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Mutual Funds

Intro on Mutual Funds:
         Why Your Broker/Advisor May Be Pushing Class 'B' Mutual Funds
         Hiding The Load In Mutual Funds
         A Look into No-Load Mutual Funds
         Loads vs. No-Loads
         Index Funds

         Analyzing Mutual Fund Costs, Risk and Performance:

Be Aware of Total Cost of Your Mutual Fund
Mutual Fund Purchases and Breakpoints
12b-1 Fees and Enhanced Payouts

My broker gets irritated every time I quote and he says that much of your information is wrong. As a case in point today he mentioned that the great number of no load funds turning to loaded funds illustrates the importance and long term superiority of loaded funds.
Class C Shares
Cracking Down on Class B Shares and Mutual Fund Switching
Two Important Areas of Focus
Bank-Run Mutual Funds

Mutual Fund Update
The Components of a Stock Mutual Fund's After-Tax Returns
Taxes and Mutual Funds

The Real Cost of Mutual Fund Wrap Accounts, and "Fund of Funds"
Keys to Analyzing Any Investment (In Analyzing Investment Products and Services section.)
Taking Time to Learn Online

For more information on IRAs, mutual funds and distributions click here.

What You Should Know About The Mutual Fund Scandal

In the past, most of the problems within the mutual industry have been associated with greedy brokerage firms or brokers rather than the mutual fund managers themselves. We have warned about the disadvantages to the investor of Class B shares by commenting that the only one that benefits from Class B shares is the seller or broker. Regulators are now probing brokers that pushed Class B funds when other classes of funds would have cost the investor much less. Over the past year news has come out that several brokerage firms failed to credit the appropriate sales commission discount on larger purchases of Class A shares. Currently, Morgan Stanley is being investigated by Massachusetts, and was fined $2M by the National Association of Securities Dealers, for encouraging its sales force to sell more in-house funds with cash prizes. Morgan Stanley's clients were never informed of those cash incentives. All of these separate scandals have been generated by brokers putting themselves first rather than their client. That was until last quarter when New York Attorney General Eliot Spitzer, made public serious allegations regarding many of the largest mutual fund companies. The source of many of these violations was the actual money manager or mutual fund companies themselves and not simply the greedy brokerage industry as it has been in the past. Serious breeches of fiduciary responsibility are allegedly involved within an industry in which trust is everything. It is hard to believe that those mutual fund families would risk their reputation for the sake of more fees but that is exactly what transpired. So what should investors do if they own one of the fund families guilty of wrong doing? At we have always stressed finding the best investment for a one's specific investment objectives and risk tolerance and with so many mutual fund choices it does not make sense to stay with a fund company that you cannot trust. There are certainly other considerations like tax implications when getting out of such funds. In general, you would be better off with management that shares your interest rather than ones that could be actually working against you in favor of large investors and hedge funds. This same principal of looking for the best funds, with the most favorable risk parameters, leads us to funds with the following attributes that may also limit scandals:

  • Majority of money managers net worth is in his/her funds
  • Managers that close their funds when assets grow to meaningful levels
  • Managers that do not establish new "hot" (i.e. internet) fund of the period or advertise short periods of dramatic outperformance
  • Managers that avoid the conflicts of interest with managing a hedge fund concurrently with a mutual fund
  • Managers that put limits on trades and even establish redemption fees for shorter term trades
  • Managers that have independent client compliance officers that report to independent board of directors

We like the way stocks have taken one step back to spring two steps forward since hitting its low in October 2002 and testing those lows in March 2003. After such huge gains it is wise to buy on weakness (one step back periods) and not chase those speculative stocks and funds that have done so well. The scandals summarized below, within the mutual fund industry came out after the latest rally that left most investors much more sanguine about stocks in general and mutual funds in particular. The timing was very fortunate because if these scandals would have been made public last year, when many investors were suffering from their third consecutive year of losses, there would have been a more meaningful impact on mutual fund out-flows. Investors should also realize that the current investigations will certainly dig up more but that the loss of your money due to fraud is remote. The allegations are more concerning the dilution of your gains by mutual funds favoring the large investor. To date the worst of the culprits seems to be the Strong Funds, PBHG Funds, Putnam Funds, and Alliance Capital. Highly placed executives in these fund families were aware of the wrongdoing and maybe even played a part in it. Most of these funds have loads (sales commissions) and/or charge above average operating expenses. In addition, many of these funds had below average performance. Here are the dozen with the most serious allegations in the investigations so far:

OneGroup – BankOne's mutual fund division
Federated Investors – select investors were granted preferential status said it will reimburse other investors
Fred Alger Management –high expenses & loaded
Janus Funds – warned about this group during internet craze over three years ago
Nations Funds –Bank of America's main fund group
AllianceBernstein – another with high expenses & loaded
Putnam Funds – lost largest amount of assets due to investor departures to date
Scudder Funds – owned by Deutsche Bank
Invesco Funds – problematic alliances with Deutsche Bank
Strong Funds – founder Richard Strong departed after directly participating in market timing for his own account.
PBHG Funds - Pilgram Baxter & Associates alleged illegal and improper trading in funds
Charles Schwab Corp. - investigating illegal mutual fund trading including possible cover-up (deleted emails)

It should also be noted that several Merrill Lynch and Prudential Securities brokers have already been implicated in facilitating illegal late trading in several various mutual funds.


