The Basics of Mutual Fund Investing

Some people don’t know where to start buying mutual funds, so they keep their money in banks, waiting for the right moment.

Others accumulate mutual funds as they would knickknacks. They buy a little of this and a little of that, until they own a jumbled assortment of things that may not work well together.

Even sensible investors who have prudently divided money among a few funds and been happy with the results are often uncertain whether they’ve done the right thing.

To be sure, trying to select mutual funds can be a maddening exercise. It’s as much an art as a science.

For starters, it’s simply impossible to predict with any certainty how the stock and bond markets that funds invest in will behave in the future. It’s almost as challenging to foretell which funds will beat the market averages and which will lag them.

Performance can be disrupted by many other factors--your fund’s manager might resign or your fellow investors might pull their money out, requiring the managers to sell prematurely.

Nonetheless, you needn’t be paralyzed. You can proceed with a general plan of attack and build a portfolio that makes sense for you. The mutual fund charts published today on D12-15 can help.

Here’s how to get started:

Narrow the Choices

Many novice investors undoubtedly feel overwhelmed by the vast number of mutual funds available--more than 6,000. But hundreds of these selections--probably thousands--may be inappropriate for you and can quickly be disregarded.

For example, if you are mostly worried about keeping what you already have--which means you seek “capital preservation” and would be happy with the current income that money produces--forget about aggressive small-company-stock funds.

If you require long-term growth, cross out money market funds and conservative bond funds. If you plan to research, select and monitor your own investments, disregard those funds that are sold at a higher cost or “load” by brokers and financial planners.

Decide Your Risk Tolerance

A big part of the process boils down to learning--or at least recognizing--what type of investor you are.

* Do you seek appreciation or stability?

* Can you let your money ride for many years or just a few months?

* Would a bad year in the markets cause you to lose sleep, or would you shrug it off as a temporary setback?

If you work with a broker or financial planner, your advisor will probably start off by quizzing you about your goals, fears and temperament so he or she can draw up a list of suitable investments. But you can also test yourself by completing one of the many investor profile quizzes offered by larger mutual fund companies, either in pamphlet form or over the Internet.

Key variables include your general financial status, tax situation, investment sophistication and time horizon (the number of years before you need to spend the money).

“You have to be careful not to put short-term money in the stock market,” says Kurt Brouwer, an investment advisor and author in Tiburon, Calif. “I think some people are doing that now because they think they can keep the money in for a year, earn 18%, then buy a house. We tell long-term investors that they should be thinking in terms of a 20-year horizon, if not more.”

Another critical consideration is your risk tolerance, or ability to stomach market fluctuations. The key to investing is sticking with a plan long enough for it to bear fruit. That means accepting the inevitable downdrafts as part of the process.

“If you have $100,000 invested in stock funds, ask yourself how far your portfolio would have to drop before you became inordinately uncomfortable,” suggests Joe Duran, senior vice president at FundMinder, a Sherman Oaks company that manages mutual fund portfolios for clients. “Of the people we work with, roughly 80% indicate they would head for the doors after a 10% drop.”

Even when you know your appetite for risk, it’s important to understand that risk measurement is itself an uncertain endeavor that is generally based on what has happened in the past. The future may be different, whether because of slow changes in the nature of the economy or major technological breakthroughs--or disasters.

That said, the reason the stock market is expected to continue performing better than the bond market or bank accounts in the long run is that stocks represent ownership in companies that tend to grow with the economy itself. Bonds and bank accounts are simply loans, albeit with higher interest rates paid for higher risk, but those loans give you no chance to share in the profits of the companies or banks that borrow the money from you.

Yes, there is a risk that stocks will perform poorly for many years and not recover in your lifetime. But there is also a risk that if you are not invested in the stock market, you will miss out on bursts of increasing profits and economic growth or simply fail to keep up with inflation.

The same kind of risk analysis applies, with finer distinctions, when deciding among mutual fund categories. Funds that specialize in specific countries or sectors are riskier than general stock funds; funds that invest primarily in small companies are riskier than those that invest in large companies.

Devising an Allocation Plan

Once you assess your risk tolerance, it’s fairly easy to draw up a suitable target portfolio. Essentially, this means earmarking a certain percentage of your investment dollars into stock funds, bond funds and “cash” (“cash” refers to fairly liquid but safe investments in places such as savings accounts, bank certificates of deposit and money market funds). This is known as asset allocation.

