Investor confusion is running rampant in the wake of unprecedented growth in the mutual fund industry, a recent Securities and Exchange Commission survey says.
Among the survey’s more troubling findings: Roughly one in four investors thinks mutual fund shares are federally insured, the survey of 1,000 investors showed. One out of every three thinks it’s safer to buy a mutual fund from a bank than a broker. And one investor in six is convinced you can’t lose money on a money market fund.
In fact, mutual fund shares have no federal insurance backing, and the safety of the investment has nothing to do with where it is purchased. It is also possible to lose part of your principal in a money market fund, although it rarely happens.
A great deal of the confusion is understandable, says Don Phillips, publisher of Morningstar Mutual Funds in Chicago. Not only are mutual funds increasingly catering to less sophisticated investors, some basic fund information is purposefully complex and misleading, he says.
With fund balances growing by roughly $22 billion a month, knowing the common mistakes-and how to avoid them-could save investors a fortune.
Mistake: Considering the past more than the future. Many people are pouring money into bond funds partly because bonds have had a tremendous decade, with total returns comparable-and sometimes exceeding-those of stocks. But what many people fail to consider is that the value of bonds tends to rise when interest rates drop. And, over the past decade, interest rates have plunged from record highs around 22 percent to today’s historic lows of about 6 percent. It is mathematically impossible for rates to fall as far as they did during the past decade, so total returns on bond funds are almost guaranteed to languish in the not-too-distant future.
Solution: Before you invest based on historic returns, analyze whether the market has changed in a way that makes the past a poor indicator of the future.
Mistake: Focusing on fees, rather than what the fees are for. A new trend is to buy so-called “load funds” (those that charge up-front marketing fees) from a discount broker, who charges a smaller “load” or fee.
On the surface, it seems reasonable to pay less for the same fund. But, in fact, the main advantage to buying a load fund is that the person who sells it is able to give you investment advice. If you don’t need advice, there are plenty of no-load funds that offer the same advantages as the load funds, experts say. So paying even a cut-rate price to buy a load fund could be a bad deal if you’re not getting advice to go with it.
Solution: If you need advice, don’t balk at paying for it. If you don’t, buy a no-load fund.
Mistake: Believing everything you read. A lot of the information published by fund companies and trade groups is misleading.
For instance, fund directories often list mutual funds by category, with divisions for growth funds, income funds, international funds, and so on.
However, funds are frequently miscategorized, either innocently or on purpose, Phillips notes. For instance, Morningstar recently analyzed the holdings of a variety of funds and found that Fidelity Capital Appreciation, a so-called “aggressive growth” fund, was 40 percent invested in international holdings.
Meanwhile, Janus Worldwide, an “international” fund, had only 20 percent of its portfolio invested internationally.
If you wanted to shift investments from growth stocks to international stocks, your logical inclination would be to sell Fidelity Capital Appreciation and buy Janus Worldwide, Phillips adds. But, in fact, you’d be doing the opposite of what you’d planned simply because you failed to consider whether the fund’s label was appropriate.
Some documents also misstate what the fund will be doing, simply to leave the fund manager’s options open, Phillips says. One fund prospectus-a legal document given to fund investors-devoted six pages to explaining complicated risk-hedging techniques that the fund could employ, for example. But the fund manager said he had no interest in “hedges.” The information was only there because the fund’s attorneys thought it ought to be an option, in case the fund manager ever changed his mind.
Solution: Check your local library for Morningstar Mutual Funds directory, which examines what the fund is rather than what it says it is.
Average annual returns
Mistake: Confusing “average annual returns” with annual returns. Fund companies frequently disclose their average annual return over long periods, and that can be helpful to someone who has a long-term investment horizon. But averages mask volatility-the up-and-down swings. And volatility can be pivotal, particularly if you have a reasonably short investment horizon.
For example, John Smith is investing $10,000 for five years and he’s looking at both Fund X and Fund Y. Fund X has had a 12.5 percent average annual return over the past 10 years. Fund Y has returned just 10 percent. Which should he choose?
To get the answer, he looks at actual annual returns and finds that Fund Y has consistently posted returns ranging between 9 and 11 percent and has a relatively conservative philosophy that reduces the chance of a major loss. Fund X, on the other hand, takes chances and has the track record to prove it.
Its annual returns have varied between annual gains of 80 to 45 percent down swings. Since Smith doesn’t have enough time to ride out market swings, he chooses Fund Y.
Solution: Do your homework, getting both average annual returns and actual annual returns to see which individual fund provides you with the greatest return for the smallest amount of risk.
Yield versus total return
Mistake: Confusing yield with total return. Investors who are new to the stock market often mistake yield with return, particularly if they have been investing in certificates of deposit, where yield and return are the same.
Solution: Watch both how much the fund pays to investors in dividends-the yield-and whether the share price appreciates or depreciates. Total return is calculated by adding together both dividends and share price appreciation or depreciation.
Remember: Investing in mutual funds can make filing your annual tax return far more difficult, particularly when you sell your shares. Why? Mutual fund investors pay tax on annual dividend distributions, even if their dividends are automatically reinvested in the fund. The value of the reinvested dividend increases your investment cost and your tax “basis.”
But some investors simply forget about the added investment when they sell, Phillips notes. They’ll remember they paid $1,000 when they bought the fund and got $5,000 five years later, so they might report a taxable gain of $4,000. But if they accounted for the reinvested dividends, they might find their true cost was $4,000. Doing it right would save this investor $840 in tax.