Hiding The Load In Mutual Funds

A "load' is simply the mutual fund industry's term for sales charge, which is a fee investors pay directly out of their investment. In recent years, as investors have become more sophisticated, there has been a trend toward devising various alternatives (methods for investors to pay the sales charge). These payment methods are referred to as multiple classes of shares, and have greatly added to the confusion of purchasing mutual funds. Multiple classes of shares are shares sold from the same fund with a different sales load charged for each share class. Here are the most common share classes currently sold with their pricing or cost structure:

  • Class A Shares are sold with a "front-end" load. The sales charge is deducted directly off the top of your investment and paid to your broker with the remainder invested in the fund. This sales charge can be as high as 8 1/2%, but due to the market environment it has been averaging 4 - 4 1/2%.
  • Class B Shares generally charge a "back-end" load for exiting a fund within 5-7 years of purchase. This fee is sometimes called a Contingent Deferred Sales Charge (CDSC) or a surrender charge. A back-end charge typically starts at 5-6% of the redeemed assets during the first year of purchase and declines by one percentage point each year until it reaches zero. However, since the broker must be compensated for selling the fund whether or not you redeem in the first several years, B shares often have higher annual expenses paid out in the form of a 12b-1 fee. After the back-end load expires (5-7 years), the 12b-1 fee is no longer deducted from the funds assets and the B shares convert to A shares.
  • Class C Shares are often referred to as "level load" shares. While they do not charge either a front or back-end load, C shares deduct a 12b-1 expense each year for the life of the investment.
  • Institutional Class Shares are available for the larger investments or through an advisor that has already established minimum criteria. The total expense ratio on these funds is usually significantly less than the same fund via other class shares. For example, the American Century Income and Growth Fund Advisor Class Shares have a competitive 0.94% total expense ratio, while the Institutional Class shares of the same fund total expense ratio is only 0.49%. It pays to check out all your options before you invest - as the above example illustrates a nearly 50% cost savings each year by purchasing the appropriate class shares of the same fund.

Most A shares offer reduced sales charges for large purchases at various breakpoints. An investor that purchases less than $10,000 in a typical Class A fund will pay a 5% sales commission. A purchase worth $50,000 may result in a 3.5% commission. Usually, the sales commission is waived at $1 M, but you still may pay a 12b-1 charge that is taken out internally each and every year.

It should be noted that B and C shares do not reduce commissions on large orders. The broker typically receives a flat commission of 4% for these orders. Similar to the 12b-1 extra fees, the client does not notice the commission because it is taken out internally from the annual expenses. Thus, class B and C shares are very expensive over time and should always be avoided for large sums. In fact, mutual fund companies are suppose to discourage large sales of B shares. Many have set limits of $200,000 for such shares, but brokers may still find funds that don't adhere to the rules or find ways around the limits. There are also virtually limitless combinations of the above charges, such as Class M shares having a smaller front-end charge than the Class A combined with a more modest 12b-1 charge than Class B or C.

There are two significant points investors should keep in mind when looking at different share classes of mutual funds. First and foremost, none of the above mentioned fees will add to your investment performance as the fees are deducted from the amount you invest simply to pay a broker. Secondly, it is the investor's responsibility to determine the fees (and hidden sales charges) on all mutual funds before they invest. While cost should not constitute your sole reason for purchasing a fund, it should play a critical role in your investment decision.


A Look into No-Load Mutual Funds

First of all, lets discuss the cost equation of mutual fund investing. Total costs are often overlooked by investors many times due to confusing sales practices and overly creative marketing techniques. A variety of different sales charges and fees have been introduced over recent years that make cost analysis even more confusing to investors. In fact the term no-load can no longer be construed as meaning no sales charges or added fees as it has in the past. Currently, investors must look for "true" or "pure" no-load to assure themselves of not paying any of the following various charges:

  • Front-end sales charge - an initial one time deduction from your investment made into the fund, usually ranging from 3.0-5.5% on each and every purchase.
  • Back-end sales charge - a deferred charge imposed when you redeem shares of the fund. Typically this charge declines over time but an additional 12b-1 charge is also usually imposed every year.
  • 12b-1 charge - an additional charge deducted from the fund each year to pay for distribution and marketing costs.
  • Redemption fee - is the amount charged when money is withdrawn from the fund typically only applicable for short period of time, often 30, 60 or 90 days.

Investing in funds with any of the above charges only reduces the amount of your investment dollars at work for you. In addition, studies have shown that funds with 12b-1 charges have, on average, taken more risk in attempts to compensate for their added charges. It should also be noted that all mutual funds will have ongoing administrative fees (the cost of running the fund) and management fees (the cost for managing the fund's assets) in addition to the varied transaction expenses in managing the assets. We use over 20 investment criteria over and above, our low expense and no-load parameters in selecting the most appropriate fund for each investor's specific situation. Some of the most important aspects in the selection process will be the defensive measures that fund managers incorporate to preserve capital and reduce volatility. This analysis will be particularly important during more turbulent market environments as opposed to what we experienced in 1995. In other words, they are much more relevant now than they were last year. Other important variables to analyze in addition to the fund's investment and risk parameters, include turnover ratio and capital gains exposure. This will not only give you a good idea on the style of the fund manager, but also can limit the tax liability to the individual investor.


