mini-course series - mutual funds (part 3)

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MINI-COURSE SERIES

MUTUAL FUNDS

Part III

MUTUAL FUNDS 1

PART III

IBF | MINI-COURSE SERIES

CLASS A, B AND C SHARES

Commissions are commonly called “loads.” A number of publications question whether

or not an investor should pay any kind of commission. These publications believe that

anyone paying a commission is either foolish or ignorant. However, one must also ask

what the investor receives in return. The periodicals that promote mutual funds are load

publications—they charge a fee for their information. Yet, none of these services point

out that the reader could go to the local library and get the same information free.

If someone is willing to pay for advice, the question then becomes which is best for the

investor, A, B or C shares? The answer depends on how the investor psychologically

feels about commissions, the expected holding period, and the likelihood of finding a bet-

ter investment opportunity while the mutual fund shares are owned.

Some investors strongly dislike having to pay an upfront commission. For them, B or C

shares are preferable because the commission is not seen and the added expenses are tak-

en out over the course of several years. Other investors expect to hold shares for a num-

ber of years and an upfront commission may be the best value, depending upon the

amount invested, assumed rate of growth, and the actual number of years owned. Still

other investors prefer the flexibility of being able to exit a fund family at anytime and use

the money elsewhere; for them, C shares make the most sense.

As the table below shows, A or C shares result in higher returns if less than $100,000 is

invested. Class A shares are the favored choice if $100,000 or more is invested. In all but

two instances, B shares are the second best choice if less than $100,000 is invested.

Share Class That Produces The Highest Returns: Summary

Annual return $20,000 $50,000 $100,000 $250,000

8% (5 years) C B A C A B A C B A C B

8% (10 years) A B C A B C A B C A B C

12% (5 years) C B A C A B A C B A C B

12% (10 years) A B C A B C A B C A B C

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During 2006, the NASD imposed more than $40 million of fines on brokerage firms for

improperly selling B and C mutual fund shares. During the early part of 2007, the SEC

acknowledged that one of its key arguments no longer exists; the agency had assumed A

shares were always better than B shares. The NASD commission now believes that cost

alone is not the only decision in making investment recommendations.

Most of the lawsuits against brokerage firms were based on one of three things: (1) fail-

ure to tell clients that A shares can be cheaper than B shares, (2) fraud, and/or (3) suita-

bility. In a 2007 case dropped by the SEC, the agency acknowledged that even at the

$250,000 breakpoint, B shares may not be more expensive for the client than A shares.

One broker, now retired, spent $400,000 in legal fees and lost $1.6 million in deferred

compensation in 2001 when his broker-dealer fired him over the sale of B shares. In late

2005, a NYSE arbitration panel ordered the firm to pay the terminated broker all deferred

compensation plus legal fees.

REVIEWING PERFORMANCE

What all this means is that a number of different asset categories have performed quite

well and that investors have a choice, depending upon their objectives, time horizon, tax

bracket, level of risk and ability to make a lump-sum or periodic payments. The investor

must decide which of the following investment vehicles to use: (1) individual securities,

(2) exchange-traded funds (ETFs), (3) exchange-traded notes (ETNs), (4) enhanced ap-

preciation notes (EANs), (5) closed-end funds (CEFs), (6) real estate investment trusts

(REITs), (7) unit investment trusts (UITs), (8) annuities and/or (9) open-end mutual funds

(the emphasis of this course).

The CFS program covers all of the investment vehicles described above except individual

securities and annuities. Course materials provide insight into how multiple investment

vehicles can be used to construct a unique and effective series of diversified portfolios.

Once your clients understand the workings of mutual funds, it is doubtful they will want

to use anything else for the bulk of their portfolio. Mutual funds are truly the best invest-

ment vehicle ever created. The types of assets open-end mutual funds invest in provide

the flexibility, returns and risk level that your clients are looking for.

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MUTUAL FUND CATEGORY RETURNS

Equity Mutual Fund Return Figures for 2011

Category Return Category Return

Large Cap Growth -2.5% Foreign Large Growth -12.4%

Large Cap Value -0.7% Foreign Large Value -12.7%

Mid Cap Growth -4.0% Emerging Markets -19.9%

Mid Cap Value -3.9% Precious Metals -20.9%

Small Cap Growth -3.6% Health / Biotech 7.7%

Small Cap Value -4.4% Natural Resources -14.1%

European Region -15.0% Real Estate 7.4%

Pacific Region -20.6% Technology -7.6%

Latin America -22.9% Utilities 10.5%

Global -8.0% Foreign Small Growth -14.7%

Foreign -13.9% Foreign Small Value -16.3%



Large Cap Growth 15.5% Foreign Large Growth 14.7%

Large Cap Value 13.7% Foreign Large Value 7.5%

Mid Cap Growth 24.6% Emerging Markets 19.4%

Mid Cap Value 22.0% Precious Metals 42.0%

Small Cap Growth 27.0% Health / Biotech 8.9%

Small Cap Value 26.1% Natural Resources 18.6%

European Region 9.9% Real Estate 27.1%

Pacific Region 19.0% Technology 20.1%

Latin America 18.7% Utilities 7.9%

Global 13.8% Foreign Small Growth 23.0%

Foreign 10.3% Foreign Small Value 20.9%

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Large Cap Growth 35.0% International 32.7%

