Investing Basics DISCLAIMER This information is being provided as a service for NTM members to help them achieve their investment goals. The materials and web-links provided will give you access to in- formation concerning investing, taxes and retirement programs. We make no express or implied guarantees. All final conclusions depend upon the unique circumstances of each individual investor. As always with investment material, past performance is no guaran- tee of future results. If you desire expert advice, we would recommend contacting a li- censed financial advisor or licensed tax advisor before making any final conclusions. The Power of Compounding At the heart of sound investment theory is a simple mathematical formula known as the Power of Compounding. If you put your money in an investment with a given return — and then reinvest those earnings as you receive them — the snowball effect can be as- tounding over the long term. This is particularly true in retirement accounts, where your principal (initial investment) is allowed to grow for years tax-deferred. Suppose you have $10,000 in your bank account and decide to put it into an investment with an 8% annual return. For the first year, you earn $800 on your initial investment (called “the principal”), which gives you a total of $10,800. If you leave those earnings alone, rather than spend them, then the second year would deliver another $864, or 8% on both the original $10,000 and the $800 gain. Your two-year total: $11,664. The longer you keep reinvesting those earnings, the more dramatically your nest egg will grow. $50,000 $45,000 $40,000 $35,000 $30,000 T o ta l $25,000 $20,000 $15,000 $10,000 $5,000 $0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 Year As you can see, compounding produces modest — but steady — gains over the first few years. But the longer you leave your money in, the faster it begins to grow. By year 20 in our example, your money would have quadrupled to more than $46,000. Of course, the power of compounding also works for cash accounts such as money- market funds which have lower interest rates. If you adjust the interest rate downward to 4% (which would be a very good rate of return for a money-market fund in 2004), you’ll see what you’re giving up: Your 20-year return on that $10,000 drops to around $22,000. Now increase the interest rate up to 10%. At that rate, your $10,000 investment balloons to $67,275. The average historical annual rate of return for the stock market is around 11%. The lesson is this: The longer you leave your money invested and the higher the interest rate, the faster it will grow. That’s why stocks or mutual funds are the best long-term in- vestment value. Of course, the stock market is also much more volatile than a savings account. But given enough time, the risk of loss is diminished by the general upward momentum of the economy. Time Lessens Risk Although the stock market has ups and downs it has consistently realized an annual growth rate of around 11% from 1926 through 2000. While the line zigzags up and down from year to year, the overall trend is upward. Con- sider this: If in 1929 you invested $1,000 in large-cap stocks, you’d be sitting on roughly $1 million today (according to data from the Center for Research in Securities Prices). Those long-term gains are all the more remarkable when you consider that the 73 years in question (1929 to 2002) included the Great Depression, the market doldrums of the early 1970s, the two market crashes that punctuated the 1980s, as well as the recent bear mar- ket (from 2000 to 2002). The 10-year periods with positive returns far outnumber those in which investors lost money. Isn’t investing just gambling? The financial markets are often compared to a casino. You know, put some money down on Intel and you might as well be playing blackjack. If that’s your impression, and it’s keeping you from investing, consider this: If investing is nothing more than organized gambling, then it’s one of the rare kinds where the odds are stacked in your favor. History has shown that with enough time and a little discipline, you are all but guaranteed to make a nice return on your investment. You merely need patience and a willingness to put your savings to work in a balanced portfolio of securities tailored to your age and cir- cumstances. To see why, you have to understand how investing works. It’s not about throwing all your money into the “next Microsoft,” hoping to make a killing. And it has nothing to do with getting a stock tip from your brother-in-law and clicking over to E*Trade to buy as many shares as you can get. Investing isn’t gambling or speculation. It’s taking reasonable risks to earn steady re- wards. As we’ll see, it works because investing allows you to participate in the consistent growth of the world’s economy, which hardly follows a straight line, but does trend up- ward over time. It’s also true that the longer you stay invested, the more dramatic your money will grow. This neat trick — called the Power of Compound Interest — is a mathematical certainty, something you can bank on. There is some risk involved with investing, but when it comes right down to it life itself is a gamble! You take a chance anytime you drive or fly, but that doesn’t stop us from traveling! Have you read the warning labels lately on popular medications? Here’s one from a cold medicine: Warning: This drug may cause a severe allergic reaction (difficulty breathing; closing of the throat; swelling of the lips, tongue, or face; or hives); liver prob- lems (yellowing of the skin or eyes, abdominal pain); blood problems (easy or unusual bleeding or bruising); or low blood sugar (fatigue, increased hunger or thirst, dizziness or fainting). Other, less serious side effects are more likely to oc- cur including: dryness of the eyes, nose, or mouth; drowsiness or dizziness; blurred vision; difficulty urinating; or excitation in children. It almost seems like the cure is worse than the sickness. Why would anyone risk taking a cold medicine? The Scriptures teach wise planning: The Parable of the Talents Matthew 25:14-30 (NLT) Again, the Kingdom of Heaven can be illustrated by the story of a man going on a trip. He called together his servants and gave them money to invest for him while he was gone. He gave five bags of gold to one, two bags of gold to another, and one bag of gold to the last — dividing it in proportion to their abilities — and then left on his trip. The servant who received the five bags of gold began immediately to invest the money and soon doubled it. The servant with two bags of gold also went right to work and doubled the money. But the servant who received the one bag of gold dug a hole in the ground and hid the master’s money for safekeeping. “After a long time their master returned from his trip and called them to give an account of how they had used his money. The servant to whom he had entrusted the five bags of gold said, ‘Sir, you gave me five bags of gold to invest, and I have doubled the amount.’ The master was full of praise. ‘Well done, my good and faithful servant. You have been faithful in handling this small amount, so now I will give you many more responsibilities. Let’s celebrate together!’ “Next came the servant who had received the two bags of gold, with the report, ‘Sir, you gave me two bags of gold to invest, and I have doubled the amount.’ The master said, ‘Well done, my good and faithful servant. You have been faithful in handling this small amount, so now I will give you many more responsibilities. Let’s celebrate together!’ “Then the servant with the one bag of gold came and said, ‘Sir, I know you are a hard man, harvesting crops you didn’t plant and gathering crops you didn’t cultivate. I was afraid I would lose your money, so I hid it in the earth and here it is.’ “But the master re- plied, ‘You wicked and lazy servant! You think I’m a hard man, do you, harvesting crops I didn’t plant and gathering crops I didn’t cultivate? Well, you should at least have put my money into the bank so I could have some interest. Take the money from this servant and give it to the one with the ten bags of gold. To those who use well what they are given, even more will be given, and they will have an abundance. But from those who are unfaithful, even what little they have will be taken away. Now throw this useless servant into outer darkness, where there will be weeping and gnashing of teeth.’ Note: The unfaithful servant allowed fear to govern his decision. He replied, “I was afraid I would lose your money, so I hid it in the earth and here it is.” Ecclesiastes 11:4 He who observes the wind will not sow, and he who regards the clouds will not reap. Proverbs 20:4 The lazy man will not plow because of winter; He will beg during harvest and have noth- ing. Proverbs 22:13 The lazy man says, “There is a lion outside! I shall be slain in the streets!” Risk vs. Reward Risk is a fact of life for any investor. Stocks plunge. Companies go bankrupt. The stock market goes through periods of decline. There’s even risk in doing nothing: Thanks to inflation, $100 left moldering in the bank earning no interest will be worth about $75 in 10 years. To earn rewards, you have to assume a certain amount of risk. The higher the risk you’re willing to assume, then the higher the reward you will achieve. On the other hand, the lower the risk you assume, the lower the reward. If you minimize your exposure to the perils of investing, then you have to accept lower returns. During the late 1990’s, most investors thought they had a great tolerance for volatility because the market was booming. But around the year 2000 the U.S. economy took a downward turn. After three years of a bear market (where stock prices decline for a pro- longed period of time), some of those same investors decided that they have no risk toler- ance, and today they are missing out on the market’s gains. How much of a tolerance for risk do you have? For most of us, the right place is somewhere in the middle. Recogniz- ing that dangers do exist, you simply need to follow a few easy strategies in order to minimize the risks. Before investing a person needs to determine their tolerance for risk. However in doing so, you need to realize that “risk tolerance” has more to do with time than temperament. The more time you have to make up for short-term losses, the more aggressive you can be with your investments. A younger person investing for retirement should have a greater tolerance for risk than someone in their 60’s. The easiest way to reduce the risk of investing — and improve your reward — is to increase the time you hang on to your in- vestments. Of course, the opposite is also true: If you’re saving for a short-term goal, then it’s best not to bet the ranch on a fund that has substantial swings both up and down. Minimizing the Risks Three easy strategies will help protect your investments and minimize your risk: • Diversification • Dollar Cost Averaging • Asset Allocation Diversification The single best way to protect yourself from a meltdown in one stock or industry is to spread your risk across several different investments. The more diversified your portfolio is, the less any one investment can hurt you by blowing up. The old saying, “don’t put all your eggs in one basket” aptly applies to investing. While it might be tempting to pile all your money in dynamic performers, keep in mind that they can head south, too. The les- son is: Spread your investments around. Dollar-cost averaging This strategy is to invest fixed amounts of money at regular intervals, regardless of the markets’ movements. Dollar-cost averaging is another form of diversification — only instead of spreading your money over a bunch of different investments, it diversifies your investments over time. As a result, when the price is lower, more shares of the security are purchased than when prices are higher. $300 invested into the same fund every month will get you a lot more shares when the fund is down than when it’s flying high. Many stock investors try to “time the market” so that they will buy stocks at a low price and sell at a high price. That takes a lot of research and a fair amount of luck. Dollar cost averaging eliminates those headaches. Dollar cost averaging allows you to buy more shares when the fund is down and fewer shares when it is up. Here’s how it works: Sup- pose you decide to put $300 a month into a mutual fund that invests in the stocks of large companies. Your mutual fund company can set up an automatic investment account for you — a 403 (b) — and the money is pulled straight from your Sanford account on the same day each month. If a share of the fund costs $50 in October, your $300 will buy six shares. If the price rises to $75 in November, you buy four shares. If the price drops to $25 in December you buy 12 shares. The idea is that your money buys more shares when the price is cheap and fewer when the price is high. Asset allocation Asset allocation is yet another way to diversify. It takes advantage of the fact that when it comes to risk and reward, financial categories like stocks, bonds and money-market ac- counts all behave quite differently. Stocks, for instance, offer the highest returns among those three “asset classes,” but they also carry the highest risk of losses. Bonds aren’t as lucrative, but they offer far more sta- bility than stocks. Money-market returns are puny, but you’ll never lose your initial in- vestment. An asset-allocation strategy looks at your particular goals and circumstances and determines what asset mix gives you the optimal blend of risk and reward. Here’s an example. Say your goal is retirement. When you’re young — in your 20s or 30s — and have time to make up for short-term market losses, an asset-allocation scheme would put you heavily into stock funds. You might even spice it up with a mix of large- cap stock funds, small-cap stock fund and international stock funds to diversify your port- folio. As you move into your late 30s and early 40s, however, you’d probably want to give your portfolio some stability and income. Maybe you’d shift to a 75/25 blend — still favoring stock funds, but also include safer bond funds. The closer you got to retirement age, the more you would ratchet up bond funds and taper off stock funds. And in your last few years, when