The Real Cost of Mutual Fund Wrap Accounts, and "Fund of Funds"

The positive aspect in purchasing true no-load mutual funds can be totally negated if such purchases are made through "wrap" accounts or "fund of funds". Wrap accounts are brokerage accounts that purchase a variety of mutual funds under one (wrapped) account in your name. "Fund of funds" are mutual funds that pool investor's monies together to purchase a portfolio of various mutual funds. Both charge an annual fee of usually between 1-2%, on top of your ongoing cost of each and every mutual fund held. Instead of purchasing a low cost competitive group of mutual funds, investors typically get what turns out to be a high cost investment vehicle (similar to Class C mutual funds), with annual expenses as high as 4% or more.

The best way to illustrate the opportunity cost associated with such additional annual charges is to show the difference of a 1 or 2% lesser annual return equates to over time.

Example: Investor #1 and #2 invest $10,000 over a 25 year period. Both investors receive a return of 12% annually over this period, but investor #2 has a wrap account that charges an additional 2% each year. After the 25 year period, investor #1 has $61,654 more from his/her original $10,000 investment than investor #2.

$10,000 Grew To:

Investor #1: $170,001 @ 12% Annually
Investor #2: $108,347 @ 12% Annually minus 2% in additional charges

The total cost involved over a long period of time is even more dramatic for aggressive investors seeking a high total return. Even a more modest additional charge of 1% makes a dramatic difference. Example: Both investor #3 and #4 invest $10,000 over 25 years. Both investors average 21% a year, but investor #4 pays an 1% additional charge to a broker under a wrap fee arrangement. Investor #3 ends up with an astounding $120,000 increase in value solely by avoiding the additional 1% annual cost.

$10,000 Grew To:

Investor #3: $1,173,909 @ 21% Annually
Investor #4: $   953,962 @ 21% Annually minus 1% in additional charges

After looking at these examples, it is not hard to see the importance in avoiding added costs when it comes to long-term investments such as mutual funds. Make sure you are at least buying Institutional Class shares if you are investing in these types of programs. This way the added cost from these mutual fund programs or timing/advisory programs will be lessened. So there may be something even better than your typical no-load mutual fund out there. If you’re working on a fee basis now, your advisor should be suggesting lower cost institutional class shares, if available, for a good part of your mutual fund portfolio.


Loads vs. No-Loads

According to the Investment Company Institute over $4.5 trillion of assets existed in mutual funds at the close of 1997. The popularity of 401(k) retirement plans in conjunction with the best bull market in history, has created an unprecedented thirst for mutual funds. Skilled sales people try to continue the debate on buying load or no-load funds, but to all except the most unsophisticated investor, the case is a mute point. Pure no-load funds have no up-front sales charge upon purchase (or hidden back-end charges for that matter). Also, they are the most cost efficient on an ongoing basis. The average annual expense ratio is 1.15% for no-loads, and an amazingly high 1.64% for loaded funds. This equates to the average load fund being 43% more costly to operate each year - these costs do not even include the initial sales charge. If loaded funds were better investments than no-loads, a case could be made for all the extra costs and sales charges, but the opposite is true. In each of the past four years, no-loads have outperformed loaded funds, and since 1995, no-loads have been increasing their performance advantage over load funds (see table below). Don't misunderstand, there are good load funds, but why pay the commission in the first place, in addition to the higher ongoing expense each year. Besides, most load funds can now be purchased on a no-load basis through the right sources.

Loads vs. No-Loads
Average Annual Returns

1994 1995 1996 1997
No Load Funds -1.04% 31.64% 20.26% 25.07%
Load Funds -1.60% 31.41% 19.25% 23.65%
No Load Advantage 0.56% 0.23% 1.01% 1.42%


The Components of a Stock Mutual Fund's After-Tax Returns

The after-tax returns that an investor receives from a stock mutual fund is a function of: the investor's tax circumstances, the fund's pre-tax returns, and the fund's tax-efficiency. A mutual fund's tax-efficiency, in turn, is determined by the specific components of the fund's return which include: realized short-term capital gains and investment income (all taxed as ordinary income), realized long-term capital gains (taxed at rates up to 20%), and unrealized capital gains (not taxed until realized).

How Taxes Can Hurt Returns?

For stock fund investors, distributions of net investment income and realized short-term gains are taxed at federal rates as high as 39.6%. For Example, a growth fund returns 20% in one year and derives 14% of that return from realized short-term gains and dividends, 4% of that return from realized long-term gains, and 2% from unrealized gains. The 20% annual gains turns out to be an actual 13.7% after-tax gain for a high tax bracketed investor. This equates to a loss of over 31% of the fund's total return due to taxes and this does not even take into consideration potential state tax liability as well.

When Is a 20% Gain Actually Less Than 13.7%

Pre-tax Returns Tax Rate After-Tax
Short-Term Gains and Dividends 14% 39.6% 8.5%
Long-Term Gains 4% 20.0% 3.2%
Unrealized Gains 2% 0.0% 2.0%
Total Return 20% -- 13.66%

Over 31% of total return is lost to taxes!