Large Cap Value 23.1% Emerging Markets 75.7%

Mid Cap Growth 40.4% Precious Metals 51.1%

Mid Cap Value 37.3% Health/Biotech 22.5%

Small Cap Growth 36.2% Natural Resources 40.5%

Small Cap Value 32.6% Real Estate 30.3%

Equity Income 22.9% Technology 53.8%

European Region 36.6% Utilities 16.4%

Pacific Region 51.3% U.S. Stock Fund 32.0%

Latin America 113.1% S&P 500 Funds 25.9%

Global 33.9% Balanced 23.4%



Large Cap Growth -40.7% International -44.2%

Large Cap Value -37.4% Emerging Markets -55.5%

Mid Cap Growth -44.5% Precious Metals -28.2%

Mid Cap Value -38.3% Health/Biotech -23.0%

Small Cap Growth -42.1% Natural Resources -47.8%

Small Cap Value -33.5% Real Estate -39.9%

Equity Income -33.8% Technology -44.7%

European Region -47.0% Utilities -33.5%

Pacific Region -45.9% U.S. Stock Fund -38.7%

Latin America -57.3% S&P 500 Funds -37.3%

Global -41.3% Balanced -26.9%

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From 1972-2010, the S&P and 5-year government bonds never suffered losses the

same calendar year; the worst loss for the S&P 500 was 2008 (-37%), while the worst

loss for 5-year bonds was 1994 (-5%). Over the same period, the S&P 500 experienced

negative returns 9 times (23% of the time); 20-year government bonds had negative re-

turns 10 times (26% of the time). Yet, during these 39 years, both assets had a negative

return the same year just two times (1973 and 1977).

Odds of S&P 500 Outperforming

Long-Term Gov’t Bonds [1961-2010]

Holding Period Stocks > Bonds

1 year > 60%

3 years > 70%

5 years > 75%

10 years > 90%

20 years > 99%

Fixed-Income Mutual Fund Return Figures for 2011


Long-Term Government 32.7% Municipal High-Yield 10.1%

Med.-Term Government 6.7% Emerging Market Debt 1.8%

Short-Term Government 2.1% High-Yield Corporate 2.8%

Long-Term Municipal 10.2% Inflation-Protected Bonds 11.0%

Med.-Term Municipal 8.8% World Bond 3.5%

Short-Term Municipal 3.5% Long-Term Corporate 11.6%

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Long-Term Government 11.2% Municipal High-Yield 3.7%

Med.-Term Government 5.8% Emerging Market Debt 12.4%


Long-Term Municipal 1.6% Inflation-Protected Bonds 5.9%


Short-Term Municipal 1.6% Average Taxable Bond 8.1%



Long-Term Government -0.1% Municipal High-Yield 30.8%

Med.-Term Government 7.8% Insured Municipal 14.0%


Long-Term Municipal 16.9% Mortgage 8.7%


Short-Term Municipal 6.6% Average Taxable Bond 18.3%



Long-Term Government 9.3% Municipal High-Yield - 25.1%

Med.-Term Government -0.1% Insured Municipal -6.2%

Short-Term Government 4.1% High-Yield Corporate -26.2%

Long-Term Municipal -9.1% Mortgage 1.3%

Med.-Term Municipal -1.3% World Bond -6.5%

Short-Term Municipal 0.0% Average Taxable Bond -7.7%

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DOMESTIC INDEX RETURNS

2010 Bonds, Bank CDs, Metals and Real Estate

Barclays Indexes Return Bank Instruments Return

Long-Term Treasury 9.4% 1-Year CD 0.6%

U.S. Credit AA-rated 7.1% 30-Month CD 1.0%

Municipal Bond 2.4% Money Market Deposit 0.2%

Med-Term Treasury 5.3% Metals (futures contracts)

Mortgage-Backed 5.5% Platinum 19.3%

Money Market Fund 0.04% Gold 28.7%

Residential Real Estate Silver 81.8%

OFHEO repeat-sales -3.2% Rare Coins 10.3%



Long-Term Treasury -13.0% 1-Year CD 1.2%


Municipal Bond 12.9% Money Market Deposit 0.4%

Med-Term Treasury -1.4% Metals (futures contracts)