you simply could not afford big market losses, your portfolio would be heavy on short-term bonds or money-market funds — the least risky of all investments. There are a number of on-line tools to help you determine your asset allocation. Time vs. Risk During the 1990’s investors made significant gains from stocks and mutual funds. This is called a “bull market.” But in the year 2000 our country headed into a recession and the market began a downward trend which is called a “bear market.” After a three year de- cline, it’s certainly understandable that some investors just could not get over their fear of losing money in the market. They seem to view stocks as an anxious game of Russian roulette: The longer they stay in, the greater their chance of experiencing more losses. In fact, history shows that the opposite is true. The easiest way to reduce the risk of invest- ing — and improve gains — is to increase the time you hang on to your investments. The graphs below uses historical data from 1950 through 2002 to compare investment returns over different lengths of time for small-cap stocks (high risk), large-caps (moder- ate risk), long-term bonds (low risk) and T-bills (very low risk). The first graph starts out by showing results for investments held over one-year periods. There’s no doubt about it: Over such short intervals, small-cap funds are definitely the riskiest bet. Sure, you could’ve doubled your money if you’d invested during the year starting July 1982 — the best 12 months of the bunch. But if you’d invested during the year starting October 1973, near the beginning of the OPEC oil embargo, you would’ve faced a disastrous 41% loss. Compare that with 20-year Treasury bonds — during their worst year, beginning April 1979, they were down only about 13%. But what about investing for more than a year? Even investing for two years instead of one cuts your risk significantly. As the length of time increases, the volatility of invest- ments decreases sharply. Adjusting for inflation, the best 20-year gain a portfolio of long-term Treasury bonds could muster was 7.9% a year (October 1981 to October 2001). And bondholders who invested from 1961 to 1981 actually lost money. Meanwhile, with the same inflation adjustment, small-fund investors averaged an 8% gain over the 20-year periods measured. Their best result was a strong 13.5% from Janu- ary 1975 to January 1995, their worst, 2.7% starting January 1955. Of course, this doesn’t mean you’re guaranteed to make money buying small-cap funds. Although the numbers show that it’s a good idea to stay in the market as long as possible, they say nothing about how long you should hang on to particular funds. The overall les- son, however, is simple: The market delivers its cruelest blows to those who cash out too early. Bear Market Blues Didn’t investors lose money during the three year bear market after 2000? Yes, but those who have stuck it out are singing a different tune! It seems that despite all the negatives of 2003 — the war in Iraq, terrorism threats and ugly employment figures — the long-awaited economic recovery finally came around. With the help of the lowest interest rates in decades and generous tax cuts, the stock market ended 2003 with a bang: the Dow was up 25.5%, the S&P 500 gained 28.7%, and the NASDAQ tacked on an im- pressive 50%. Many investors who bailed out after the 2000 stock bubble burst have come to regret their decision. Those who stuck it out have enjoyed the market’s significant gains. Be- cause the fact is, even though it could be quite some time before the losses of the three year bear market are recouped, it’s going to happen. History has proved it. Types of Investments • Stocks • Bonds • Mutual Funds • Other Investments Stocks Stock is ownership, simple as that. Buy a share of Microsoft and you acquire a tiny sliver of the software giant, tying your fate to that of Bill Gates, for better or worse. This is ownership in the most literal sense: You get a piece of every desk, contract and trademark in the company. Better yet, you own a slice of every dollar of profit that comes through the door. The more shares you buy, the bigger your stake becomes. Bill Gates owns by far the most Microsoft shares. Over the past decade, his stake in the company has hovered around 21%. But his stake also ebbs and flows with everybody else’s stakes as the company’s value on the stock market changes from day to day. Stocks are probably not the best investment for most of us who do not have the time or resources to research them. Here’s what Dave Ramsey (Christian financial advisor) has to say about investing in stocks: Looking back at the last 78 years, the performance of the stock market as a whole has av- eraged near 12% annually; yet the average return of the single stock investor is closer to 7% annually. Mutual funds typically hold 50 to 250 stocks in their portfolio. They hire mathematical geniuses to determine exactly how long to hold them and when to sell them to maximize returns. The average investor is simply not going to compete with the brains of most mutual funds, long term. Also, if you place much of your nest egg with one or two single stocks, your risk skyrockets. Your sleep will be much less restful when your nest egg stock doesn’t meet earnings, sees it’s CEO locked up for fraud, or takes a 35% plunge because the analysts decided your stock is a hold instead of a strong buy. If you must satisfy your need to test your brother in law’s hot stock tip, then limit this invest- ment to no more than 10% of your portfolio. NOTE: By the time you get the hot tip, it’s old news to our friends inside the mutual funds. Bonds A bond is a loan and its holder is the lender. Who’s the borrower? Usually, it’s the fed- eral government, a state government, a local municipality or a big company like General Motors. All of these entities need money to operate — to fund the federal deficit, for in- stance, or to build roads and finance factories — so they borrow capital from the public by issuing bonds. A key difference between stocks and bonds is that stocks make no promises about divi- dends or returns whereas bonds do. When a company issues a bond, it pledges to pay back your principal (the face value) plus interest. If you buy the bond and hold it to maturity, you know exactly how much you’re going to get back (in most cases, anyway — there are some exceptions). Bonds are also known as “fixed-income” investments — they assure you a steady payout or yearly income. And although they can carry some risk, this regular income is what makes them inherently less volatile than stocks. Just because bonds have a reputation as conservative investments doesn’t mean they’re always safe. Any time you lend money, after all, you run the risk it won’t be paid back. Companies, cities and counties occasionally do go bankrupt or default on their debts for extended periods. U.S. Treasury bonds alone are considered rock-solid. By far, the greatest danger for a buy-and-hold bond investor is a rising inflation rate. Why is inflation such a problem for bondholders? Think about it this way: Rising prices make today’s dollars worth less in the future than they’re worth today. Since a bond can lock up your money for as long as 30 years, a rising rate of inflation can have a particu- larly corrosive effect. Here’s what Dave Ramsey (Christian financial advisor) has to say about investing in bonds: Bonds are often stereotyped as safe investments with returns slightly lower than stocks. This simply is not the case. Bonds, just like stocks, are traded on the secondary market. This means the value of bonds goes up and down each day just like stocks. The risk in- volved with bonds is not significantly lower than stocks. In some cases, it is much higher. Bonds are debt instruments, used by companies to raise capital. The bond payments themselves are made by the companies and are dependent on the financial strength of the individual companies. Good companies can miss bond payments. Got any Service Mer- chandise bonds? Enron bonds? Also, the returns associated with bonds are not attractive compared to stocks. It’s better to invest in balanced mutual funds which included bonds. Balanced mutual funds mix stocks and bonds inside of a mutual fund. You can study the track record of balanced mutual funds just like any other fund. Mutual Funds A mutual fund is a pool of money used to invest in whatever the fund specializes. Most funds specialize in stocks but some buy gold, bonds or other investments. Many funds focus on certain areas like China or US technology stocks. Example: Fidelity Magellan is the largest fund in the country. The minimum investment is $2500. Thousands of investors have put money into the fund which, in turn, invests the money in US stocks, the fund’s specialty. A large full time staff monitors the investments and makes decisions under the direction of a fund manager. One appeal of mutual funds is that smaller investors receive the same world class exper- tise and purchasing power as the large institutions. Investors who buy funds need only be concerned with the quality and long term performance of the fund. They do not need to worry about each individual stock or bond purchase the fund makes. Mutual funds are an excellent way for investors to have their money handled by world class professionals. Diversifying your investments will protect you from the market’s worst storms. The more types of stocks or bonds an investor owns, the less any one of them can hurt them by tanking. Depending on just a few investments is always asking for trouble. Yet building and maintaining a diversified portfolio isn’t for everybody. To do it right, you might have to keep an eye on as many as 20 to 60 different stocks and bonds at once. Some people thrive on this sort of thing, but most of us lack the time, interest or experience to give a complex portfolio the attention it demands. Mutual funds — pools of stocks or bonds that are managed by professional investors — are an excellent way to diversify without all the work of tracking stocks and bonds. Funds come in all shapes and sizes, from Fidelity’s $68 billion Magellan Fund to the $20 million Women’s Equity Fund. Most of them work this way: A sponsor company like Fidelity or Vanguard rounds up money and pays a portfolio manager to buy groups of securities according to a specific investing strategy. The company then sells shares in the fund to the general public at a price reflecting the value of the pooled securities. Buy a share of the fund, and you own a small percentage of the total portfolio, meaning you par- ticipate in any of the fund’s investment gains or losses. Depending on the fund, you can own a piece of 20 to 500 different companies for a minimum investment of $1,000 to $5,000 — sometimes even less. You may have to pay a fee for the service, but a good fund offers plenty of advantages. Ideally, the pros have years of experience and are given access to piles of industry and company research. It’s also true that, unlike a bank certificate of deposit or an annuity, a mutual fund investment is completely liquid, meaning you can get in or out simply by picking up the telephone. While diversification through mutual funds can help to buffer from the crash of one er- rant stock, they’re still subject to market risk. If the broad market drops, then chances are that your fund will usually sink right along with it. However, there are some mutual funds that will perform well even through a bear market. Though mutual funds lessen the work load of the investor, the wise investor still must do some homework. There are plenty of lousy funds out there that charge you a lot in fees, and do badly even when the market does well. It’s essential to choose your funds wisely and strategically. Other Investments CD’s (Certificate of Deposits) A certificate of deposit or CD is a certificate issued by a bank that indicates a specified sum of money has been deposited. The certificate guarantees to repay your principal — the amount you deposited — with interest on a specific maturity date. The amount of in- terest you receive depends on prevailing interest rates, the length of maturity and how much you deposited. There are often significant penalties for early withdrawal of your money. CDs are insured by the Federal Deposit Insurance Corporation (FDIC). That makes your investment safe from everything but inflation. For savings (emergency funds, saving for purchases, etc.) CD’s are great. As invest- ments, they are poor. CD’s guarantee you a small return, which increases the longer you commit to leave it. CD’s typically pay 1% or 2% per year. Inflation increases 3% to 4% per year. If you invest in a CD and receive 2%, you’ll pay taxes on this gain (if not in a retirement account like an IRA). You’re looking at an after tax return of 1.5%, when the cost of living increased more than twice this amount. The only guarantee you receive is that your money will lose value over time compared to the cost of bread, gas, electricity, etc. Long term, you need to earn a minimum 6% annual return to pay taxes and be left with enough to account for inflation so that your dollars do not lose value. In order to grow your investment, you must outpace inflation. Mutual funds are the preferred vehicle for long term investing. Annuities Annuities are a big favorite of many brokers and financial planners. And it’s no wonder: They’re easy to sell because they sound so safe and easy — a diversified, tax-deferred investment that is protected from losses in case you die. They also can generate fat com- missions for the folks who sell them. You can guess which part the planners emphasize to their clients. Except in a few limited instances, there’s really no point in buying an annuity. You can get the same returns and tax benefits from a mutual fund held in your IRA or 403(b). And the no-loss insurance is not worth the exorbitant fees you’re normally asked to cough up. To see why, you first need to understand how an annuity works. Annuities generally come in two varieties: fixed and variable (there are others, but these are the ones you will most likely encounter). Insurance companies (through brokers) sell them as a sort of combination retirement account/insurance policy. You put your money in, and the principal is allowed to grow, tax deferred, for a set