Taxes and Mutual Funds

By now most investors know to avoid purchasing mutual funds before their distributions, in regards to taxable accounts. Over the past ten years, approximately 20% of the investment return on the average equity mutual fund has been lost to taxes. On an initial investment of $100,000, the amount lost to taxes during those ten years would total over $65,000. This does not even include the added transaction and administrative costs for the fund, nor the additional state tax liability. Most mutual funds leave investors vulnerable to short-term trading which creates profits that are considered ordinary income taxed up to 39.6%. Taxes can be even more of a nemesis to your after-tax return than high fees and/or commissions. According to Morningstar, the least tax-efficient mutual fund of the largest fifty gave up nearly 50% of its return to taxes - that is a 9% cost per year! While some funds try to minimize taxes, this strategy eventually becomes a mixed blessing. The longer a fund has been managed in a tax efficient manner, the bigger the amount of unrealized capital gains it will have built up, exposing shareholders to a possibility of a huge future tax hit. For example, the well managed Sequoia Fund has a potential capital gains exposure of over 69% of its assets. If the market soured and shareholder redemption's soared, these and similar funds might have to sell long-term winners, triggering the tax. This is why it is important to research a funds tax efficiency and potential capital gains exposure, so you can maximize total after-tax returns for all of our taxable mutual fund investments.


Index Funds

Taxing matters of index mutual funds:

It is not a secret that index funds which track the Standard & Poor's 500 have been the hottest mutual fund ticket on Wall Street. The out-performance of index funds of late has created an unprecedented surge of new investors into index funds. Through the first 75 days of 1999, for example, thirteen billion dollars out of the nineteen billion dollars that flowed into equity funds went into large-cap index funds. That is an amazing 68.4% of every dollar of equity mutual funds going into index funds! During the same period last year, just 16.4% of total equity fund flows went into large cap index funds, or only $6.8 billion of the $41.3 billion total. While index exposure should be a part of most mutual fund portfolios, some of the attraction (excellent recent performance and tax efficiency) of index funds would dramatically swing against investors with any prolonged market downturn. This same problem would be seen with tax managed funds, another currently popular mutual fund concept. Both index funds and tax managed funds accumulate large amounts of unrealized gains over time. Prospective investors should carefully consider the following when deciding whether to invest in an index or tax managed fund:

  • the size of the fund's unrealized capital gains,
  • the growth rate of the fund's embedded gains position,
  • the likelihood of the fund realizing embedded gains during your anticipated investment period.


Taking Time to Learn Online has always stressed researching a mutual fund's risk level and total expenses as much (if not more so) than its past performance. By doing this, investors can buy the best performing funds (in accordance to their risk level) that have the lowest cost. Thus, capitalizing on a "dual" play for one's mutual fund investment by combining solid performance with low cost. There is no better way to invest in mutual funds over the long term. The Securities and Exchange Commission has added a mutual fund cost calculator on its website (, available to the public. This calculator features the total cost (you must know the fund's expense ratio and sales commission), in addition to the "foregone earnings" (what you lost in future earnings with the money you paid out in costs). For example, a $10,000 investment in a mutual fund with a 3.5% load and 1.25% annual expense ratio that earns 12% per annum would cost $101,364 over 30 years. The same return and time period with a no-load fund having a 0.37% annual expense ratio would cost $31,531. This represents a total cost differential of $69,883 on an initial $10,000 investment over the hypothetical 30 years. This cost calculator is an excellent way to see the true cost, over time, between loaded funds and no loads, plus the difference between high cost versus cost efficient funds.


Why Your Broker/Advisor May Be Pushing Class 'B' Mutual Funds

Their is a common misconception that Class 'B' shares of mutual funds are a better alternative for investors because the front end load (commission) is not immediately taken out. The truth is Class 'B' funds tend to reward the broker with higher total commissions/fees over the long term. The broker or advisor not only receives an upfront commission (typically 4 or 5 percent) but in addition the commission on Class 'B' shares are not discounted for larger deposits like they are in Class 'A' shares. The chart below is the best illustration in showing why you should avoid class 'B' shares at all costs. A broker/advisor that sells $1M worth of Class 'B' funds a year for 10 years (assuming a conservative 8% annual return of assets) will net $2,896,985 commission/fees over the next twenty years. In comparison, a 5% Class 'A' loaded fund with no 12b-1 fees or trailers would net the broker/advisor a total of $500,000. This $2,396,985 of addition compensation is all internally generated from your pooled mutual fund assets, and thus, unless you read the prospectus you don't even know it is being taken out. Some brokerage firms are actually using similar illustrations to what is seen below to motivate brokers to push Class 'B' mutual funds, particularly in circumstances where the initial investment is rather meaningful.

