truth About Unit Investment Trusts has plenty of material on what to focus on in regards to analyzing mutual funds, but many brokers are selling Unit Investment Trusts (UIT) and we wanted to touch on that subject. Both mutual funds and UITs are baskets of securities pooled together and purchased by investors that either go or down based on the value of their underlined securities. Both are also regulated by the investment company act 1940. In contrast, the Unit Investment Trust portfolio is fixed meaning that once the securities are filled, securities are generally not bought or sold. Closer to the passive investing of index mutual funds, UITs are even more passive in that they generally do not make any changes. (Index funds will change positions based on specific changes noted that occur in their specific index). Opposed to mutual funds UITs also have expiration dates, generally 1-5 years. When the trust expires, investors either take their money or roll it over into another UIT.

There are several drawbacks to UITs that once again are usually not detailed to investors by those selling these investment vehicles. The first being the inability of the UIT to protect, adjust, or vary the portfolio based on market expectations or conditions. Secondly, considering these passive restrictions UITs are still very costly many with high sales charges in addition to annual administration charges. The typical five year UIT charges 4.5% partly paid up front. If you sell the shares before expiration, you still pay the full sales charge. The average annual administration charge is 1.1% very high when you figure that no actual money management acitivity has taken place once the initial portfolio is established. UITs are also hard to compare since no formal performance figures are kept by third party sources. They are more like sector funds and should be compared to mutual funds since no-loads, sector or even index funds may be better alternatives.Brokers like UITs for their high compensation combined with locked in commissions and lesser performance scrutiny. UITs have grown 906% from $7.49B in 1990 to $75.31B in 1999, according to the Investment Company Institute. In comparison, mutual funds sales have soared 27,000%, from $4.63B to $1.273 trillion during the same period. The aforementioned drawbacks are the main reasons the recent UIT growth pales in comparison mutual funds. Just like with loaded mutual funds and funds with ongoing 12b-1 fees, it is best to be wary in regards to the vast majority of Unit Investment Trusts.


A Tough Lesson Learned

Those investors who did not heed our words of warning regarding internet stocks early in 2000 have found themselves with some painful losses. Another pitfall with the recent market rebound is feeling complacent and not understanding how hard it is to rebound from huge losses. Investors must realize that it will take years to recover 50-80% losses of the past. It is critical to understand the math in trying to overcome such losses. For example, the average tech fund suffered 70.1% losses from March 10, 2000, through April 4, 2001. Many experts are receiving accolades on the financial networks on their recent rebounds that may give investors a false sense of security. The average tech fund gain of 38% since April 4th yet this still settles investors with a 60% loss from March 2000 highs, as once you lose so big it becomes increasingly problematic to recoup your losses. When a fund loses 10% it takes an 11.1% advance to get back to its original value. This is all because investors have less money working for them after the initial drop. The recovery percentage grows exponentially as the magnitude of the drop increases. After a 50% drop on an investment, a fund must double in value (+ 100%) just to get back even. With an 80% drop, however, the percentage explodes to an amazing 400% just to get to break even. The best real life example is from the actual results of the Profunds Ultra OTC Fund which lost 94.71% between March 2000 and April 4, 2001. In the month since, the fund actually rose by a larger percentage soaring 95.6% through May 2, 2001. The bottomline is that investors in the fund from March 2000 still are sitting on an 89.7% net loss even after its most recent 95.6% gain. A $10,000 investment in March equated to a paltry $1,035 total value on May 2, 2001. So the next time you hear or read about the company success and recovery of these popular tech stocks, look at it from a minimum 1 or 2 year perspective before patting the manager on the back (like much of the media is eventually doing).


Variable Life Insurance Trap

The media has finally picked up on the excessive compensation for those brokers who sell class B type mutual funds. After discussing how such funds for large investors are sold mainly for the sake of increasing the compensation (and therefore your total costs!) for those brokers selling them to you, it was good to see recent Wall Street Journal* and Barron's** articles discuss this fact in great detail. In fact, Pru Bache has gone so far as to restrict any of its brokers from selling B shares for any accounts over $100,000.

The next area that we see of growing concern is the deceptive illustration and aggressive forecast used in selling variable life policies. Many such policies were sold under the assumptions that the contract values would rise substantially, thus lowering the cost of the overall insurance. As it turns out, decreasing values increase the actual cost of the insurance, thus hindering potential future growth even more so. Many times due to the cost of these policies it may be better to buy term and invest the difference in low cost/no load mutual funds. In other words, try to keep your investment portfolio seperate from your life insurance holdings.

If you are not getting such objective alternatives from your life insurance agent or financial planner, it may have something to do with the outrageous commissions of up to and over 90% of first year premiums that they have on the line (plus the continuous renewal and trailing compensation).