pe- riod — usually until you’re 59 1/2. Then, you either “annuitize” what’s in your account (which means you get steady payments over a fixed period of time) or you can take a lump-sum distribution (which could leave you with a hefty tax bill). In either case, you’d better be comfortable with the decision. Most of the time, you can’t change your mind. A big part of the pitch, however, is the death benefit. If you die and your account has dropped below what you originally put in, the insurance company makes up the differ- ence to your beneficiary. But don’t be fooled: The death benefit is triggered in only three of every 1,000 variable-annuity accounts, according to Limra International, an insurance- industry research group. The difference between fixed and variable annuities is that the “fixed” contract guaran- tees you a set interest rate during what is known as the “accumulation period” — the time before you take withdrawals. Oftentimes, however, if you read the fine print, you’ll find that the great rate that’s being plugged only lasts for a brief period. After that, it can change dramatically, although there may be a minimum interest-rate guarantee. With a variable annuity, the return is based on your choice among a set of mutual funds, bonds or cash-equivalent investments that is usually predefined. Because of this relative flexibility, variable annuities are by far the most popular type of annuity. And you can expect your broker to pump up the idea that the rate you earn is up to you. Pros The one big perk of an annuity is that, unlike an IRA or 403(b), it doesn’t limit the amount of cash you can put in at any one time. That means if you max out your regular retirement plans in a given year — but still have a chunk of money you want to sock away for retirement — you might consider buying a low-fee variable annuity. Fortu- nately, a few have become available over the past few years. T. Rowe Price, for example, offers annuities with 1.31% annual expenses (for the insurance and the funds). And Van- guard’s fees total only 0.67%. (For a more detailed discussion of when a variable annuity might be right for you, see “Who Should Buy Variable Annuities?” on Smart- Money.com.) Cons Most annuities are notorious for the high fees they charge. On average, you’ll pay about 2.3% in basic fees for a variable annuity, compared with 1.4% for the average mutual fund. And many variable-annuity providers tack on additional fees on top of that, like an annual “contract charge.” Another problem is the taxes. Withdrawals from variable an- nuities are taxed as ordinary income, which can run as high as 35%. But mutual-fund shares held in taxable accounts for more than 12 months are taxed at the lower capital- gains rates, which means you won’t owe more than 15% to Uncle Sam. Moreover, if you die still owning the annuity, your beneficiary could owe income tax as well as estate tax on the proceeds. That’s not true of mutual funds. Types of Mutual Funds Why are there so many different types of funds? Mostly because there are so many dif- ferent ways to invest. A fund manager’s job is to create a portfolio that blends different types of stocks and bonds to achieve the maximum return for a given level of risk. Some managers are more willing to roll the dice on risky stocks in search of high rewards. Oth- ers are more defensive, seeking reasonable gains without the threat of big losses. Some invest only in foreign stocks, some favor small companies, some like utilities — the list goes on. For investors, this diversity provides the opportunity to tailor a portfolio of funds to meet particular objectives. Take a 55-year-old man eyeing retirement in a few years. Seeking some growth but not much risk, he may put part of his money into a steady, large- company equity fund, while protecting the bulk of his nest egg in a money-market fund with lower — but virtually guaranteed — returns. A 30-year-old woman, on the other hand, has years to make up for any short-term investment losses. So she may want to put most of her money in a more aggressive equity fund that promises more risk, but higher returns. No Need to Get Fancy There are funds geared to just about any investment objective — from funds that buy only biotech stocks to those that invest only in Russian companies. This has encouraged some investors to move in and out of funds like stock traders, trying to time the market. What gets lost in the shuffle is a simple, time-honored principle: Investors do best if they pick a set of promising funds and leave their money in them for the long term. If all this sounds hopelessly confusing, it doesn’t have to be. Most people’s investment objectives can be satisfied without getting fancy. The truth is, there are only a few broad categories of funds that really matter to most people. Index Funds These are mutual funds that seek to produce the same return that investors would get if they owned all the securities in a particular index. The most common variety is an S&P 500 index fund, which tries to mirror the return of the Standard & Poor’s 500-stock in- dex. Index funds have the lowest expense ratios in the fund universe and are also very tax-efficient because of their low turnover ratios. They can be good funds for investors who don’t want all the hassle of researching mutual funds. Among investors, index funds can be a heated debate. Index funds are neither evil nor the answer to all your investment needs. An index fund can be a part of a well-diversified portfolio. As an investor, you should understand that index funds are not typically ac- tively managed. If the index your fund mirrors plunges, so will your fund. Actively man- aged funds on average trail index funds by 0.75 percent a year. To a large extent, this is because of the greater expenses that actively managed funds charge. Are index funds right for me? That’s the question many worried investors asked them- selves during the bear market. Most everyone was a fan of index fund investing back in the late 1990s, citing low fees, tax efficiency and all-around simplicity (and good returns sure helped). From 1995 to 1999, when the S&P 500 (the index most favored by inves- tors) returned more than 20% annually, it was easy to be a devotee of index funds. Things got a whole lot harder when the index posted tough losses three years in a row. In 2003, however, the sun came out once again and the index posted a 29% again. And over time, the return of this index has been decidedly positive: Since 1926, it’s delivered 10% average annual returns. So while you shouldn’t necessarily expect a smooth ride, index funds can still make up the backbone of a solid, long-term portfolio. After all, it’s difficult to beat the S&P 500 in the long run. Yes, a terrific fund manager should be able to beat the index. But most managers don’t. In fact, over the past five years, 53% of all mutual funds have underperformed the S&P 500 on a cumulative basis. The truth is, for many investors — particularly young ones just starting out — index funds remain the easiest, most effective way to go. If the goal is long-term growth and simplicity, these no-fuss funds are the best solution. So how do they operate? Technically, index funds do have managers, but they don’t have a lot to do. They simply buy all the stocks or bonds in a chosen index with the goal of matching that group’s performance. And what’s an index? It’s a grouping of stocks cho- sen to represent a certain market segment. The S&P 500 index, for instance, consists of large stocks. The Nasdaq Composite index is heavy on technology companies. And the Russell 2000 is a benchmark for small-cap companies. Index funds have other advantages: tax efficiency and low expenses. Since the manager doesn’t have to look actively for stocks, these funds are relatively cheap to operate. The Vanguard 500 Index fund, for example, has an incredibly low annual fee of 0.18% of your investment. The average large-cap fund charges more than seven times that much. It’s always good to diversity. A good strategy is to invest not only in an index fund of large-company stocks, such as the S&P 500, but also in a small-company stock index fund and/or in a foreign stock index fund. Bottom line? While index funds might not look all that attractive over the short term, they are one of the best options around for long-term investors. Major Indexes DOW JONES INDUSTRIAL AVERAGE (DJIA) The oldest, best known and most widely quoted stock market index. The DJIA re- flects a price-weighted average of 30 actively traded blue chip stocks. These 30 secu- rities represent between 15-20% of the market value of the New York Stock Ex- change traded stocks. S&P 500 An unmanaged group of stocks often considered representative of the stock market in general. This index is composed of 400 industrial, 20 transportation, 40 utility, and 40 financial companies. RUSSELL 2000 A commonly cited index of small-cap stocks. Exchange-Traded Funds Exchange Traded Funds (ETFs) are a cross between a stock and an index fund. Like mu- tual funds, ETFs are baskets of securities. Like stocks, ETFs trade on an exchange. Unlike regular mutual funds, ETFs can be bought and sold throughout the trading day. Anything you might do with a stock, you can do with an ETF. An ETF invests in a basket of stocks which mimics a chosen market index. An investor wanting to invest in an ETF may place an order with a broker just as he would do for any stock, with a similar procedure for selling them. Unlike an index mutual fund, where transactions are processed at the end of the trading day, investors can trade the ETFs on a real-time basis. You can buy and sell shares of the ETF at any time the market is open. On the plus side, ETFs have a lower management fee than most index funds. However, an investor has to pay a brokerage fee each time he buys or sells an ETF. Even with the low fees available at discount and online brokers these days, brokerage commissions can seriously erode ETFs’ low-expense advantage, especially when investing small sums of money. For example, if you were planning to invest, say, $100 a month in ETFs, even a cost of just $10 per trade would mean 10 percent of your investment is being siphoned off. So your ETFs’ price would have to rise 10 percent just to recoup your buying cost -- and you’ll have to pay a commission when you sell too. For this reason alone, ETFs are generally better suited for investors who are socking away larger amounts of money — as in 401(k) and IRA rollovers. If you’re more likely to be dollar-cost-averaging with small sums or you tend to invest sporadically with mod- est amounts of money, you’re probably better off in a regular mutual fund. Liquidity Risks of ETFs: While liquidity in a mutual fund is assured at NAV price, liquid- ity in ETFs are not. Rather ETFs are linked to the demand on the stock exchange. If trad- ing is light, there is a possibility that an investor may not be able to liquidate his ETF at the chosen time. Some ETFs offer an exit option to investors (through the fund) if there are no quotes on the ETF for five consecutive days. However, the exit load imposed in this case is quite large (2.5% of the NAV price). A Comparison of ETFs and Index Funds Comparison ETFs Index Funds Tax Efficient Not always good Good Min Investment Roughly $5,000 $50 Dividend Reinvestment No Yes Brokerage Commission to Cost to Buy Sell None on no-load funds both buy and sell Trades Minute by minute like a stock At the end of the day Stock Fund Types Stock funds are often grouped by the size of the companies they invest in — big, me- dium, small or tiny. By size we mean a company’s value on the stock market: the number of shares it has outstanding multiplied by the share price. This is known as market capi- talization, or cap size. Big companies tend to be less risky than small fries. But smaller companies can often offer more growth potential. The best idea is probably to have a mix of funds that give you exposure to large-cap, midsize and small companies. Large-Cap Stock Funds Large-capitalization funds generally invest in companies with market values of $8 billion or more, according to investment-research firm Morningstar. Some, like the Vanguard 500 Index fund, merely mimic the index and invest in all 500 companies. Others, like Fi- delity’s huge Magellan fund, try to beat the index by picking a mix of large caps that will outperform the broader market. Large-cap funds are typically less volatile than funds that invest in smaller companies. But that doesn’t mean you shouldn’t expect some bumps along the road if you invest purely in large caps. As we saw during the bear market (2000 to 2002), even the biggest companies can stumble badly. Nevertheless, over the long term, a fund that invests in well-established companies should offer a smoother ride than its smaller siblings. The trade-off is that you can expect slightly smaller returns. For most investors — particularly those with a relatively long investment horizon — a good large-cap fund can create a solid cornerstone of a portfolio. Mid-Cap Stock Funds As the name implies, these funds fall in the middle. They aim to invest in companies with market values in the $1 billion to $8 billion range — not large caps, but not quite small caps, either. The stocks in the lower end of this range are likely to exhibit the growth characteristics of smaller companies and therefore add some volatility to these funds. That said, their solid long-term record combined with their reduced risk when compared with small caps, makes them a good core holding for a young investor. Small-Cap Stock Funds A small-cap fund focuses on companies with a market value that’s typically below $1 billion. The volatility of the fund often depends on the aggressiveness of the manager. The most aggressive small-cap managers buy hot growth and technology companies, tak- ing big risks in hopes of big rewards. More conservative “value” managers look for com- panies that have been beaten down temporarily by the stock market. Because of their volatility, you should make sure when investing small-cap funds that you have enough time to make up for short-term losses. There are times when the market turns away from small-cap companies altogether for extended periods, as we witnessed most recently in 1998. Since then, however, small-caps have performed remarkably