Class 'A' Commissions
Year Mutual Fund
Up Front 5%
(First Year)
1 $1,000,000 $50,000
2 $2,080,000 $50,000
3 $3,246,400 $50,000
4 $4,506,112 $50,000
5 $5,866,601 $50,000
6 $7,335,929 $50,000
7 $8,922,803 $50,000
8 $10,636,628 $50,000
9 $12,487,558 $50,000
10 $14,486,562 $50,000
11 $15,645,487
12 $16,897,126
13 $18,248,897
14 $19,708,808
15 $21,285,513
16 $22,988,534
17 $24,827,422
18 $26,813,616
19 $28,958,705
20 $31,275,402
TOTALS $500,000

Class 'B' Commissions
Year Mutual Fund
Up Front 5%
(First Year)
.25% Trail
(Years 2-6)
1% Trail
(years 7+)
1 $1,000,000 $50,000 $50,000
2 $2,080,000 $50,000 $2,700 $52,700
3 $3,246,400 $50,000 $5,616 $55,616
4 $4,506,112 $50,000 $8,765 $58,765
5 $5,866,601 $50,000 $12,167 $62,167
6 $7,335,929 $50,000 $15,840 $15,869 $65,840
7 $8,922,803 $50,000 $15,480 $33,007 $81,709
8 $10,636,628 $50,000 $15,480 $51,516 $98,847
9 $12,487,558 $50,000 $15,480 $71,506 $117,456
10 $14,486,562 $50,000 $15,480 $71,506 $137,346
11 $15,645,487 $15,480 $93,096 $108,935
12 $16,897,126 $13,140 $116,412 $129,552
13 $18,248,897 $10,244 $141,594 $151,817
14 $19,708,808 $7,075 $168,790 $175,864
15 $21,285,513 $3,673 $198,162 $201,835
16 $22,988,534 $229,884 $229,884
17 $24,827,422 $248,274 $248,274
18 $26,813,616 $268,136 $268,136
19 $28,958,705 $289,587 $289,587
20 $31,275,402 $312,754 $312,754
TOTALS $500,000 $158,398 $2,238,586 $2,896,985


Mutual Fund Update

The divergence in the market has never been greater between the haves and the haves not. The heroes of yesterday in the investment world finished their worst year in history both of a relative and absolute basis. Warren Buffett, the Oracle of Omaha, has had the best investment record of our time but his Berkshire Hathaway holdings finished down 49% in 1999. This was his first down year ever. Another past investment star was manager of the Oakmark Fund - Robert Sanborn. Mr. Sanborn was on the cover of Barron's as the best money manager in the country just four years ago. His fund has lost an average of 4.4% per year the past three years culminated by a drop of nearly 30% in 1999. So how did these stars fall from grace after years of outperforming their peers? Better yet, what about those new funds that specialize in high tech, biotech and telecom stocks that have averaged triple digit percentage returns? The divergence is absolutely incredible, and investors that have not invested in the above three sectors can attest to not enjoying this great bull market of late. Investors should remain flexible and invest in lower cost mutual funds that match your risk tolerance. Chasing those high double digit or even triple digit percentage returns is not the most prudent thing to do with your monies currently. Investing in funds that held companies like Coke and Procter & Gamble should also be avoided because those stocks have been overpriced for several years in comparison to their growth rates. So it is critical to differentiate the fund managers that were buying Procter & Gamble, for example, over $100 a share from those that may be accumulating now at 1/2 that price. Investors are best served by investing in funds that participate in the high growth areas without paying the exorbitant prices. There are always bargains to be had - it is just that during times like these they are much more difficult to uncover. We suggest if you are invested in these high flying mutual funds (and have a long term horizon) then you may wish to hold and ride the volatile waves. If you are thinking about getting in, it is better to limit your allocation in such funds so that the market swings don't force you to get out at the wrong time. At times like these it is best to err on the side of caution. We would adjust some of the excessive gains made last year in the high tech sector back into the more conservative side. This way investors high tech exposure does not become too concentrated. After all, the average high tech fund was up 187% in 1999 and is already up 36.4% the first ten weeks of 2000. Investors were too scared about Y2K six months ago - now they may be just too euphoric particularly regarding the high techs, biotechs and telecoms.


Bank-Run Mutual Funds

The Wall Street Journal recently featured an article on the poor performance of bank-run mutual funds. (W.S.J. 8/14/00) Banks are getting aggressive in their marketing of such funds to offset relatively flat deposit and loan growth. The strategy was to increase the more consistent fee generated income to stabilize earnings and cash flow during times of decreased economic certainty. According to the Wall Street Journal, the typical bank-run U.S. mutual fund has badly lagged the mutual fund averages last year, and continue to dramatically underperform this year as well. Two examples where the outflow of money (despite banks' strong marketing tactics) has been especially bad include Sun Trust Banks of Atlanta and First Union of Charlotte. Like many banks, which have never before emphasized the money management arena, bank funds have typically not attracted the high quality money managers and instead always seem to be following one or two steps behind. The best example of this is with Sun Trust as they did not even have a technology related fund until late 1999 after many high tech funds actually recorded triple digit annual returns. Of course, establishing such a fund after such amazing returns only set up Sun Trust fund investors for the major NASDAQ plunge this spring - taking the blunt force of the losses without the preceding positives. It is no wonder that Sun Trust experienced $800m of the net overflows from its stock and bond funds over the first half of 2000, while First Union fund investors bailed out of $1.3b of fund assets during the same six month period. Again according to the Wall Street Journal, almost all banks have suffered as the overall tally would have been in the red had it not been for Bank of America's Nations Funds Unit which benefited by capturing hot growth manager Tom Marsico from the Janus Funds.

