Portfolio Management - Mutual Fund Analysis

The Series 7 exam will also cover analysis of mutual funds. There are two sets of data points used to compare mutual funds:

  1. Non-statistical
  2. Statistical

We will discuss each in turn within the following sections.

Non-Statistical Analysis
Starting with the non-statistical, or qualitative, criteria, the first things an investor ought to look at are the funds' investment objectives and policies. As you saw in the section on packaged securities in Chapter 6 "Packaged securities and retirement/estate planning", a fund's objective can be either growth or income, and it can pursue those objectives by adopting the appropriate policies.

For example, growth funds can invest specifically in growth stocks, speculative stocks or stocks within a particular geographic or economic sector. Meanwhile, income funds may invest specifically in municipal bonds, corporate bonds, government bonds, money markets or defensive stocks.

Other non-statistical factors used to compare mutual funds include the following:

  • Minimum purchase amounts: These are typically $500, $1,000, $5,000 or more, often required by the mutual fund issuer or by the selling group member. Even so, the cost of entry into bond mutual funds is typically far lower than the cost of actual bonds.

  • Conversion privileges: These give an investor the right to switch from one fund to another in the same family. There is usually no reinvestment cost, but sometimes these transfer charges are required by the fund family.

  • Various sales charge methods: These can add up quickly and erode the returns on an apparently high-performing fund. Charges include front-end loads on purchasing fund shares and back-end loads on selling shares, as discussed in Chapter 6 "Packaged securities and retirement/estate planning". Even no-load funds have marketing and operating fees, usually described as 12b-1 fees, or they impose account fees on investors who do not maintain a certain threshold balance, or they have purchase fees which are paid to the fund family rather than to the broker and are thus not considered sales loads.

  • Withdrawal options: These come into play if the fund is part of a retirement or variable annuity plan. At retirement age, an investor may have the choice of a lump sum or a periodic withdrawal schedule. Prior to retirement, he might be penalized for early withdrawal. If the plan is employer-sponsored and the investor changes jobs, he might be able to rollover the fund into a plan sponsored by his new employer.

  • Letter of intent (LOI): This is a statement expressing a client's intent to invest an amount over the breakpoint within a specified period of time. Many fund companies allow purchases completed within 90 days before the LOI is signed and within 13 months after the LOI is signed to be used to reach the breakpoint. Those expecting to invest regularly in a fund with a front-end sales load should find out if an LOI can help them qualify for a reduced charge. Failure to invest the amount stated in an LOI allows the fund to collect the higher fee retroactively.

Look Out!
A LOI provides a mutual fund investor with a way of immediately qualifying for a lower sales charge, based on his/her intention to make the deposits over the next 13-months that reach the breakpoint. If the investor fails to make the deposits, and only "new money" counts, the fund will bill the investor for the difference between the breakpoint sales charge and the amount that would have been charged without the breakpoint

: This gives an investor a discount on current mutual fund purchases by combining both current and previous fund transactions to reach a breakpoint. For example, if your client is investing $10,000 in a fund today, but she previously invested $40,000, those amounts can be combined to reach a $50,000 breakpoint, which will entitle her to a lower sales load on the $10,000 purchase.

  • Diversified portfolio: This is a factor because owning various types of funds can help reduce the volatility of a portfolio over the long term. Having a diversified portfolio does not mean you will never lose money; the only protection against sudden, systemic losses is to put some assets into a money market fund. As noted earlier in this chapter, a portfolio can be diversified in four different ways: 1) by asset class (stocks, bonds and cash), 2) by geography (U.S., foreign developed markets stocks, emerging markets stocks), 3) by risk profile (growth, income) and 4) by industry sector (for example, real estate and technology).

  • Eligibility for conduit theory application on distributions: This is a factor because not all investment companies qualify for this treatment, and their distributions might be decimated by taxes on the corporate level before reaching the investors.
  • Statistical Analysis
    Moving on to statistical measures used to compare mutual funds, there are several quantitative concerns you must bear in mind when presenting a client with options:

    • Sales charges: These charges matter, regardless of the timing - front- or back-loaded. The investor ought to know if they are closer to 4% or to 8% of purchase price.

    • Distribution fees: Also known as 12b-1 fees, these cannot exceed 0.75% average NAV per share according to NASD rules.

    • Performance over time in terms of growth, income, total return: These are all affected by the age of the fund, its risk profile, its volatility and its expenses. It is important to note two things here:

      1. A fund that outpaced the market every year for the past 20 years is not necessarily going to do so again this year; past performance is not indicative of future performance.

      2. The age of a fund might have no correlation to its success; "rookie" funds often beat the more established players.

    • Expense ratio: This is operating expenses divided by average NAV. You will find these figures - which determine what percentage of assets go straight into paying expenses before being distributed to shareholders - in the fund's prospectus or quarterly report.

    • Comparison of front-end vs. back-end load charges over time, and how they can affect the total expenses paid by the investor: Sometimes a fund will give the investor a choice between a front-end load and a back-end load. The back-end load is initially higher than the front-end load, but it decreases over time. If your client is looking to invest for the long haul, this may be advantageous for her.

    • Portfolio turnover: This is the purchases or sales of assets in the fund (whichever is lower) divided by the average NAV. The higher the portfolio turnover, the greater the transaction costs incurred by buying and selling securities, and this can adversely affect the fund's performance.
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