well, outperforming their peers during the bear market, and gaining a whopping 44% when the market turned around in 2003. What’s the bottom line? Small-cap funds can provide a good kicker for aggressive inves- tors who need to build as much wealth as possible while they’re young. Micro-Cap Stock Funds We’re talking about the smallest of small fries here — companies with market values be- low $250 million. These funds tend to look for start-ups, takeover candidates or compa- nies about to exploit new markets. With stocks this small, the volatility is always ex- tremely high, but the growth potential is exceptional. Wasatch Micro Cap, for instance, sported a five-year average annual growth rate of nearly 29% at the beginning of 2004. But, then again, during one three-month period in 2002, it shed 21.9%. If you’ve got a strong stomach and some money that you won’t need anytime soon, it could be worthwhile to invest in this type of fund. But beware: Micro-cap funds can rear up and bite you. Stock Fund Strategies Every manager is different, but there are three broad archetypes when it comes to invest- ment strategies: value, growth and blend. The issue here is whether the manager is, a) seeking to “discover” cheap stocks, betting that the market will eventually discover them, too; or b) willing to chase popular (a.k.a. expensive) stocks, hoping to cash in on their momentum. Value Funds These funds like to invest in companies that the market has overlooked or lost faith in. Managers search for stocks that have become “undervalued” — or priced low relative to their earnings potential. Sometimes a stock has run into a short-term problem that will eventually be fixed and forgotten. Or maybe the company is too small or obscure to attract much notice. And then there’s what can happen during times of economic uncertainty, when large groups of stocks get broadly punished, even though a specific company’s fundamentals haven’t necessarily changed. In any event, the manager makes a judgment that there’s more po- tential there than the market has recognized. His bet is that the price will rise as others come around to the same conclusion. The big risk with value funds is that sometimes the “undiscovered gems” they try to spot remain undiscovered. That can depress results for extended periods of time. With most value funds, however, volatility is low, and if you choose a good fund, the risk of long- term poor performance should be minimal. Also, because these fund managers tend to buy stocks and hold them until they turn around, expenses and turnover are low. Add it up, and value funds are suitable for many long-term investors. Growth Funds As their name implies, these funds tend to look for the fastest-growing companies on the market. Growth managers are willing to take more risk and pay a premium for their stocks in an effort to build a portfolio of companies with above-average earnings momen- tum or price appreciation. This group is the most volatile of the three investment styles. And unfortunately, when growth slows, watch out — the more momentum a stock has, the further it’s likely to fall when the news turns bad. That’s why only aggressive investors — or those with enough time to make up for short-term market losses — should buy these funds. Blend Funds These can go across the board, investing in both growth and value stocks. They might, for instance, hold some high-growth biotech stocks as well as some cheaply priced industrial cyclical stocks. That means they’re tough to classify in terms of risk. The Vanguard 500 Index fund invests in every company in the S&P 500 and could therefore qualify as a blend. But because it’s also a large-cap fund, it tends to be steady. The Legg Mason Spe- cial Investment fund, on the other hand, is more aggressive, with more than double the weightings in technology stocks than the S&P 500 as of the end of 2003. In order to de- termine if a particular blend fund is right for your needs, you’ll probably have to look at the fund’s holdings and make a judgment call. International Stock Funds It is indeed a small world, after all. But that doesn’t mean a good international fund shouldn’t be in your portfolio. Although the gap is closing, the economies of the world’s different regions still tend to boom and bust in cycles that offset each other. As a result, international stocks can provide excellent diversification for a portfolio heavy on U.S. stocks. International funds give you exposure to overseas markets at varying levels of risk. The narrower their geographic region, the riskier they can be. Consider the pummeling Asian funds endured during the outbreak of severe acute respiratory syndrome (SARS) in Sin- gapore, Hong Kong and China. In just nine short weeks toward the start of 2003, Pacific Asian funds (excluding Japan) lost 8%, according to Morningstar. Investors feared that the outbreak could not be contained and fled the region. But those who stayed put were rewarded when SARS fears soon receded. Funds investing overseas fall into four basic categories: world, international, emerging market and country specific. As always, diversification is the key to keeping risk in check. A good fund manager can also help, since research is scarce and foreign compa- nies are notoriously difficult for individual investors to track on their own. World Funds World funds are the most diverse of the four categories. But don’t be fooled by their cosmopolitan-sounding name. They’re able to invest in any region of the world, including the U.S., so they don’t actually offer as much diversification as a good international fund would. A prime example: Dreyfus Founders Worldwide Growth, which is 60.6% invested in North America and 37% invested in the United Kingdom and Western Europe. World funds tend to be the safest foreign-stock investments, but that’s because they typi- cally lean on better-known U.S. stocks. Foreign Funds These funds invest most of their assets outside the U.S. Depending on the countries se- lected for investment, foreign funds can range from relatively safe to risky. Fidelity Di- versified International, for instance, has its assets spread over more than 21 different countries, many of which are in Europe. Templeton Foreign, on the other hand, has sig- nificant exposure to some of the most traditionally volatile regions in the world, with a 24% weighting in Pacific Rim countries such as Thailand, South Korea and Hong Kong. The average foreign fund has a less than 10% stake in these regions. The best thing to do is to choose a fund with the best balance, or make sure the manager has done a good job of moving in and out of regions profitably. Country-Specific Funds These funds invest in one country or region of the world. That kind of concentration makes them especially volatile — particularly if you pick a fund that invests in a country that’s viewed as an emerging market (see below). Granted, if you pick the right country at the right time — like Russia in 2003, for example — the returns can be substantial. But pick the wrong one, and watch out. Only the most sophisticated investors should venture into this territory. Emerging-Markets Funds Emerging-markets funds are the most volatile. They invest in undeveloped regions of the world, which have enormous growth potential, but also pose significant risks — political upheaval, corruption and currency collapse, to name just a few. Of course, as the recent bear market taught us, domestic stocks can be extremely volatile as well. So adding a small slice of emerging-markets exposure to your portfolio could be one way to reduce the overall risk of your portfolio. We still wouldn’t recommend this group to a short-term investor, but long-term investors will find that the best way to cut risk is to have one’s fingers in many pies. Sector Stock Funds Sector funds do what their name implies: They restrict their investments to a particular segment — or sector — of the economy. Vanguard Health Care, for instance, only buys only health-care companies for its portfolio. No matter which sector you’re interested in investing in, chances are there’s a fund that tracks it. Fidelity, for example, has a whole stable of sector funds from Fidelity Select Insurance to Fidelity Select Automotive. The idea is to allow investors to place bets on specific industries or sectors whenever they think that industry might heat up. While such a strategy might appear to throw diversification to the wind, it doesn’t en- tirely. It’s true that investing in a sector fund definitely focuses exposure on a certain in- dustry. But it can give you diversification within that industry that would be hard to achieve on your own. How? By spreading your investment across a broad swath of stocks. Of course, such concentrated portfolios can produce tremendous gains or losses, depend- ing on whether your chosen sector is in or out of favor. For example, in 1999 technology funds soared by an average of 135% — only to crash miserably during the next three years. When the economy finally started to recover in 2003, however, these funds were once again ahead of the pack, gaining 75.5%. Needless to say, sector funds carry more risk than generalized funds. That’s why we sug- gest that you don’t invest more than 5% of your total portfolio in a specific sector. But some sectors are clearly more volatile than others. For example, MFS Utilities, which holds mostly conservative, income-producing stocks, has about one-half the volatility of the Franklin Biotechnology Discovery fund. The lesson here? Sector funds are a great way to spice up a portfolio. But like Tabasco sauce, a little goes a long way. Choosing Mutual Funds If mutual funds are supposed to make investing easier, then why is choosing one so often such an anguishing experience? Maybe it’s because there are more than 8,250 funds available — 8,000 of which you’ve never heard of before. Maybe it’s because an alarmingly large number of them lag the market over the long run. A good mutual fund can help pay for your retirement. But what makes a good fund and where do you find one? The Web offers you some great research and information tools to aid you in your quest to find the right funds. But before we get started with all the fine points of picking good mu- tual funds, there’s something that you should know: You can save yourself a whole lot of trouble and just about guarantee success by simply choosing an index fund and holding on to it for the long haul. Index Funds As has been stated, index funds are cheap. They’re tax-efficient. And they routinely beat the majority of actively managed funds. Over the past 10 years, only 30% of domestic equity funds beat the S&P 500. And over the past 20 years, only slightly more than 12% did, according to investment-research firm Lipper. What are the chances that you would have picked one of the few winners? They’re probably pretty remote! Fund of Funds A fund of funds is exactly what it sounds like. It’s a mutual fund that invests in other mu- tual funds. At first this may seem redundant to you, but here are some big advantages to investing in a fund of funds: • Double Diversification—A mutual fund diversifies across many different stocks. A fund of funds diversifies among many different funds. • Simplicity—Instead of investing in many different funds to achieve the same re- sult, you can just invest in one fund. This allows for much less paperwork. • Cheap for Beginning Investors—It’s tough to diversify when starting out be- cause of account minimums. A fund of funds allows the investor to diversify among hundreds or thousands of stocks in one small account. • Institutional Advantages—A fund of funds can often invest in large institutional funds that are too expensive for small investors. They also have the ability to in- vest in some load funds without paying the load. There are some of the disadvantages also: • Extra Fees—Some fund of funds will charge fees at the “parent level.” Therefore you end up paying double maintenance fees. It would be cheaper for the investor to buy the same mutual funds themselves. • Expense Ratios—Some fund of funds have high expense ratios which will drag down returns over time. Depending on your situation, investing in a fund of funds may make sense for you. It is an attractive option for new investors. Before investing in a fund of funds, take a close look at the expense ratios to make sure they are not too high. Life-Cycle Funds Most people would be delighted to find a simple, one-stop-shopping opportunity to pick investments. That would be an index mutual fund or a fund of funds — it’s like shopping at Super Wal-mart. Better yet would be a one-shot-lasts-a-lifetime investment — one that adjusts itself automatically as you get older and, presumably, more conservative. Now there is such a product: life-cycle mutual funds. Starting in the early 1990s, many mutual fund families began offering “life-cycle” funds designed to carry investors from one stage of life to the next. Life-cycle funds, also re- ferred to as “age-based funds” or “target-date funds”, are a special breed of the balanced fund. They are a type of “fund of funds” structured between growth and preservation of capital. The distinguishing feature of the life-cycle fund is that it automatically adjusts to become more conservative as you approach retirement. Although lifecycle funds all share the common goal of first growing and then later preserving principal, they can contain any mix of stocks, bonds, and cash. The manager of each life-cycle fund periodically shifts his holdings to a more conservative mix, replacing stock funds with bond funds and bond funds with cash funds. A 2020 fund might have 70 percent stock holdings now, for example, and be expected to have only 20 percent stocks when 2020 rolls around. It’s a natural and desirable progression: The closer you get to retirement, the less expo- sure you have to stock market gyrations and the more investments you have in stable, in- come-producing securities. That automatic rebalancing is a major attraction for life-cycle funds. The fact is that most investors know they need to switch to more conservative allocations as they get older, but many never get around to it. Surveys show people who participate in employer-sponsored retirement plans often don’t change their asset allocations once they sign up because they just don’t know what