Such dismal showings were definitely not what the banks had in mind when they put this emphasis on the fee based side of money management. When customers yank their monies, the banks not only give up all current and future fee revenue streams, but also lose the opportunity to sell other even higher margin products into the future. Many of the bank mutual funds also have sales charges and/or added annual costs to compensate your private banker/representative. (See other mutual fund articles for specifics on what to analyze and research before you purchase any mutual fund.) So the next time your banker suggests a new investment for your retirement or savings/checking account assets, make sure you investigate all your options (including no loads outside of the bank) before you give your "okay".



Investors learned last year the importance of selecting the right mutual fund. Analyzing total mutual fund expenses should also become more critical now that 20-30% annual returns may be much less frequent than what we have recently experienced. Index funds are easy to compare since their structure is geared to match the corresponding index. Money management skill is restricted (just mirroring index), so mutual fund expenses become one of the main variables. Yet annual fees vary greatly even with index funds as the table below illustrates. Of the five most costly funds four are from insurance companies and one from a bank. ONE Fund, from Cincinnati based Ohio National, has an incredibly high 1.58% annual fee for their S&P 500 index fund. In comparison, Vanguard's S&P 500 Index Fund has an annual expense ratio of 0.18%. When factoring in the 5% initial sales charge with the ONE Fund and the no load of the Vanguard, then the total cost differential between two S&P 500 index funds is truly amazing. In an environment in which the market no longer goes straight up it is imperative to look at the risk inherent with each fund as well as the total costs. See more on mutual funds in our Mutual Fund section including our warning over a year ago on why index funds may not be the best place for your money. This warning was at the height of popularity for index funds and last year these funds dramatically underperformed.


Funds With The Highest Fees
Fund Name Parent Expense Ratio Sales Charge
ONE Fund (S&P 500) Ohio National 1.58% 5.00%
Pillar: Equity Index Summit Bancorp 1.05% 5.50%
Mainstay Equity Index New York Life 0.94% 3.00%
Mason Street: (Index 500) Northwestern Mutual 0.85% 4.75%
North American: Stock Index American General 0.83% 5.75%
Funds With The Lowest Fees
Barclays: Shores S&P 500 Barclays Global Investments 0.09% None*
SPDR Trust Series I State Street Global Advisors 0.12% None*
Vanguard 500 Index TR Vanguard Group 0.18% None
USAA S&P 500 Index USAA 0.18% None
SsgA: S&P 500 Index State Street Global Advisors 0.18% None

*exchange traded funds, that trade like stocks, with commissions to buy/sell shares.

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It is more critical than ever to be in the right areas and to invest prudently. Since the inception of we have stressed to our readers to be properly diversified and understand the risk they are taking with each of their investments. Numerous investors have gotten out of high risk tech stocks and mutual funds after reassessing their risk parameters but what should investors that have not sold do now? If you were underperforming before the attack and/or paying high cost then the odds are that such dismal results will continue. Do not feel that all investments will recover when the economy and market in general recovers. There will be even greater differences in performance between those that simply follow the herd and those investors that take advantage of the herd's extremes.

Secondly, it is critical to reassess your risk parameters and make sure you are properly diversified. For nearly two years now we have been stressing to readers that if they are overexposed to technology stocks, then it is important to lessen one's exposure immediately. One of the reasons we felt any stock market progress was limited was the continued high levels of tech exposure we saw with new investors coming into our offices. Even when this sector went down, investors were far too optimistic and exposed in technology. Unfortunately many investors were sold into this exposure through mutual funds without understanding the inherent risk due to their extremely high valuations.

A Look Back (9/24/01)

We stated at mid-morning last Friday that we may be at least a temporary bottom for stocks. This was due to panic selling from individuals, heavy margin calls and a very pessimistic opening with tremendous shorting, which are all signs that a turnaround was finally in order. We were buyers Friday, but too many unknown variables are still out there to prevent prudent investors from chasing stocks from significantly higher levels. It was very positive from a shorter term perspective that the market not only rebounded from their morning lows, as we expected, on Friday but also held strong into Friday's close (for which we were pleasantly surprised). Investors were really stretching for reasons to buy last week after being closed four consecutive days for the first time since WW I. Here are our five most outlandish reasons we heard to buy, thus demonstrating the extremes that led stocks to their worst week since 1940.

  1. Buy because the rebuilding of what the terrorists destroyed will be a boom for the economy. This was the first reason we heard to buy shortly after the attack. This is so absurd that our only response would be that if we really wanted a booming economy then we should all go home and simply break all of our windows.
  2. Buy for patriotic reasons, another totally faulty reason to buy stocks. If you want to donate monies to charity that is one thing but don't confuse it with investing. We actually stated in Member's Only on the day after the attack that this could actually hurt stocks as the people that bought last Monday actually panicked out on Friday pressuring shares even further.
  3. Buy because we are oversold. We heard this as the rationale for investors to buy on Monday because prices were down so much even before the attack. What investors failed to realize was that prices were only down from incredibly over inflated levels from the dot-com bubble. So it took until Friday with the NASDAQ down 72% and the D.J.I.A. down over 30% until prices even got close to attractive levels.
  4. Buy because if they turn over Bin Laden prices will soar. There were various versions of this including when we attack prices will rise just like they did with the Persian Gulf War (at least this one is a bit more plausible), but all versions fall into the slim to none likelihood category.
  5. Buy hotels because... Again many versions of this one but our favorite was a Wall Street analyst from a major firm recommending several hotel stocks early last week because all the brokers in NYC were using their rooms at $199 a day for work since they are now displaced. The more important factor is that all their other hotels outside of NYC are running at 10-20% occupancy from their typical 60-80%.


