We New Jerseyans like a good laugh — except when it involves our money.No investor wants to be made a fool, so this April, Inside Money will prevent you from falling prey to some of the biggest jokes mutual fund companies play on investors all year long. Instead of making you laugh, these jokes could cost you — big.
Joke #1: A money manager who bails
There are many reasons a money manager will leave a mutual fund, and anytime that happens, a fund can change. In theory, a fund’s style shouldn’t change substantially after a manager leaves because the next person at the helm should be following a fund’s objective as identified in the prospectus. But there are times when the new manager takes the fund in a different direction, still within the prospectus’ guidelines but with a different trading style and with different goals. That could result in a very different fund from the one you bought into.
There also can be ugly tax consequences. If the new manager doesn’t like the holdings in the fund, there could be a lot of selling in the new manager’s first year, which could mean a large taxable gain for you. In the past year, there were 694 mutual funds where the manager tenure lasted less than one year, according to morningstar.com.
What to do?
When new managers come in, learn their track record with previous management assignments. Do the managers have experience with this type of fund? Will they change the fund’s style?
Check the fund’s company website, call them, and Google the new manager to see what you can learn. Then check fundalarm.com, a site that tracks personnel changes and offers insight on what the change may mean.
Joke #2: Funds that merge
Sometimes a mutual fund family decides to kill one of its offerings. Most often the fund is consolidated, or merged, with another fund. Suddenly, your money is put into a sister fund that may have significant differences from the original fund. The most common reason to close a fund is because it has a poor record compared with its peers. By sucking the fund up into another, the company can erase the nasty performance figures. In this turbulent economy, it’s no wonder some companies want to eliminate funds that don’t perform. In 2010, there were 710 fund mergers. There were 1,267 in 2009 and 767 in 2008, according to morningstar.com.
What to do?
Heck, if you wanted a different fund, you would have moved your money. Learn about the new fund. If it suits your goals, fine. If not, move your money without delay.
Joke #3: Performance is relative
A fund may boast a 10 percent gain for the year, and you might be excited. But a performance number alone doesn’t say enough. Sure, 10 percent sounds good, but what if all the other funds in its class earned 15 percent or 20 percent? Performance is relative. Apples to apples. You need to know how a fund’s performance compares to its peers. That’s the only way to be sure how it’s doing.
What to do?
Look up your fund on morningstar.com and click the “performance” tab. See how the fund performed and where it ranks compared to others in its category.
Joke #4: Higher-than-average fees
Fund companies should be paid for managing money, but not overpaid. Higher expense ratios will eat into your returns.
What to do?
As with performance numbers, compare apples to apples. International funds are generally more expensive than domestic ones, so compare similar funds. Visit morningstar.com and compare your fund’s fees with those of funds in the same category. If yours are higher, consider switching to a fund with comparable performance but more reasonable expenses.
Joke #5: Taxes
Unless your fund is in a tax-advantaged basket, such as an IRA or a 401(k), you’ll be paying taxes on gains each year. During the year, a mutual fund will buy and sell shares. Generally there are gains, at the end of the year, and the fund will distribute those capital gains taxes to its shareholders. Imagine a fund purchased shares of a stock for $10 in 2000. By 2010, the stock rose in value to $30. The manager decides to take profits and sell the stock, so that’s a long-term capital gain of $20 per share. Shareholders will receive their own distribution of those gains, which must be reported on their tax returns.
What to do?
If you own investments outside of tax-deferred accounts, make sure they are tax-efficient, such as index funds. Keep the actively managed or often traded funds inside your 401(k) or IRA. Also try not to buy new funds in December. It’s possible you could get hit with capital gains taxes even though you didn’t own the fund, or benefit from those gains, during the year.