to do. Life-cycle funds put the decision on how to allocate your contributions in the hands of professionals. Life-cycle funds are a good choice for people who don’t have time, the energy or the in- clination to manage a portfolio. It’s the simplest way to assure that you have a diversified portfolio that is generally appropriate to your age. Vanguard Example To get a better understanding of how these funds work, let us compare two Vanguard life-cycle funds. The Vanguard Target Retirement 2025 Fund is designed for people who plan to retire in 2025. As of Sept 30, 2004, the asset mix for this fund was as follows: In comparison, the Vanguard Target Retirement 2015 Fund has a more conservative mix. It has more fixed income assets and also contains some inflation-protected securities. Fidelity vs. Vanguard While all life-cycle funds are similar in concept, they can be structured and maintained differently. When shopping for a life-cycle fund there are some important factors to con- sider. Let’s compare Fidelity and Vanguard—the two largest suppliers of these funds. Both have different management styles for their funds. Fidelity offers actively managed funds, while Vanguard uses passively managed funds. Because of this Fidelity charges more in maintenance fees. When comparing different life-cycle funds, beware that the same retirement date does not necessarily mean the same level of risk. For example, the Fidelity Freedom 2025 Fund has an equity weighting of 75% stock funds. Vanguard’s equivalent fund has an equity weighting of 59% stock funds. Because of this the Fidelity Freedom 2025 assumes a greater level of risk. You should not take this difference in the fund’s risk profile lightly. You need to decide what type of risk exposure is right for you. Many life-cycle funds, specifically the target date funds, use age as the overriding factor in determining how much of your money to put in stock, bonds or cash. That concept is OK if you believe that everybody who is 30 has the same tolerance for risk as everyone else who is 30. However, your risk profile is not necessarily a function of age! Here are some things to keep in mind: Risk. Some managers choose more aggressive investments, and some choose to move out of the stock market slower than others. Cost. There are a few life-cycle funds that take a 5.75 percent of your investment upfront, to pay sales commissions. As usual, Vanguard charges the lowest maintenance fees. Its 2025 fund, for example, has an annual expense of just 0.22 percent. Life-cycle funds have gained popularity for their sensibility and simplicity. Many inves- tors are overwhelmed by the responsibility of managing their retirement portfolio and by the bewildering number of investing options facing them. Life-cycle funds bring sanity to all of this with a solution that delivers simplicity, focus, and peace of mind. Why Choose an Actively Managed Fund? So if index funds or life-cycle funds are such a good solution, then why bother looking for an actively managed fund? Here are a few reasons ... • Because you believe a certain fund manager can beat the market indexes. • Because you want a fund manager who practices a particular style not offered by index funds. • Because you want to invest in a specific market sector, like health care or finan- cial services. During the last bear market while the S&P 500 lost value many of the sector funds posted some great returns. • Because you simply feel more comfortable knowing that a human being is picking the securities in your fund. Life-cycle funds are great for many people, but not for all. They are mass-market prod- ucts, with no allowances for individual circumstances, goals and attitudes about invest- ing. If you would like an actively managed fund, but you don’t want to spend the time doing a lot of research, there are financial websites that offer good suggestions. Here are a few: • ! " # $ • • % It should be obvious, but before you can intelligently choose a mutual fund, you have to have a basic understanding of how mutual funds work. Define your investment goals. Are you saving for retirement? Putting some money aside for a house down payment? Funding your children’s college education? Your answers could lead you in several different directions and that could narrow the field of appropri- ate funds significantly. You should set up an asset allocation program, and then consider matching your fund picks to your suggested allocations — large-cap stocks, intermediate-term bonds, etc. Most studies show that a properly allocated portfolio is crucial to maximizing your re- turns. Here’s a tool to help you determine an asset allocation program: & ' % ( ( ( Finally, you have to decide how much risk you want to take. The more time you have un- til you need your money, the more aggressive you can be. But you also have to consider how comfortable you are with volatility. If your fund dips 5% or 10% one month, is it going to keep you up at night? OK, now the search can really begin. You know what type of fund you’re looking for — let’s say you’re hoping to fill the large-cap stock portion of your asset-allocation program — and you know how much risk you’re willing to take — a moderate amount, as long as the returns are good. What you need is a way to narrow the field down to a manageable list of potential candidates. If you’re investing through a 403(b) plan, your choices may already be narrowed for you. In that case, you simply have to find the fund that provides the best fit. Otherwise, there are several ways to focus in. You can ask a broker to help you — an expensive option. You can examine the offerings of a trusted fund company like Fidelity or Vanguard. Or you can use a fund finder offered by a number of websites. Here’s some useful tools: • % • " ) # $' ) You may have heard the phrase before: “Past performance is no indicator of future re- sults.” It’s written in tiny print at the bottom of every mutual fund advertisement — right below the part where they brag about their past performance. It’s true that investors should never assume that the past will repeat itself. But those who ignore a mutual fund’s historical record do so at their own peril. It’s the best measure we have of a fund man- ager’s competence. Interestingly, past performance is probably a better predictor for the stinkers than it is for the highfliers. A 1998 study of ongoing performance by fund-tracking firm Morningstar, found that while its four- and five-star funds (the best performers) didn’t necessarily re- main atop the charts, its one- and two-star funds did continue to flounder. The lesson is pretty obvious — you should always strive to avoid the perennial losers. How should you evaluate performance beyond that? First, examine multiple time periods. Many investors get burned by heeding the siren song of last year’s hot fund. Take the Van Wagoner Emerging Growth fund (VWEGX), which finished 1999 above all U.S. equity funds with a 281% gain, then plunged 21% in 2000 and more than 59% in 2001, landing at the bottom of the barrel. Had you been wowed by the ‘99 gain, but checked the fund’s three-year record, you would have seen its erratic history. That’s a red flag that management isn’t fully in control. What if you have a more ordinary that does not fluctuate wildly? How do you tell how good that really is? The best way is to compare its numbers to both a relevant benchmark index (like the S&P 500 or other funds in the same category) as well as other funds with similar objectives. A great tool to help you evaluate mutual funds is Morning Star. Here’s an example: As you can see by the graph, this fund has outperformed both the S&P 500 and other funds in its own category. It also has a 5-star rating which is the highest the Morning Star gives. But you should remember that just because a fund gets a 5-star rating today is not guarantee that it will maintain that 5-star rating. It’s wise to make sure you’re comfortable with the fund’s risk profile and its propensity for short-term volatility. After all, if your fund choice is going to make you sick with worry, what’s the point? Risk is generally a function of investing style. There are two broad categories most fund managers fall into. Some managers chase popular, but risky, companies with high earn- ings growth. Others look for undiscovered bargain stocks, hoping that their prices will pick up over time. Growth funds (run by the former) tend to suffer wider short-term price swings and more turnover. Volatility, of course, isn’t always bad — as long as it comes with added returns. Value funds (run by the latter) are less volatile on the downside, but you sometimes pay for that with less dramatic upside. Morning Star ratings, which range from one to five stars (five being the best), take into account both a fund’s performance and its risk for the life of the fund. Basically, Morn- ingstar subtracts the fund’s risk score from its performance score. A five-star rating means a fund has scored in the top 10% of its Morningstar category, while funds with fours stars fall into the next 22.5% of their category, and so on down the line. Please remember that “risk tolerance” has more to do with time than temperament. The more time you have to make up for short-term losses, the more aggressive you can be with your investments. The easiest way to reduce the risk of investing — and improve the gain — is to increase the time you hang on to your investments. However, if you’re sav- ing for a short-term goal, then your tolerance for risk would be significantly less. You can never predict what a fund will earn next year. But you can almost always predict what its expenses will be. So, why not control what you can? No-load funds with low an- nual expenses are certainly preferable. Here are some tips: • Try not to buy funds with expense ratios greater than the sector average. For large-cap funds, that was 1.30% at the beginning of 2003. For small-cap funds, it was 1.48%. For foreign-stock funds, it was 1.71%. And for taxable bond funds, it was 0.95%. • When viewing similar load and no-load funds with equal returns, choose the no- load. • However, don’t be so rigid as to always rule out load funds. Some funds like Growth Fund of America (AGTHX) have actually made up for their loads with strong returns and low volatility. Furthermore, many of the best-performing sector funds, like Fidelity Select Insurance (FSPCX) and Fidelity Select Financial Services (FIDSX), come with 3% sales charges. Generally, the longer you plan to stay in a fund, the less an upfront load matters. • If you do buy a load fund, long-term investors should select the class “A” shares that charge a high upfront load, but have little or no annual fees (used for market- ing and distribution). Short-timers should stick with share classes that have low loads but higher 12b-1s. Then there are taxes. They can sneak up and bite you, too, if you’re not careful. Unless you hold your fund in an IRA or other tax-advantaged retirement account, a fund’s tax- able distributions reduce your after-tax gain. One of the best ways to avoid big distributions is to find funds with low turnover. That means the manager isn’t churning his portfolio all year, generating capital gains in an at- tempt to boost returns. The basic guideline is this: Investors should avoid funds with turnover above 80%. (A turnover of 100% means the manager replaced holdings repre- senting the entire value of the fund during the latest 12-month period.) The rule doesn’t apply so easily to bond funds, whose securities mature and must be replaced. Remember that index funds have a very low turnover. Tax-conscious investors should also avoid funds with high dividend yields. That’s be- cause dividends are taxed at income-tax rates as high as 38.6% (in 2003) rather than the lower capital gains rates (on holdings of 12 months or more). And, if you’re really op- posed to taxes, you should consider index funds, which are generally the most tax- efficient type of funds. Their holdings should only change when the composition of their benchmark index does or when the fund needs to pass out redemptions to shareholders. While we’re on the topic of expenses, make sure to see if the minimum initial investment of this fund is within your means. When you invest in a fund, you’re really investing in a manager or a team of managers. These are the people who decide when a stock or bond should be bought or sold for the fund. When the manager leaves, much of the skill of running the fund goes with him or her. This is less true of some of the bigger fund firms, such as the American funds, which are run by teams of managers, and Fidelity and T. Rowe Price. All these companies have skilled teams of analysts to supplement the work of the manager. With a team-managed fund, you may never know exactly who is making the key decisions regarding the portfo- lio. However, it can be reassuring to know that several people know the ropes at the fund, and continuity is practically guaranteed if a manager departs. So when you’re considering a fund, make sure you look at how many years the manager has been on the job. If the manager has been around just two years, consider only those two years in judging the fund’s record. The previous record belongs to someone else and is beside the point. Likewise, if a manager has moved around a lot, it can be useful to look at his returns from his previous jobs — information a fund company can furnish. But what if you’re considering a fund with a new manager? Track down his or her previ- ous record. (Often the manager transferred from another fund at the same fund company). If the manager’s history is cloudy, consider buying a different fund. You should also keep in mind that a change in fund management can often lead to high portfolio turnover (and high taxes) as the new manager shapes the fund to his or her own liking. To get to know a manager, read articles about him or her in Kiplinger’s Personal Finance or other sources. Call the fund and order a recent annual report. Often funds will mail you articles about the manager. Some Sound Advice Don’t obsess over past results Nothing is more attractive than a fund with a great record. With the market’s perform- ance so pathetic in the last couple of years, any fund that boasts double-digit returns looks like a lifesaver. But some lifesavers turn out to be