*Wall Street Journal article "Prudential Limits Broker Sale of Class B Shares"

**Barron's article "Second Class", 7/9/01


The Truth on 529 Plans

Named after the section of the federal tax code that governs them, 529 plans are tax advantage programs that help families save for college. College savings plans are for students of all ages and cover all college costs including tuition, fees, room & board, textbooks, computers and supplies. All 50 states have 529 plans which can be used at most colleges and universities throughout the country, including graduate schools. Some foreign education institutions also may be eligible. Many states have plans with no residency restrictions so you can live in New York contribute to a plan in Maine and send your child to California for college. Please note that certain state tax advantages to residents who participate in a local plan may be lost if one opts out for another states plan. The other big negative to these plans is expenses which in some states can run as high as nearly 11% annually. It is vital to check all expenses before committing to a 529 plan. Here are some of the most common fees, charges, and expenses found in college savings plans:

  • Enrollment Fee. Several college savings plans charge a minimal enrollment fee. Currently, the highest enrollment fee is $90. Most enrollment fees are under $50.

  • Annual Maintenance Fee. Most college savings plans charge annual maintenance fees. These fees usually range from $10 to $50. Many plans reduce or eliminate this fee for residents, if you make automatic contributions, or if you maintain a certain balance, typically $25,000.

  • Sales Charge (Load). Several college savings plans charge a sales charge when you buy certain investment options within a plan or purchase a plan through a broker or investment adviser instead of directly from the state. Generally, you can determine the sales load by looking at the fees and expenses section of the offering circular or prospectus. Not every plan has a sales load. The load also may differ between classes in a single plan.

  • Deferred Sales Charge. A deferred sales charge or contingent deferred sales charge (CDSC) is a charge you pay when you withdraw money from an investment option or college savings plan. It is sometimes referred to as the back-end load. The charge may start out at 2.5% for the first year, and get smaller each year after that until it reaches zero. Generally, you can determine the deferred sales charge by looking at the fees and expenses section of the offering circular or prospectus. Not every college savings plan has a deferred sales charge. In some plans, a deferred sales charge also may be levied on certain classes of the plan.

  • Administration/Management Fee (Expense Ratio). This is the total annual college savings plan operating expenses expressed as a percentage of the plan's assets. For example, an expense ratio of 1% represents an annual charge to the plan's assets - including your proportional interest in those assets - of 1% per year.

  • Underlying Fund Expenses. Because college savings plan portfolios typically invest in a number of mutual funds, they bear part of the fees and expenses of these underlying funds. This expense is expressed as a percentage of a mutual fund's assets. Because college savings plan investment portfolios sometimes invest in a number of mutual funds, the offering circular or prospectus may contain fund expenses percentages for each of these funds.

If you don't think fees can make such a difference in your child's total net proceeds for college, they make more of a difference than the cost differential of mutual funds.

  • Fees, Charges, and Expenses
    All 529 plans have various fees and expenses. Not only do these charges vary among 529 plans, but also they can vary within a single 529 plan. With college savings plans, there are an even wider variety of fees and expenses. Like mutual funds, some college savings plans have different classes. Often referred to as Class A, B, or C shares, units or fee structures, each class has different fees and expenses. You can look at the offering document to see if a particular college savings plan offers more than one class.

    It is very important to take fees and expenses into account when selecting a college savings plan. Slightly larger fees and expenses can make a big difference in the value of your investment over time. Let's say you invest $10,000 in a college savings plan with a return of 10% before expenses. With a plan that had annual operating expenses of 10.97% (Yes, one plan has expenses that can be this high!), after 18 years, you would end up with only $6,866. That's over $3,000 less than you started with. If the college savings plan had expenses of 0.85%, you would end up with $47,680 - an 85% difference!

So review all details of each specific plan because the costs can be prohibitive. Austan Goolsbee, professor of economics at University of Chicago Graduate School of Business says that not only are the long run benefits of 529 plans "seriously compromised" by excessive management fees added by states but also most of these plans limit investors to a single financial firm that offers only 2 or 3 investment options. Between the high costs and limited investment options many early investors in 529 plans are finding themselves hopelessly underwater in their accounts, especially if they made one large lump sum deposit initially. While the tax benefits of 529 can be worthy, please realize that if you buy into a high expense plan the tax benefits will merely be neutralizing the high costs. Utah currently has the cheapest plan, but it even adds 0.25% of state fees to Vanguard's low 0.07% annual costs while expense wise TIAA-CREF is the next lowest cost plan... but make sure you research and get details on all costs not just the mutual fund component's annual expenses. Also, keep in mind that 529 plan's tax-free withdrawals are now slated to expire in 2010 (even though there is talk that such benefits will be extended there is no certainty of this right now).