Mortgage-Backed 5.7% Platinum 54.0%


Residential Real Estate Silver 47.6%

OFHEO repeat-sales -4.0% Rare Coins -7.9%



Long-Term Treasury 24.0% 1-Year CD 2.4%


Municipal Bond -2.5% Money Market Deposit 0.7%

Med-Term Treasury 11.3% Metals (futures contracts)

Mortgage-Backed 8.3% Platinum -38.2%


Residential Real Estate Silver -25.4%

OFHEO repeat-sales ~ -6.0% Rare Coins 8.8%

MUTUAL FUNDS 8

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HEDGE FUNDS

Hedge funds are loosely regulated pools of capital that invest in stocks, currencies,

bonds, and/or commodities. Hedge funds are similar to mutual funds but with fewer

rules, less government oversight, and much greater investment flexibility. Hedge

funds are usually either limited partnerships or offshore corporations. These funds

can take both long and short positions, use leverage and derivatives, and invest in many

markets at the same time. Minimum initial investments typically range from $250,000

to $10 million. Frequently, these funds have a one-year lock-up for first-time investors.

The median fee structure, according to TASS (which collects data on hedge fund re-

turns), is a 1.5% management fee plus a 20% incentive fee. Over the last 10 years

(ending 12-31-2005), this came out to an average fee of about 3.8% annually. Hedge

funds are not required to report returns, most of the results reported to data collec-

tors are voluntary.

The two main biases that pump up hedge fund returns are survivorship and back-

fill. When a hedge fund fails, the fund, along with its poor performance, is frequently re-

moved from the index and data set. This leaves an artificially inflated index composed

solely of surviving funds that have all had some level of success. And because hedge

funds must report returns in order to join an index, they frequently tend to join on-

ly after a period of solid performance—what is referred to as “backfill.”

Today, the SEC is looking into a number of potentially abusive hedge fund practices. One

is secret agreements, known as “side letters,” that give certain investors privileged in-

formation about holdings or special redemption terms. These side letter agreements

are not part of a hedge fund’s general offering memorandum; they can provide in-

creased liquidity, lower management fees, greater portfolio transparency, and/or

access to the fund’s prime brokers, lawyers, and accountants.

Side letters give some investors preference over others without disclosing such infor-

mation to all shareholders. It is estimated that roughly half of all hedge fund managers

make separate deals with certain investors. The majority of side letters are with hedge

funds that manage less than $1 billion.

Hedge funds are also under scrutiny for improperly valuing holdings to hide losses

or trump up returns (which increases management fees). SEC examiners believe that

some hedge funds are invested heavily in exotic instruments that lack marketability.

There is also the question of internal controls; a failure by some hedge funds to separate

their business practices. For 2011, hedge funds lost an average of 5%.

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Portfolio valuation is a major concern of hedge fund observers. Many of these funds

own thinly traded securities and complex derivatives whose values can be subjective. A

number of past enforcement cases against hedge funds have involved valuation methods

that mask or hide losses or artificially inflate returns. Some funds, claiming certain

holdings are difficult to value, put 10-15% of their portfolios in so-called “side pock-

ets,” which are sequestered from the overall package. A few funds have up to 25%

of their holdings in side pockets—a warning sign.

A study in the November/December 2005 issue of the Financial Analyst Journal found

that average hedge fund returns lagged behind the S&P 500 (from 1996-2003); some

performed so poorly they went out of business (600 in 2005—this works out to almost

three per trading day).

According to a report by Dresdner Kleinwort, hedge funds need to generate returns

of 18-19% in order to deliver a 10% return to investors, once fees, incentives and

trading costs are factored in. Hedge funds can improve returns through leverage. It is

estimated that the $1.3 trillion invested (as of early 2010) in hedge funds borrows from

$1.2 to $5.5 trillion at any given time.

THINGS TO DO

Your Practice

For clients who want to make a gift to a newborn grandchild, consider having them

buy one share of Disney stock. This is one of the few stock certificates that is very

colorful and includes a number of Disney characters—a perfect gift to frame next to a

crib.

The Next Installment

Your next installment, Part IV, will cover four topics: after-tax returns, tax efficien-

cy, systematic withdrawal plans and growth vs. value. You will receive Part IV in a

week.

MUTUAL FUNDS 10

PART III


Learn

Are you ready to take your practice to the next level? Contact the Institute of Busi-

ness & Finance (IBF) to learn about one of its five designations:

o Annuities – Certified Annuity Specialist® (CAS

®)

o Mutual Funds – Certified Fund Specialist®

(CFS®)

o Estate Planning – Certified Estate and Trust Specialist™

(CES™

)

o Retirement Income – Certified Income Specialist™

(CIS™

)

o Taxes – Certified Tax Specialist™

(CTS™

)

IBF also offers the Master of Science in Financial Services (MSFS) graduate de-

gree. For more information, phone (800) 848-2029 or e-mail [email protected].

mailto:[email protected]

mini-course series - mutual funds (part 3)

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