People using an asset allocation strategy essentially have a financial road map at their fingertips. They have a plan for staying in the stock and bond markets over the long haul, and they won’t let short-term price declines send them scurrying to the sidelines. They learn to watch the performance of their portfolio as a whole, without worrying so much about fluctuations involving individual investments.

At its simplest, an asset allocation plan involves choosing among growth, current income or capital preservation.

All investments possess one or two of these traits but not all three. A money market mutual fund, for example, delivers capital preservation with current income but no real growth or appreciation potential. Common stocks promise growth--perhaps with some dividends on the side--but no assurance of capital preservation.

As a rule, stocks are most closely identified with growth, bonds with current income and money market instruments with capital preservation. An allocation plan would also include sub-categories such as small stocks, international stocks or high-yield bonds.

Advantages of Mutual Funds

Mutual funds work superbly as asset allocation building blocks because they provide diversified exposure to specific investment categories even for people on a shoestring budget.

Suppose you want to divide $10,000 equally among four types of investments: large U.S. stocks (D12-13), small U.S. stocks (D12-13), foreign stocks (D14) and California municipal, or tax-free, bonds (D15). You could invest $2,500 in funds specializing in each of those categories. Each of these funds typically would hold at least several dozen stocks or bonds, which you hope are chosen carefully by experienced managers. That means you would end up with a slice of several hundred securities.

Mutual funds allow you to “focus your portfolio in the direction you want, with the ability to make changes almost instantly, at little or no cost,” says Brouwer. “That would be impossible with any other form of investment.”

How many funds should you hold?

The answer depends largely on the amount of money you have, and how much time you can commit to tracking a portfolio. At one extreme, there’s nothing wrong with owning a single “balanced” fund (D15) that splits its assets among stocks and bonds. Most large fund groups, or families, offer one of these broadly diversified products.

But there’s usually good reason to add more narrowly focused funds from various categories, allowing you to cherry-pick the best in each.

Don Wilkinson, a financial advisor at United Planners in Newport Beach, says he commonly recommends between 10 and 20 funds for his clients, who typically count assets of $500,000 and up. He thinks it’s crucial for most people to have some holdings in broad categories such as U.S. and foreign stocks. But he also recommends exposure to certain key sectors or industries. “Financial services, technology and health care are three industries of the future,” he says. “Everyone should have a piece of these.” (See D13 for top sector funds.)

Choosing Funds

Once you’ve drawn up an allocation strategy--after defining your goals, risk tolerance, income needs and the like--it’s time to put your portfolio together by selecting individual mutual funds. Of the myriad factors, which ones are most critical?

One is a fund’s investment approach--a combination of its stated objectives and the means it intends to use to reach those goals. All funds must state what they’re trying to accomplish and how they intend to do it in the prospectus, a sort of owner’s manual, supplied to shareholders. Unfortunately, some funds are quite vague in defining strategies or purposely allow their managers to retain considerable flexibility. That’s one reason fund tracker Morningstar reorganized its fund categories last year to reflect what the funds actually owned rather than what they said they would own. (Such categories are reflected in today’s charts.)

You might encounter a fund that very specifically pledges to seek capital appreciation by investing in the same stocks that make up the Standard & Poor’s 500 index. Another fund might seek capital appreciation by bargain-hunting among so-called value stocks, including those trading in foreign markets or on smaller domestic exchanges.

Is it best to stick with funds that pursue a narrowly defined investment course, the way S&P; 500 index funds do? Not always.

But if you want a manager who enjoys considerable flexibility--as set forth in the prospectus--make sure you realize the portfolio might change. Managers who are allowed to shuttle assets between foreign and domestic markets--or among stocks, bonds and cash--will be changing your asset allocation all the time, sometimes dramatically.

“Before you even look at a fund’s track record, you need to find funds that match your investment objectives,” says Brouwer. “You might read or hear of a great bond fund, for example, but if you’re a growth investor, you might not need it.”

Checking Performance

Next, evaluate a fund’s performance, both in absolute and relative terms. How has the fund fared against similar types of funds and against the market overall? Has its performance, or “total return,” improved or gotten worse?

One big advantage of mutual funds is that their performance numbers are reported in a standardized manner and are independently verified by third-party outfits such as Lipper Analytical Services, Morningstar and Value Line.

