How to Understand What is in Your Mutual Funds Account

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What You Really Own and Don’t

Mutual Funds are one of the most popular tools in use today for people who want to invest. They are convenient, liquid, professionally managed, diversified and perceived as “simple.” While much of that can be true, do you understand what the cost is for that convenience? For that matter, do you have any idea what you are actually investing in?

Let’s Take a Look at Open End Funds

When it comes to Mutual funds, I believe I have heard it all! The most common things people believe about their mutual funds are:

  • Their funds are “safe.”
  • Their no load funds are free and charge no fees of any kind.
  • Mutual funds are tax free.

Mutual funds come in every shape and size and many flavors. From the comments I have listed it is clear that there is a lot of misunderstanding when it comes to mutual funds. Today I hope to give you some insight into some of the under appreciated risks, quirks and surprises that can be experienced when investing in this popular tool.

What’s in Your Fund?

  1. There are more than 25,000 open end mutual funds available in the United States. By comparison, there are less than 8,000 publicly traded stocks! You have A shares, B shares, C shares, I shares, R shares and many other classes of shares. The most popular for individuals are the A, B, and C shares. Each of the different classes charge different fees in different ways. Some charge on the front end (A and C shares), others charge on the back end (B and C shares). They all charge ongoing management fees (Yes, even “no load” funds!). So when you are buying a fund, it is important to know what class of shares and how much is being charged for all the fees. This disclosure should be in writing, preferably in the prospectus.
  1. How much tax liability is hidden in my fund? Especially at this time of year as we head into fall, knowing the answer to this question can really help you avoid nasty surprises come tax time next year. Open end mutual funds are known as “pass through entities.” That means that all gains and losses are passed through to the shareholders. Since it has been over 7 years since the market had a 20% or greater drop, there are stocks and other holdings that have appreciated a great deal. After all, if a fund bought a stock like Google in 2008 at the bottom, it would have paid under $150 per share. Today the stock is over $800 per share, a gain of over 500%! While that is good news for someone who bought back then, if the fund decided to sell the stock, shareholders of record would pay tax on that 500% gain, even if they just bought the fund today! That is why it is important to know about this if you are buying a fund and it is not in a retirement account. In addition, if you were to buy a fund in the fourth quarter, you will be given a 1099 for all capital gains realized for the fund during the entire year! This means that you could actually buy a fund, lose money and still have to pay taxes on gains you did not enjoy! This happened in 2000-2002 and again 2008-2010. Don’t let this happen to you!
  1. Is my manager, the same one that made the fund famous? Especially in the larger fund families like Fidelity, there can be turnover in management. It is important to know if the fund you have researched is still being managed by the person who created that track record. Peter Lynch made the Magellan Fund famous with his performance from 1977 until he retired in 1990. The person who replaced him, someone not so famous, with an entirely different management style, and philosophy did not have any where near the same performance as Mr. Lynch had provided. Some funds have teams of managers, instead of just one, understanding who is investing your money can make a big difference.
  1. What am I paying in fees? In funds, there are loads and fees. There are 12b1 fees in some funds, most have management fees and many have both. These are the disclosed fees. Also, today one of the fastest growing types of funds is known as “Target Date Funds.” These are especially popular in 401k’s. You should know that the headline fund like “Target 2025 fund” has its fees and the funds that it owns also have their own fees.

In addition, there might be front end “loads” and “conditional deferred sales charges” also known as CDSC’s. These are also disclosed. What is harder to figure out are the more subtle costs of a fund. First, trading costs are not reported. Transactions costs can “make a fund two or three times as costly as advertised” according to an article in the Wall Street Journal from 2010. This article estimates that trading costs for stock funds can run from 1% to as high as nearly 3% annually! There are other, more subtle costs as well. Brokerage commissions, bid-ask spreads and taxes are some of them. Usually when a fund does a lot of trading, these costs are higher. High trading volume, known as “turnover” can also generate a lot of taxes, especially short term capital gains, which cost a lot more than long term capital gains come tax time. Once all of these are added in, the annual cost to own a fund can run as high as 5%!!!

  1. Is the fund adding a lot of risk to an investment? I hear all the time that someone has avoided an asset class that they would like to invest in due to the lack of liquidity. Liquidity is important, but with certain types of assets can become downright dangerous when liquidity is added. See, open end mutual funds are required to provide liquidity in the form of guaranteeing that they will redeem your shares if you want to sell. I know that sounds great, but it leaves the manager in a tough position. If they keep a lot of cash available in order to pay for redeemed shares, then performance can be reduced. If they have too little cash, then they can be forced to sell something in order to provide you with cash for your shares. If markets are volatile or illiquid, then the manager may have to take a much lower price to find a buyer. This can be especially true for assets like corporate bonds, especially high yield or “junk bonds.” When the markets were dropping in 2008, there were very few buyers for those bonds, which caused further drops in value, which caused more redemptions, which….. I think you get the picture. We saw this just recently in the second half of last year and early this year many bond funds lost 20-30% or more in a very short time frame. Assets like real estate, private equity, business development corporations and junk bonds can all be found in a “liquid” open end mutual fund. Just know that losses will be accelerated if there is another significant sell off as managers are forced to sell, but buyers can’t be found.

Mutual Funds Aren’t All Bad

Mutual Funds offer many desirable features. Professional management, liquidity, and ease of purchase are some of the many reasons to like them and invest in them. They can be a helpful tool for wealth building. However, you want to avoid any nasty surprises that might end up costing big time over your investing life. Do your homework or if you work with an advisor to pick funds, make them give you as much documented information about these areas as possible. Know and understand as much as you can about the fund you are investing in. That will keep negative surprises to a minimum.

If you are frustrated with the costs, hidden taxes and lack of transparency of mutual funds, you may wish to consider alternatives. You can contact us here if you would like to discuss how other options could help you get more out of your money.

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