waterlogged. Past performance is a good starting point in your search for a great fund. But it’s hardly the end of the quest. Look for consistency Don’t pay too much attention to the top-performing funds of the past 12 months. Recent performance doesn’t mean a lot. What does is long-term success. Look at performance over three, five, or ten year spans, more if possible. Also be sure that past performance can be attributed to the current fund manager. Any fund can get lucky — have a great few months, or even a year. What you want are funds that are good year after year after year. That demonstrates an ability to do well un- der any number of conditions, not just dumb luck. Compare the fund’s performance over the past five years versus other funds that employ the same investment style. Avoid comets — funds that have one great year and then flame out. A fund that’s in the top 10% among its peers one year may turn out to be a comet in the longer run. It’s not necessary for a fund to be in the top 10% every year, or any year, for that matter. What you want are funds that stay above average almost every year. Beware volatility The issue of volatility is a tale of the tortoise and the hare, except that in this context the hare sometimes wins the race. Like the hare, some funds bounce around a lot — topping the performance charts one month only to end up in the cellar the following month. Most investors should own both low-risk and moderate-risk stock funds. But a fund that has achieved superior returns relative to its volatility rank is usually worth a close look. Some studies show that such funds are more likely to continue to be good performers than are funds that achieve slightly higher returns but with greater volatility. Watch your dimes Your chances of picking a fund that will deliver above-average results over time increase the more you can get the wind at your back. This means keeping your eye on seemingly small things, such as how much you pay in annual expenses to the fund. Every cent you pay in expenses is money out of your pocket. In general, you don’t want to pick a high-expense fund if there’s an equally attractive fund with lower expenses. U.S. no-loads have an average expense ratio of 1.14%. Inter- national no-load funds average 1.44% per year, and bond funds 1.10%. Expenses are es- pecially important when choosing bond or money-market funds, where returns are some- times slender. A mutual fund with a high expense ratio is almost guaranteed to do poorly. An expense ratio of 1.25 percent is normal. (Expense ratio equals expenses divided by assets.) When funds do poorly, their shareholders leave and expenses go up. When funds do well, shareholders climb on board and expenses usually go down (except in the case of espe- cially greedy fund families). In addition to keeping your expenses low, you should almost always avoid funds that as- sess loads or sales charges. A load is a payment that goes to a financial adviser, broker or insurance agent for helping you pick a fund, or sometimes it goes directly to the sponsor of the fund. The load may be assessed when you buy the shares, or it may be taken out annually in the form of a so-called 12b-1 fee, which can amount to up to 1% per year. The point is simply this: If you’re picking a fund on your own, why pay this ransom? Compare apples to apples Funds can be divided into major investment styles, from funds that invest in stocks of small, undervalued companies to funds that invest in stocks of large, fast-growing com- panies. Comparing a fund with another fund that doesn’t practice the same investment style is a bit like measuring the speed of an SUV against the speed of a race car. You should evaluate a fund’s performance versus others that have the same investment style (or against an appropriate benchmark index). Don’t fall in love The hardest thing about investing is knowing when to sell. It’s almost always more diffi- cult than buying a fund. Once you’ve bought a particular fund, it’s yours and tough to let go of, no matter how bad things get. The temptation is to hold on until you break even, or at least until a fund bounces back. But bounces can be small and then cease. It’s very hard to recognize (or admit) a mistake, cash in your chips and move on. What’s the best way to surmount this hurdle? Look at your funds dispassionately, as you would if you were deciding what to buy. If you wouldn’t buy one of the funds you own today, then sell it, and replace it with something better. Every fund has a bad year. Hold on if a fund falls behind its peers for a year. But after two or especially after three years of below-average results, it’s time to either find out what is holding the fund back and be satisfied with the explanation, or pull the plug. Pay the piper When you sell a fund that’s not tax exempt or tax deferred, you’ll likely have to pay capi- tal-gains taxes. Funds are also required to distribute taxable gains to you and other inves- tors at least once each year. Many investment “experts,” who should know better, advise investors to stay with funds that have big gains (even if their prospects aren’t so hot), as well as to shop for so-called tax-efficient funds — that is, funds that use techniques to minimize the taxes you must pay until you sell your shares. Those are bad ideas. The fact is, you will eventually have to pay taxes on your gains in funds. The only question is whether to pay up sooner or later. The difference is peanuts, no matter how tax-efficient the fund is — unless you can salt money away in a tax- managed index fund for 20 or 30 years. The thing to do is find the best funds you can and pay the taxes each year on your share of their income and capital gains they produce. And don’t lose sight of one important, and positive, aspect: The higher your taxes, the more money you’ve made. Stay away from gimmicks Mutual funds are in business to make money. At times, that means marketing takes the lead over common sense. In the late 1990s, the market was flooded with technology and Internet sector funds. The recent bear market has seen a propagation of bear-market funds, gold funds and funds that claim they’ll do well no matter how the market behaves. Unless your portfolio doesn’t have enough holdings in technology or health or real estate, you’re probably best off avoiding sector funds. You are better off sticking to diversified funds. Such funds give managers more freedom to invest in the best stocks they can find. After all, that’s what you’re paying them to do. A Few Notes on Taxes and Investing Non-Retirement Accounts With non-retirement accounts you may have to pay a Capital Gains tax and/or Distribu- tions tax at the end of the year. If you sell all or a portion of your mutual fund you will have to pay taxes on any gains that you made. That also true if you switch holdings from one mutual fund to another mutual fund even if it’s in the same family of funds. Retirement Accounts It’s wise to put as much money as you can — as early as you can — in a tax-deferred re- tirement account. The government has thrown you a bone. You simply can’t afford to waste it. Retirement accounts aren’t really magic, but they seem that way. That’s because your earnings are allowed to grow tax-deferred until you reach retirement age. Over a long pe- riod — say 25 years — the power of compounding will more than compensate for the fact that your accumulated profits will eventually be taxed at ordinary rates as you liqui- date the account. Compounding is a multiplier effect: The more you have in the account, the faster it grows. To see what we mean, take a look at the table below. It shows how much you’d have (af- ter you pay your tax bill) if you invested $5,000 annually in a taxable account versus a tax-deferred account over various time periods. As you can see, the longer your invest- ment horizon, the better off you are investing in a deferred account. Tax-Deferred vs Taxable Investing After-Tax Taxable Tax- Value After: Account Deferred 5 yrs. $21,555 $22,572 10 yrs. 51,090 55,737 15 yrs. 91,709 104,468 20 yrs. 147,726 176,069 25 yrs. 225,135 281,275 Figures based on a $5,000 annual pretax investment in the tax-deferred account and a compa- rable after-tax investment in the taxable account, with each earning an 8% average annual return. Source: T. Rowe Price Associates. Of course, 403(b)s have other advantages. You’re reducing your annual taxable income, which means a smaller bill each year come tax time. 403(b) Plan This is a retirement-savings plan for employees of colleges, hospitals, school districts and nonprofit organizations. The plan, which is similar to the 401(k) plan offered to many corporate employees, is funded by employees with contributions that are deducted from pretax pay. Employees manage the investment accounts themselves. Investment gains aren’t taxed until the money is withdrawn after retirement. Withdrawals before age 59½ are subject to a 10% penalty charge. Traditional IRA This is another tax-deferred retirement plan that can help build a nest egg. Individuals whose income is less than a certain amount can generally deduct some or all of their an- nual IRA contributions when figuring their income tax. This can help reduce a person’s tax burden. A 403(b) has the added advantage of also reducing self-employment tax. The contributions grow tax-deferred until withdrawn. Withdrawals before age 59½ are subject to a 10% penalty charge. Roth IRA This is a special type of IRA established in the Taxpayer Relief Act of 1997 that allows taxpayers, subject to certain income limits, to save for retirement while allowing the sav- ings to grow tax-free. Taxes are paid on contributions, but withdrawals, subject to certain rules, aren’t taxed at all. A single person can contribute up to $3,000 and a married cou- ple up to $6,000 annually to this type of individual retirement account. Those who will be age 50 or older at year-end can contribute an extra $500 annually. Under special circumstances you can withdraw funds from your Roth IRA before you reach age 59½ without paying taxes or a penalty. How? Your Roth IRA funds must be at least five years old. Also, the money you withdraw must be used specifically in cases of disability, death, or the purchase of a first home ($10,000 lifetime limit) for you or your immediate family. Asset Allocation Diversifying Between Asset Classes In its simplest terms, asset allocation is the practice of dividing resources among different categories of investments. The theory is that the investor can lessen risk because each as- set class has a different correlation to the others; when stocks rise, for example, bonds often fall. At a time when the stock market begins to fall, real estate may begin generat- ing above average returns. The amount of an investor’s total portfolio placed into each class is determined by an as- set allocation model. These models are designed to reflect the personal goals and risk tol- erance of the investor. Furthermore, individual asset classes can be sub-divided into sec- tors (for example, if the asset allocation model calls for 40% of the total portfolio to be invested in stocks, the portfolio manager may recommend different allocations within the field of stocks, such as recommending a certain percentage in large-cap funds, mid-cap funds, small-cap funds, sector funds, etc.) Asset Allocation Model Determined by Need Although decades of history have conclusively proved it is more profitable to be an owner of corporate America (i.e. stocks), rather than a lender to it (i.e. bonds), there are times when stocks are unattractive compared to other asset classes such as bonds. A widow, for example, with one million dollars to invest and no other source of income is going to want to place a significant portion of her wealth in fixed income investments that will generate a steady source of retirement income for the remainder of her life. Her need is not necessarily to increase her net worth, but preserve what she has while living on the proceeds. A young person just out of college, however, is going to be most inter- ested in building wealth. He can afford to ignore market fluctuations because he doesn’t depend upon his investments to meet day to day living expenses. A portfolio heavily con- centrated in stocks, under reasonable market conditions, is the best option for this type of investor. Asset Allocation Models Most asset allocation models fall somewhere between four objectives: preservation of capital, income, balanced, or growth. Model 1 - Preservation of Capital Asset allocation models designed for preservation of capital are largely for those who ex- pect to use their cash within the next twelve months and do not wish to risk losing even a small percentage of principal value for the possibility of capital gains. Investors that plan on paying for college, purchasing a house or acquiring a business are examples of those that would seek this type of allocation model. Cash and cash equivalents such as money market accounts, treasury bonds and commercial paper often compose upwards of eighty- percent of these portfolios. The biggest danger is that the return earned may not keep pace with inflation, eroding purchasing power in real terms. Model 2 – Income Portfolios that are designed to generate income for their owners often consist of invest- ment-grade bonds, fixed income securities (bonds of large, profitable corporations), real estate (most often in the form of Real Estate Investment Trusts, or REITs), treasury notes, and, to a lesser extent, shares of blue chip companies with long histories of continuous dividend payments. The typical income-oriented investor is one that is nearing retire- ment. Another example would be a young widow with small children receiving a lump- sum settlement from her husband’s life insurance policy and cannot risk losing the prin- cipal; although growth would be nice, the need for cash in hand for living expenses is of primary importance. Model 3 – Balanced Halfway between the income and growth asset allocation models is a compromise known as the balanced portfolio. For most people, the balanced portfolio is the best option not for financial reasons, but for emotional. Portfolios based on this model attempt to strike a compromise between long-term growth and current income. The ideal result is a mix of assets that generates cash as