Performance results, expressed as a percentage, always include reinvested stock dividends and bond interest payments, if any, as well as the price changes for the investments held.

Also, except for sales charges, or loads, if there are any, fund expenses always are subtracted from published performance results.

But though mutual fund performance figures are both visible and reliable, they can be misleading.

Most important, as all fund prospectuses warn, past performance might not repeat in the future. Indeed, funds that show up on top-performer lists in one quarter or year often don’t repeat as champs the next time around. Although some managers have shown an ability to “beat the market” over many years, most have not. And even the best don’t excel consistently.

The other key problem with performance is that there’s disagreement over which time periods to emphasize. Certainly you shouldn’t focus too heavily on a fund’s returns generated over short periods such as several weeks or months. But what about the last one year, three years or five years? Perhaps the best advice here is to favor funds with lengthy track records that encompass different market phases.

Wilkinson looks at a combination of performance over one, three and five years. (Each of these periods is featured in today’s fund listings.)

“One year is not long enough, but there’s often too much change going on over five years,” he says. “I find that three years is just about right.” But Brouwer says he favors funds that have demonstrated superior performance for at least five years.

And how should you regard a fund’s performance if the manager who built the record departed recently? Although this won’t necessarily invalidate the numbers--especially if he or she was part of a team--it does raise a red flag.

You need to dig deeper to get a feel for whether the fund’s good record can continue under the new regime. If you don’t want to worry about managerial turnover, stick with funds run by a team.

The upshot is that you should try to favor funds with a history of good performance generated by the same manager or a stable management team. But don’t immediately eliminate funds from consideration simply because they haven’t been around for 10 years. You might find your choices severely restricted.

Weighing Fund Risk

No discussion of performance would be complete without a concurrent look at risk. The two are virtually inseparable. “While people focus on the return, risk is just as important,” says Duran.

With rare exceptions, high-returning investments expose people to a greater threat of losing money. Although principal loss isn’t the only peril fund shareholders should be aware of, it’s the first thing that springs to mind and usually is the most traumatic.

But assessing a fund’s riskiness isn’t easy. For starters, there’s no universally accepted measure. One common yardstick, known as beta, pegs the volatility of a fund compared with the volatility of a benchmark such as the S&P; 500.

A fund with a beta of 1.10 thus has shown a tendency to fluctuate 10% more than the market, both up and down. But a fund’s beta depends on how it has behaved in relation to a market index.

Funds that buy stocks or bonds that aren’t closely linked with the S&P; 500 or a similar yardstick for the bond market can have misleading beta numbers. For example, both gold funds and international-stock funds have low betas--because gold shares and foreign stocks often don’t move in the same pattern as the broad U.S. market. Yet these investments can hardly be considered conservative.

An alternative measure known as standard deviation tracks a fund’s volatility in absolute terms, without reference to a market benchmark. That means all types of funds can be evaluated for riskiness on an equal footing.

Yet standard deviation, like beta, suffers from a reliance on historical numbers that can be misleading. That is, standard deviation figures can and do change over time, during various phases of a stock market cycle. Also, standard deviation is among the more complex statistics that most shareholders will encounter. Suffice to say that funds with high standard deviation scores are the most volatile.

There are various other ways to peg the riskiness of mutual funds, including some that are fairly simple. Check “to see if a fund’s performance bounces around a lot,” says Brouwer, and examine the investment results during rough market stretches, such as the third quarter of 1990 or October 1997. (The Morningstar tables today provide a measure of how top funds did in the worst three-month period in their history, as well as their performance during weak markets.)

Because no risk measure is perfect, none has universal appeal. For more than two years, the Securities and Exchange Commission has been considering proposals to require mutual funds to quantify their riskiness in a standard format and publish it in the prospectus. But because risk can be measured in more than one way, no solution has been adopted.

Sizing Up Expenses

One key advantage of mutual funds is that all performance numbers are calculated in a standardized fashion, making for easy and reliable comparisons. In all cases, a fund’s published performance figures have already been reduced by applicable operating expenses--things such as management fees, shareholder servicing costs and certain marketing outlays.

Federal and industry regulators ensure that fund companies honor this aspect of the law.

Yet shareholders routinely take a careful look at fund expenses, often using them as a key variable in choosing between two otherwise-similar funds. Why?

Partly it’s because expenses are more stable and thus more predictable than performance, increasing the likelihood that low-expense funds will fare better in the future. In the case of bond and money market portfolios, whose returns tend to cluster together, expenses play an especially critical role.