Class C Shares

If ever there was an example of how bad these alphabet share classes of mutual funds really are for the individual investor one only has to look at many current C shares money market funds. Invesco Funds recently waived part of its fee it charges their class C money market investors to keep their money market yield in positive territory. The inherently larger expenses of a class C fund actually brought Invesco money market fund’s yield down to 0.01% last month. Management decided to waive 0.10% of its fee, thus bringing the yield to 0.11%. Invesco’s Class C Money Market is burdened with a 1.74% expense ratio at the same time the average money market fund has an expense ratio at 0.61%. Mutual fund investors should review the total cost of their funds now that investment expectations are lower, plus with lower interest rates it is more important than ever to watch costs closely even with money market funds. Beware of the alphabet soup class funds that your broker may be pushing on you, and always look at your total costs.


Cracking Down on Class B Shares and Mutual Fund Switching

After years of writing about the dangers of B shares and how they only benefit the broker that sell them to you, it is good to see the regulators punishing brokers that sell such funds especially for larger investors. In April 2001, broker Michael Grimes and branch manager of St. Louis based Stifel Nicholaus, William Lasko, consented to fines and suspensions over alleged violations concerning sales of class B shares. Over a two year period 15 clients purchased more than $250,000 each of B shares from Grimes. In addition to exceeding the limit set by the fund, the NASDR argued that A shares would have been more cost effective for his customers. The NASDR also cited Grimes for generating $21,000 in gross from sales of B shares to 29 clients at the time when load waived A shares for the same fund were available. More importantly, NASDR enforcement Chief Barry Goldsmith, has recently stated that there are numerous other investigations going on regarding both fund switching and the sale of class B Shares. Brokerage firms are finally starting to wake up to these abused as Pru Bache recently place a limit of $100,000 for sales of class B as did A.G. Edwards.


Q: My broker gets irritated every time I quote and he says that much of your information is wrong. As a case in point today he mentioned that the great number of no load funds turning to loaded funds illustrates the importance and long term superiority of loaded funds.

A: In the early years of the mutual fund industry there were many more loaded funds and as investors became more sophisticated no load funds began to capture more market share. A few years ago the amount of no load funds approximately equaled the total of loaded funds. Your broker is right that many no load funds are switching to a loaded format but not for the reason of superiority. In fact we can make the case that it is just the opposite reason these funds are switching. Many fund families have switched to a loaded format rather than sell directly to investors because they could not raise money directly from investors. A difficult recent market environment, poor investment performance and/or a change in ownership are some of the reasons these funds felt the need to obtain assets from an active sales force. Some of the recent fund families that have converted to loads included Invesco, Scudder, Credit Suisse Warburg Pincus and Acorn Funds (Acorn was purchased by loaded Liberty Funds and that is the reason for that change). So these are the main reasons for no load funds switching to loaded funds, not the superiority your broker suggests. We are not saying that no load funds are better than loaded funds, only that investors should be aware of all the costs before they invest. The fact that the average mutual fund investor holds a fund less than 3 years only compounds the problem of having sales charges on mutual funds. A recent study by Kanon Bloch Carre looked at fund costs a different way then the typical annual expense ratios. Their study looked at the percentage of a fund's returns that was kept by the fund company as expenses. In other words what fund families delivered the most return for your dollar. Even though these figures did not take into consideration the initial sales charge of the funds it is investing that all five of the highest cost funds were load funds, while four of the five lowest cost funds (for the five years ending 12/31/01) were of the no load variety.


12b-1 Fees and Enhanced Payouts

After discussing all the negatives for unknowing investors in the high cost of Class B and C funds it has been rewarding to see the Securities and Exchange Commission cracking down on brokers selling such funds, especially in the case of large amounts of assets. The latest regulatory area of focus is on funds with 12b-1 fees. Even though these added annual fees were created mainly for marketing purposes, it seems many funds already with billions of assets, and some that are even closed to new investors, still charge these extra fees for marketing. As we have been stressing investors should get in writing the total annual costs for each fund before you invest. This includes all fees, commissions (if applicable) and transaction costs obtained from the Statement of Additional Information. Another area to be aware of is the extra incentives many companies are giving brokers who push their mutual funds. Amid sagging sales during this relatively gloomy stock environment many funds are offering brokers extra commissions and other incentives. This induces brokers to sell their funds when many times they would originally not sell them. This so called dealer re-allowance is only found in the fine print of the prospectus and some of the major fund families initiating such added incentives this year include MFS Investments, Oppenheimer Funds and Zurich Scudder Investments. An example of how this works: MFS is paying A.G. Edwards & Sons brokers up to a 0.50% incentive to sell their funds for IRAs, this adds to the 17 fund families that they already receive boosted payouts on to push their respective funds. If you have to go into a higher cost, loaded fund at least make sure your broker or advisor is not getting added incentives to push certain funds on you.  