well as appreciates over time with smaller fluctuations in quoted principal value than the all-growth portfolio. Balanced portfolios tend to divide assets between medium-term investment-grade fixed income bonds and shares of large- cap mutual funds. Real estate holdings via REITs are often a component as well. Model 4 – Growth The growth asset allocation model is designed for those that are just beginning their ca- reers and are interested in building long-term wealth. The assets are not required to gen- erate current income because the owner is actively employed, living off his or her salary for required expenses. Unlike an income portfolio, the investor is likely to increase his or her position each year by depositing additional funds. In bull markets, growth portfolios tend to significantly outperform their counterparts; in bear markets, they are the hardest hit. For the most part, up to one hundred percent of a growth modeled portfolio can be invested in common stocks, a substantial portion of which may not pay dividends and are relatively young. Portfolio managers often like to include an international equity compo- nent to expose the investor to economies other than the United States. Changing with the Times An investor that is actively engaged in an asset allocation strategy will find that his or her needs change as they move through the various stages of life. For that reason, some pro- fessional money managers recommend switching over a portion of your assets to a differ- ent model several years prior to major life changes. An investor that is ten years away from retirement, for example, would find himself moving 10% of his holding into an in- come-oriented allocation model each year. By the time he retires, the entire portfolio will reflect his new objectives. Model Portfolios The following are a set of model portfolios that are expected to achieve various rates of return with the lowest amount of risk. These models suggest how you might balance your portfolio based on your tolerance for risk. Model Portfolios Continued Common Allocation Mistakes In building a retirement portfolio it’s important to accommodate what sometimes seem to be conflicting goals. Of course, your strategy should be designed for your personal goals and circumstances. These are only guidelines and there is no guarantee any particular strategy will succeed. Putting all your eggs in the equity basket Even if you’re an aggressive investor comfortable with considerable fluctuations in your portfolio value, consider keeping some part of your accumulation in other asset classes to offset the volatility of stocks. Diversification is the best strategy for reconciling low risk with strong performance. Investing too conservatively Even if you’re a cautious investor, you want to realize gains that outpace inflation over time; otherwise it’ll be difficult, if not impossible, to fund the standard of living you want and to maintain your purchasing power in retirement. Many people shy away from funds that invest in stocks because they fear the stock market’s volatility but short-term swings shouldn’t obscure its potential longer-term advantages. Putting even a small part of your retirement portfolio in mutual funds that invest in stocks will allow you to benefit from any high returns in the future. Allocating long term to a Money Market Account Money market accounts works best as a temporary holding place for funds if you’re un- certain about where to put them and need time to decide. However, most money market accounts do not even keep up with inflation. Chasing performance Constantly switching from one fund to another in pursuit of performance rarely works. Market timing is especially hazardous, since you have to guess right twice predicting both highs to sell on, and lows to buy on. If you don’t time your moves correctly, your future retirement income will suffer, either because of actual losses or because of gains you missed out on. Steady, consistent investment over time, combined with judicious pe- riodic assessment of your needs, goals, and portfolio balance, offers a sensible approach to retirement savings. GLOSSARY ACTIVE MANAGEMENT Ongoing supervision of a portfolio and its holdings to achieve maximum results. Active management is one of the main benefits of investing in a mutual fund. ADJUSTABLE RATE MORTGAGE FUNDS (ARMs) A fund that invests primarily in adjustable rate mortgage securities. Funds in this cate- gory usually attempt to maintain a relatively stable net asset value, but can still be volatile in times of rising or falling interest rates. During periods of rising interest rates, investors stand to make more money, but homeowners faced with the prospect of paying more tend to prepay, prematurely canceling the investor’s expected income. During periods of fal- ling interest rates, the value of adjustable rate mortgages decreases relative to other fixed income securities. AGGRESSIVE GROWTH FUNDS A fund with an investment objective of rapid growth of capital. Aggressive growth funds usually include funds that invest in smaller companies, funds that invest heavily in a sin- gle industry, and funds that employ riskier investment techniques such as leveraging and short selling. ADVISER The company that takes primary responsibility for managing a mutual fund. The adviser receives an annual fee for this service, usually ranging between 0.50% and 1% of a fund’s total assets. AMBAC INDEMNITY CORPORATION One of the largest private insurers of municipal bonds. This insurance provides that the bonds will be purchased from an investor at par value should the bond issuer default. Municipal bond funds featuring insured bonds tend to provide a higher degree of safety than funds without such insurance, but they also tend to offer a lower yield. ANNUAL AND SEMIANNUAL REPORTS Reports issued twice a year to a fund’s shareholders detailing the fund’s performance, portfolio holdings and current investment strategy. ANNUITY A tax-deferred investment product sold by insurers, banks, brokerage firms and mutual fund companies. Fixed annuities provide a rate of return that is fixed for a year or so but then can move up and down. Variable annuities allow investors to allocate their money among a basket of mutual fund-like sub accounts; the return depends on the performance of the funds selected. Watch out for high sales commissions, expense ratios and penalties for early withdrawals. APPRECIATION An increase in a fund’s value. ARMs (Adjustable rate mortgage funds) ARMs are mortgages that require the real estate buyer to pay an interest rate that is peri- odically adjusted. The amount of the rate is tied to some index outside the control of the lender, such as the interest rate on U.S. Treasury bills. Like fixed-rate mortgages, ARMs are often grouped by a government agency and sold as a single security, with investors receiving payments out of the interest and principal on the underlying mortgages. Funds that invest primarily in these ARM-backed securities are called Adjustable Rate Mort- gage Funds. ASIAN FUNDS A fund that invests primarily in the stocks of companies located in Asia. These funds ap- peal to investors who believe that Asia potentially represents a growth area, and want to capitalize on that growth. ASK PRICE Also known as the offering price, the ask price is the amount at which a mutual fund’s shares can be purchased. To calculate the ask price, add a fund’s current net asset value per share to its sales charge, if any. ASSET ALLOCATION An investment technique that diversifies a portfolio among different types of assets such as stocks, bonds, cash equivalents, precious metals, real estate and collectibles. When it comes to risk and reward, different asset classes behave quite differently. Stocks, for in- stance, offer the highest return, but they also carry the highest risk of losses. Bonds aren’t so lucrative, but they offer a lot more stability than stocks. Money-market returns are puny, but it’s highly unlikely you’ll lose your initial investment. An asset allocation strat- egy allows you to achieve the optimal blend of risk and reward. ASSET ALLOCATION FUND A fund that invests in a variety of asset classes, including domestic and foreign stocks and bonds, money market instruments, precious metals, and real estate. Some asset allo- cation funds maintain a relatively fixed allocation between asset classes, while others ac- tively alter the mix as market conditions change. ASSET-BACKED SECURITY A debt instrument collateralized by credit card receivables, auto loans, or other assets and securitized by a bank or other financial institution. ASSETS A fund’s investment holdings and cash. Holdings can include stocks, rights, warrants, options, bonds, CDs, RANs TANs and BANs. AUTOMATIC INVESTMENT A shareholder service that allows the periodic withdrawal of a specified amount from the shareholder’s bank account to be invested in his or her mutual fund account. Some mu- tual fund groups also offer this service as a payroll deduction plan. (See also “dollar cost averaging.”) AUTOMATIC REINVESTMENT A shareholder service that authorizes dividend and capital gain distributions to automati- cally purchase more fund shares. Taxes still must be paid on the amount reinvested even though no funds are received directly by the investor. AUTOMATIC WITHDRAWAL A shareholder service that entitles an investor to fixed payments, every month or quarter. The payment comes from the dividends, income and/or realized capital gains on securi- ties held by the fund. This service is often chosen by retirees who want to receive a regu- lar income supplement. AVERAGE ANNUAL TOTAL RETURN A standard measurement of fund performance that includes dividends, gains, and changes in share price. AVERAGE LIFE The weighted average maturity date of a portfolio of bonds. BACK END LOAD One of three possible sales charge schedules imposed by funds that charge fees. A back end load, or “deferred sales charge,” is a fee charged when fund’s shares are sold. The amount of the fee usually varies depending on how long the investment is held--generally the longer the time period, the smaller the fee. Funds sold under several sales charge op- tions usually refer to the shares sold with a back end load as class B shares. BACKDATING Backdating is used in relation to funds that offer declining proportional sales charges of larger purchases. This permits investors to count previous purchases of the fund’s shares in qualifying for reduced loads or sales charges on subsequent purchases. BALANCED FUND A fund with an investment objective of both long-term growth and income, through in- vestment in both stocks and bonds. Typically, the stock/bond ratio ranges around 60%/40%. This broader diversification across asset classes tends to further reduce risk. BALANCED TARGET MATURITY FUNDS A fund that invests to provide a guaranteed return of investment at maturity (targeted pe- riods). In order to achieve its investment objective, a balanced target maturity fund in- vests a portion of its assets in zero coupon U.S. Treasury securities while the remainder is invested in stocks that the manager believes will provide long-term growth of capital and income. BARBELL A bond management strategy where the portfolio is invested primarily in short-term and long-term bonds, but in few bonds with intermediate maturities. In theory, this approach allows one portion of the portfolio to take advantage of high yields, while the other por- tion tempers risk. BASIS POINT (BP) The smallest measure used in quoting yields on fixed income securities. One basis point equals one percent of one percent, or 0.01%. BENCHMARK INDEX Indicators used to provide a point of reference for evaluating a fund’s performance. The most common benchmark for equity-oriented funds is the S&P 500 Index. For fixed- income funds it is the Lehman Brothers Aggregate Bond Index. BETA A measure of a fund’s risk, or volatility, compared to the market which is represented as 1.0. A fund with a beta of 1.20 is 20% more volatile than the market, while a fund with a beta of 0.80 would be 20% less volatile than the market. BID PRICE Also known as the “sell” price, the bid price is the price at which a fund’s shares are bought back by the fund. The bid price of a fund share is usually its net asset value. BLUE SKY LAWS A body of state laws governing registration and distribution of mutual fund shares. For example, Blue Sky Laws require sellers of mutual funds to register the funds, and provide financial details so that investors can base their judgment on relevant data. All 50 states and the District of Columbia regulate mutual funds. BOND FUND A fund that invests primarily in bonds, whether they are issued by corporations, munici- palities, or the U.S. government and related agencies. Bond funds generally emphasize income over growth, and can generate either taxable or tax-free income. BOTTOM-UP An investment strategy that first seeks individual companies with attractive investment potential, then proceeds to consider the larger economic and industry trends affecting those companies. BREAKPOINT Dollar levels of investment in a fund that qualify you for reduced sales charges. The pur- chases may either be made in a lump sum or by accumulating shares. CALL RISK The possibility that bonds will be re-paid (or “called”) prior to maturity. This possibility increases during periods of falling interest rates. CAPITAL APPRECIATION The profit made on an investment, measured by the increase in a fund share’s value from the time of purchase to the time of sale. CAPITAL APPRECIATION FUNDS A fund that invests primarily in common stocks the manager believes will provide maxi- mum capital appreciation. Capital appreciation funds often resort to aggressive invest- ment techniques, such as rapid portfolio turnover, leveraging, and investing in unregis- tered securities in order to achieve their objectives. CAPITAL GAIN DISTRIBUTIONS A distribution to shareholders of profits realized from the sale of securities in a fund’s portfolio. Capital gain distributions are usually paid yearly, and are currently taxable at a rate up to 28%. CAPITAL GROWTH Also called capital appreciation, capital growth is an investment objective of many stock funds. Capital growth is achieved when the market values of a fund’s holdings increase, causing the fund’s net