A fund’s expense ratio, which pegs key operating costs as a percentage of total assets, is listed in the prospectus. (This information is also included in today’s tables.) On average, bond funds charge expenses of about 1%. Stock funds are more costly to run and impose expenses of 1.4%, on average. In extreme cases, fund expense ratios can exceed 2.5% and even 3%. Because high costs exert a drag on performance, they should be viewed as an immediate red flag.

An ongoing marketing charge known as the 12b-1 fee is included in expense ratios if applicable. But, as noted earlier, the sales charges, or loads, that some funds impose are not included. Still, they are worth noting. (Loads are included in today’s tables.) Years ago, load funds used to levy an 8.5% charge--representing a cost of $85 for each $1,000 investment--but such stiff levies have virtually disappeared. Prodded by competition from no-load companies--which deal directly with investors, cutting out the middleman--load groups in recent years have been forced to lower their charges. Today, levies above 5.75% are rare.

The key point to remember about loads is that the money collected from these marketing charges goes to pay the broker or financial planner who sold you a fund; it’s not retained by the fund company itself. All fund groups generate revenue in the same way, by imposing a management fee on shareholder assets. These fees, which are part of the expense ratio, typically run between 0.5% and 1%, representing a yearly charge of $5 to $10 for each $1,000 investment.

Other Factors

Additional things to keep in mind:

* The size of a fund can be important, especially in regard to funds that invest in small companies. Funds that have grown too bulky--such as those with more than $1 billion in assets--might have a tough time buying a meaningful number of shares in a small company without pushing its price up.

And if the manager wanted to bail out in a hurry, his selling action could push down the stock’s price.

Fund size isn’t such a problem for managers who specialize in large-company stocks. These issues have so many shares available that it’s hard even for mutual funds and other big institutional investors to influence their prices. And for bond funds, large asset size can be a blessing, since it implies economies of scale that can reduce a fund’s expense ratio.

* Another factor to watch is a fund’s portfolio turnover. This reflects the frequency with which a manager trades stocks or bonds--higher numbers indicate more activity. Since trading costs money, funds with high turnover rates ring up higher shareholder-borne expenses. High-turnover funds also typically are “tax-inefficient.” The more a manager trades, the more capital gains he or she will incur. The profits on these gains must be paid out to shareholders each year, and they’re taxable. That can be annoying for investors who hold their shares in straight, unsheltered accounts.

* Shareholder services can be important. Today, virtually all fund groups offer such features as dividend reinvesting, retirement accounts, free switching among portfolios and access via toll-free phone lines. But certain groups remain behind the curve in providing other services, such as Internet access to your account. Also, companies vary in terms of the breadth and quality of shareholder reports and educational materials. But, most critical, many fund families lack a broad lineup of funds.

Monitoring and Selling

Even after you’ve selected suitable mutual funds, you’re only halfway through the process. You still have to keep a watch over your holdings, with an eye on eventually redeeming shares. Selling can be more difficult than buying, for the simple reason that you have not only a monetary commitment to a certain fund, but may have an emotional attachment as well.

How often should you analyze your holdings? As frequently as you want. Just be careful not to get so caught up with tracking your portfolio that you buy and sell funds excessively. Such a response can not only derail your performance, it can also mess up your tax situation.

A simple rebalancing strategy is a good idea for buy-and-hold investors with a long-term plan. The idea behind rebalancing is to skim off some profits from your best-performing funds and reinvest the proceeds into laggards, perhaps once a year. This helps to keep your original allocation on track while providing you with an automatic “buy low, sell high” discipline. Sometimes, however, you will want to sever your ties to a particular fund. What might prompt you to sell? Common red flags include poor performance, a change in managers, rising expenses, a surge in portfolio assets or alterations in your personal circumstances that can render certain funds less suitable.

Of these, it can be especially tricky to determine poor performance. Among advisors, there’s no consensus about how much time you should give a fund before bailing.

But it is essential that you base your decision on relative, not absolute, returns. In other words, you shouldn’t unload your foreign-stock fund just because it’s losing money, especially if rival funds are stumbling too. But if your choice has been lagging the competition for at least a year or so, it might be time to get out, especially if some of the other warning signs are apparent.

Russ Wiles is a mutual fund columnist for The Times. He can be reached at russ.wiles@pni.com