On December 23, 2002, the SEC forwarded NASD Notice to Members 02-85 to all NASD firms. This Notice was issued to highlight problems the NASD and SEC have discovered during a series of special examinations focused solely on front-end load mutual fund sales practices.

The examination is specifically focused on whether or not customers purchasing front-end load mutual funds are being charged the most beneficial (the lowest) sales charge percentage possible. The Notice requires that each member firm examine its policies and procedures and ensure that its sales force is properly educated in this area. This action was taken because of the tremendous abuse by brokers not informing their clients of possible sales charge discounts.

Not only the brokers but all investors should be aware of and keep track of all breakpoints, rights of accumulation, letters of intent and other discount scenarios when purchasing mutual funds. In order to ensure that investors pay the proper sales charges, they should have detailed knowledge of the terms of the prospectus for any fund before making the investment. Breakpoint schedules, parties entitled to aggregate for ROA purposes, and other significant details can vary from fund to fund. The prospectus and statement of additional information are obviously the best and most accurate sources for this information. Clarification can also be obtained by contacting the fund company directly. As a guideline, most open-end mutual funds provide the following possibilities for discounting or waiving front-end sales charges.

  1. Breakpoints

    Based on schedules which vary from fund to fund, clients purchasing over specified dollar amounts of the fund are entitled to pay a smaller sales charge. Breakpoints can be reached via single purchases, combined purchases, rights of accumulation or letters of intent. Brokers must advise clients of potential breakpoint discounts, particularly when the client is close to a breakpoint but don't rely on this, know it yourself or look at no-load funds.

  2. Rights of Accumulation (ROA)

    Investors are generally allowed to combine current and previous purchases in the fund to reach a breakpoint on the current purchase.

  3. Combined Purchases

    In most cases, investors are allowed to aggregate fund assets held in their own accounts, and accounts of spouses and children for purposes of calculating breakpoints. The parties whose accounts can be combined vary from fund to fund. Investors should consult the prospectus for specific information and aggregate accounts as indicated.

  4. Letters of Intent(LOI)

    Investors can sign a statement expressing their intent to purchase a specified amount of a fund over a 13 month period. All purchases pursuant to the letter will be executed at the breakpoint that will be reached upon completion of the purchases. Investors should realize that if they fail to reach the amount required for the breakpoint, the fund can retroactively charge the higher fee. Many funds allow the client to "look back" 90 days from the date the LOI is signed and include purchases from that time period. If this option is chosen, the 13 month period will begin with the earliest purchase.

  5. NAV Transfers

    If you already paid a sales charge on a mutual fund investors may be able to switch to another family of funds without another sales charge. Certain fund families (e.g. PIMCO, Hartford) allow clients to purchase their funds at NAV if the purchase is made with the proceeds of the sale of another A share mutual fund. The requirements for the use of this provision vary from fund to fund and investors should consult the fund prospectus for details.

  6. Reinstatements

Fund companies have varying policies allowing for the repurchase of A share funds within certain time periods after liquidation. For example, if an investor sells $10,000 of a PIMCO fund, he/she may reinvest the redemption proceeds at net asset value within 120 days of the redemption date. Investors must realize that the reinstatement does not cancel the redemption for tax purposes and any gain or loss may be recognized according to IRS regulations. Individual funds may have limitations on the number of times a client may use this option. Once again, investors should consult the prospectus for details.

Many of the discount scenarios above can be used in conjunction with each other. Given that the failure to use available discount/waiver options is a violation of NASD regulations, your broker must take care to use any and all available options when purchasing a mutual fund for you. When buying loaded funds make sure you take note of all the above scenarios for obtaining the lowest sales charge with each and every purchase.


Be Aware of Total Cost of Your Mutual Fund

A mutual fund's annual expense ratio is thought to recognize the cost of owning a specific mutual fund. However, this number considered by most as an industry cost standard can be very deceiving. This is largely due to current accounting practices which allow expense ratios to exclude a large chunk of the cost of running mutual funds. These costs include commissions paid to brokerage firms as well as other costs associated with trading stocks. Now many people, including members of congress, are demanding greater disclosure of commissions and other transaction costs. Many people attribute these "hidden costs" to the reason why funds so often lag behind the rest of the market. These costs, on average, hover around 2.2% of the amount traded, and none of it is readily apparent. While it is undecided how these extra expenses should be made apparent and accounted for, many believe that once such costs and commissions are disclosed, there will be a sharp decrease in turnover. Listed below are four funds that illustrate the potential differences between their stated annual expense ratios and their actual total cost. In some cases the actual total costs are nearly quadruple the stated expense ratio as in the case of PBHG Large Cap Value Fund. Please note that this article does not even discuss another critical component in the total cost of your mutual fund and that is the tax implications within your personal or trust assets. Having the most tax efficient funds in your taxable accounts and non-efficient funds within your retirement plans can save you as much (and in some years even more) as the total annual costs of a fund each year.

Mutual Fund "Stated" Annual Expense Ratio Non Disclosed Commissions as a % of assets Actual Total Annual Expenses
RS MidCap Opp.
Strong Discovery
Marsico 21st Cen.
PBHG Large Cap Value
*PBHG class shares

May 2003