College tuition savings plans were named after "529" the tax-code section that sanctioned them back in 1996. Major dollars were not put into them until last year when Uncle Sam made withdrawals from 529 plans tax free when used for college expenses. These plans allow parent, grandparents and others to fund college education on a tax deferred basis with potnetial state tax benefits if participating in a state sponsored plan. However many investors are buying heavily loaded plans (even though they work) when less costly, no load identical plans are available. Over forty states have plans and there are substantial variances among investor choices. Brokerage firms are putting a full court press on in the marketing of 529 plans and this is the main reason 70% of Rhode Island participants are paying up to 4 1/4% sales charge even though an identical no load version is available. Annual expenses can even have a greater impact than the initial sales charge.. For example, if you invest $10,000 in TIAA-CREF's plan and it earns 7% over 18 years you would have $30,288, the same money at 7% in an American Express plan in Wisconsin would return 24% less solely becasue of higher costs. The other negative in regards to 529 plans that is beginning to improve is the limited investment choices in the early plans. Many were skewed toward higher risk (technology/selective and other aggressive growth equities), so be very careful with your investment selection process. For more specifics on 529 plans, please refer to


Provider (State) Total Annual Expenses Growth of $10,000
TIAA-CREF (NY) 0.65% $30,288
T. Rowe Price (Alaska) 0.96% $28,738
Alliance Capital No-Load (Rhode Island) 1.00% $28,543
Manulife Financial (Alaska) 1.97% $24,190
Alliance Capital Loaded Class C (Rhode Island) 2.00% $24,066
Strong-American Express (Wisconsin) 2.27% $22,976

Based on $10,000 investment earning a hypothetical 7% annual return for 18 years.


 Summary of New Tax Act

The primary change in The Jobs & Growth Tax Relief Reconciliation Act of 2003 was the reduction of the tax on dividends to 15% from 38.6%. Other major points of this tax package included:

  • A decrease in tax rates from 28, 31, 36, and 39.6 percent to 25, 28, 33, and 35 percent by 2006. The lowest bracket, 10 percent, will be expanded.
  • The child tax credit will be raised to $1,000 per child.
  • The marriage penalty will be reduced by expanding the 15 percent bracket and increasing standard deduction.
  • Taxes on capital gains will be cut from 20 to 15 percent and the tax paid by individuals on corporate dividends will decrease to the same rate. These new rates apply to capital gains realizes on or after May 6.
  • The IRA contribution limit increases from $2,000 to $5,000 per year and the 401k plan contribution limit increases from $10,500 to $15,000 per year.
  • The equipment investment that small businesses can write off increases from $25,000 to $100,000 (plus potential bonus depreciation benefits).


$41,000 INCOME
• Single: $211
• Married couple with two children under 17: $1,208
$126,000 INCOME
• Single: $1,827
• Married couple with two children under 17: $3,028
$63,000 INCOME
• Single: $551
• Married couple with two children under 17: $1,100
$170,000 INCOME
• Single: $2,743
• Married couple with two children under 17: $3,148

(Source: AP/Deloitte & Touche)

Investment & Tax Strategy

Dividends have just become a whole lot more valuable to individual investors. This is because dividend distributions from U.S. and qualified foreign corporations are generally taxed at the same rate as capital gains. Many experts feel that high income investors will now be more inclined than ever to consider selling their mutual funds and buying a portfolio of quality stocks with solid dividended histories. This is because with an individual portfolio of stocks an investor is in total control of when to realize capital gains - such flexibility will prove to be incredibly valuable. Mutual funds on the other hand must pay out 100% of both short and long term realized gains each year. In addition, mutual fund investors can not be certain that all of their dividends paid out will qualify for the new lower tax rate. For example, dividends paid by companies domiciled in certain overseas countries as well as dividends by any securities exclusively traded on foreign exchanges do not qualify. Other key points to consider in regards to the new tax act include the following:

  • If you are a retiree you should recalculate your quarterly estimated taxes. There is an excellent chance you should pay much less if the majority of your income comes from dividends.
  • This may also be an excellent time to rebalance your portfolio and coordinate any capital losses carry forwards with the new lower rate for capital gains as just one example.
  • Real Estate Investment Trusts (REITs) and bond investments should be part of your qualified or retirement assets since their dividend distributions do not participate in the lower tax rates.
  • Taxable portfolios should concentrate in taking advantage of the lower tax placed on capital gains (growth) as well as dividends (income from equities).
  • Mutual fund investors must coordinate tax efficient funds that take advantage of the lower rates on dividends and capital gains into taxable accounts while placing income funds that invest in REITs, bonds, as well as funds with short holding periods, into their retirement plans. Comprehensive analysis of each fund's tax efficiency is critical to take advantage of the new law.
  • Finally, interest bearing accounts such as money market funds and checking accounts, as well as variable annuities, did not obtain benefits within this tax package. Thus they join the ranks of REITs and bonds in not maintaining parity when compared to an individually managed stock portfolio.

June 5, 2003