asset value per share to increase. CDSC (Contingent deferred sales charge) A type of back end load sales charge, a contingent deferred sales charge is a fee charged when shares are redeemed within a specific period following their purchase. These charges are usually assessed on a sliding scale, with the fee reduced each year the shares are held. CERTIFICATE A physical document representing the mutual fund shares owned. Certificates are rarely issued, in the interest of economy and convenience. Shares are now recorded by the Transfer Agent, or in a brokerage account (known as “street name.”) CLASSES OF SHARES Various classes of a single portfolio are distinguished by the type of sales charge they levy. In general: -- Class A shares carry a front-end load. -- Class B shares carry a back- end load (also known as a contingent deferred sales charge). -- Class C shares carry an ongoing charge (usually in the form of an annual 12b-1 charge). CLONE FUND A fund launched to mirror a closed fund. For example, fund managers may decide to close a fund that has grown so large it is no longer able to establish positions in smaller securities. They could then launch a new fund in the closed fund’s image. While both funds would have the same investment objective, they would generally be run by differ- ent managers and would invest in different securities. CLOSED-END FUND A fund that offers a limited number of shares. The shares of closed-end funds, which are typically listed on one of the major stock exchanges, are bought and sold through brokers. The price of the shares is determined by the pressures of supply and demand rather than by the value of underlying assets. CLOSED TO NEW INVESTORS Occasionally a manager may declare a fund “closed to new investors” which means that no new investments will be accepted. This is often a temporary designation, prompted by a tremendous amount of money invested in the fund in a short period of time. The portfo- lio manager may be concerned about finding enough appropriate securities to add to the fund’s portfolio. COLLATERALIZED MORTGAGE OBLIGATION (CMO) A security collateralized with mortgages or mortgage-backed securities. Many CMOs backed by a U.S. government agency are rated AAA. Non-agency CMOs may be lower rated. COMMERCIAL PAPER Debt instruments that are issued by established corporations to meet short term financing needs. Such instruments are unsecured and have maturities ranging from 2 to 270 days. Commercial paper is rated by Standard & Poor’s and Moody’s Investor Service. COMMISSION A fee imposed when funds are bought or sold to compensate the broker for his or her role in the transaction. COMMON STOCK FUND A fund that invests primarily in common stocks. The investment objectives of common stock funds may vary greatly. COMPOUNDING Interest earned on interest previously earned and reinvested. For example, if a security paid a fixed interest rate of 10% annually and an investor invested $500, by the end of the first year the investor would have earned $50 in interest. If that interest was reinvested, the investor would enter the second year with $550 invested. At the end of the second year, the investor would have earned $55 in interest -- earning an extra $5 in interest thanks to the reinvestment of the first year’s interest. CONTINGENT DEFERRED SALES CHARGE (CDSC) A type of back end load sales charge, a contingent deferred sales charge is a fee charged when shares are redeemed within a specific period following their purchase. These charges are usually assessed on a sliding scale, with the fee reduced each year the shares are held. CONTRACTUAL PLAN A program in which a legal vehicle (plan company or participating unit investment trust) agrees to invest a fixed amount in a fund at regular intervals for 10 or 15 years. In ex- change, investors in these plans commonly receive other benefits, such as decreasing term life insurance. CONVERTIBLE SECURITY Corporate securities (usually preferred shares or stock or bonds) that are exchangeable for a set number of another form of security (usually common stock) at a pre-stated price. CONVERTIBLE SECURITIES FUNDS A fund that invests primarily in convertible bonds and/or convertible preferred stocks. CORPORATE BOND FUNDS A fund that invests primarily in corporate bonds. In general, corporate bond funds seek income over capital growth. COUNTRY FUNDS A fund that invests primarily in the securities of a single country. In some cases, country funds also invest in securities outside the single country if those securities are expected to benefit by growth in that country. COUNTRY RISK The potential for price fluctuations in stocks sold in foreign countries due to events (po- litical, financial, etc.) in these countries. CREDIT RATING A measure of a bond issuer’s creditworthiness as rated by an independent agency, such as Standard & Poor’s or Moody’s Investor Services. Ratings are set as a reflection of the perceived financial stability of the issuer, from AAA to D. Bonds rated Baa or higher by Moody’s, or BBB or higher by S&P, are considered “investment grade.” Conservative investors tend to select funds composed of all AAA rated bonds, or “investment grade” bonds. More aggressive investors, looking for high yields, are more interested in funds that invest in lower rated bonds. CREDIT RISK The possibility that a bond issuer will default, failing to repay principal or interest as promised. “Credit risk” is also known as “default risk.” CURRENCY RISK The potential for price fluctuations in the dollar value of international stocks due to changing currency exchange rates. CURRENT YIELD Annual interest or dividend payments expressed as a percentage of a bond’s current price. CUSIP (Committee on Uniform Securities Identification Procedures) A standard nine-digit code used to identify securities. CUSTODIAN The organization (usually a bank) that keeps custody of securities and other assets of a fund. DEFERRED SALES CHARGE A type of back end load sales charge, a deferred sales charge is a fee charged when shares are redeemed within a specific period following their purchase. DEPRECIATION A decline in an investment’s value. DERIVATIVE A financial security whose value is based on, or “derived” from, a traditional security, asset, or market index. DISTRIBUTION The payment of dividends and capital gains to shareholders DISTRIBUTOR The organization arranging for the sale of fund shares either directly to the public or through intermediaries, such as financial advisers. DIVERSIFICATION The practice of spreading investments among different securities to reduce risk. Diversi- fication works best when the returns of the securities are varied, so that losses incurred by securities falling in price are offset by gains of those rising in price. By nature, mutual funds are a diversified investment. DIVIDEND Short-term profits, stock dividends or interest income which funds distribute to share- holders. DOLLAR COST AVERAGING A method of investing that calls for the investment of a set dollar amount at regular inter- vals, regardless of the fund’s share price. As a result, more fund shares are bought when prices are low than at high prices, usually bringing down an investor’s average cost per share over time. Dollar cost averaging does not, however, guarantee a profit or protect against a loss. DOUBLE EXEMPT FUND A fund that only invests in tax-exempt bonds of issuers from a single state. Income from a double exempt fund is free of federal and state income taxes for investors residing in the same state as the issuers of the bonds. Double-exempt funds have been particularly popular in the high-tax states of California and New York. Double tax exempt funds are usually subject in part or whole to the Alternative Minimum Tax (AMT). AMT percent- age calculations for income tax purposes are available after each year end by contacting the fund directly. DOW JONES INDUSTRIAL AVERAGE (DJIA) The oldest, best known, and most widely quoted stock market index. The DJIA reflects a price-weighted average of 30 actively traded blue chip stocks. These 30 securities repre- sent between 15-20% of the market value of the New York Stock Exchange traded stocks. DUAL PURPOSE FUND A closed-end fund offering two classes of stock in approximately equal amounts. One class (income shares) is entitled to all the income from the fund’s portfolio (i.e., divi- dends from investments). The second class (capital shares) is entitled to all of the capital appreciation from the fund’s holdings. At the time a dual purpose fund is established, a date is set on which the fund will be liquidated. At that time, income shareholders receive preference up to the par value of their shares and capital shareholders receive any excess. EMERGING MARKETS FUNDS A fund that invests primarily in the stocks of companies in, or doing business in, develop- ing countries and emerging markets. Emerging market funds usually have an investment objective of long-term growth and are generally considered aggressive stock funds. ENERGY STOCK FUNDS A fund that invests primarily in the stocks of companies in the energy business. ENVIRONMENTAL SECURITIES FUNDS A fund that invests primarily in securities issued by environmental-related companies. These include companies involved in hazardous waste treatment, waste recycling, and other related areas. EQUITY INCOME FUNDS A fund that seeks to provide relatively high current income and growth of income by in- vesting a large portion of its assets in stocks. ETHICAL FUND A fund that only invests in the securities of firms meeting certain social standards. For example, an ethical fund might exclude securities of companies that are known to prac- tice discrimination, that operate in certain countries, or that produce specific products such as alcohol, tobacco, or nuclear weapons. EUROPEAN STOCK FUNDS A fund that invests primarily in the stock of Western European companies. EXCHANGE PRIVILEGE A shareholder service that allows shareholders to move their assets from one fund to an- other fund within the same mutual fund family, usually without any additional sales charge or fees. Fund groups vary in the specific parameters detailing when or how many times an investor may use the exchange privileges. EXCHANGE TRADED FUND An exchange traded fund (ETF) is a fund that trades like a single security or stock. It is a fund comprised of baskets of securities (stocks) that reflect the composition of a stock market index. The ETF’s value is based on the net asset value of the underlying stocks that it represents. The main difference between ETFs and index mutual funds is that the former is traded like a stock. ETFs are priced throughout the trading day whereas mutual funds are priced at the end of the trading day. The Vanguard Group (an index fund spe- cialist) currently has about two dozen funds in its ETF family, known as VIPERs. EX-DIVIDEND DATE The date on which a fund’s net asset value will fall by an amount equal to a dividend or capital gains distribution. The ex-dividend date is usually the business day immediately following the record date. EXPENSE RATIO A fund’s operating expenses, expressed as a percentage of its average net assets. Funds with lower expense ratios are able to distribute a higher percentage of gross income re- turns to shareholders. EXPENSE A fund’s cost of doing business. All of a fund’s expenses are disclosed in the prospectus as a percentage of assets. FAMILY OF FUNDS An investment management company offering funds with many investment objectives. Fund families often allow investors to transfer money between funds for either a nominal charge or no charge at all. Thus, an investor with shares in a growth fund could transfer all or part of his or her assets into another fund without paying a new sales charge if each of these funds is managed by a single investment firm. FINANCIAL SERVICES FUNDS A fund that invests primarily in the stocks of companies engaged in providing financial services, including banks, finance companies, insurance and securities or brokerage firms. FIXED INCOME SECURITY A security that pays a fixed rate of return. This term is usually used in reference to gov- ernment, corporate or municipal bonds, which pay a fixed rate of interest until the bonds mature, and to preferred stock, which pay a fixed dividend. Fixed income securities offer the guarantee of a fixed return, but do not offer an investor much, if any, potential for growth. FLEXIBLE PORTFOLIO FUNDS A fund that can invest in stocks, bonds and cash in whatever proportion the manager deems appropriate, providing the manager total flexibility to achieve maximum returns. Flexible portfolio funds are sometimes called asset allocation funds. 401(k) PLAN An employer-sponsored retirement plan that enables employees to defer taxes on a por- tion of their salaries by earmarking that portion for the retirement plan. Several invest- ment options, including a range of funds, are generally offered. 403(b) PLAN A type of individual retirement account (IRA) designed specifically for employees of qualifying nonprofit organizations (i.e., public schools, public hospitals, churches). A 403(b) plan enables these employees to defer taxes on a portion of their salaries by ear- marking that portion for the retirement plan. Several investment options, including funds, are generally offered for investment. FRONT-END LOAD One of three possible sales charge schedules imposed by funds that charge fees. A front end load, or “upfront charge” is a fee charged on the initial purchase of fund shares, and can range from 3% to 8% of the purchase amount. Funds sold under several sales charge options usually refer to the shares sold with a front end load as “Class A shares.” FULLY INVESTED The investment of nearly all available assets in securities other than short-term securities (such as savings and money market accounts). When a fund is said to be “fully invested,” it usually implies that the fund’s manager is confident that the securities markets will be improving. FUND OF FUNDS A fund that invests only in the shares of other open-end funds. Fund of funds were popu- lar during the 1960s but have subsequently fallen out of favor with most investors. GENERAL BOND FUNDS A fund that invests in bonds without any quality or maturity restrictions. GENERAL MUNICIPAL BOND FUND A fund that invests primarily in bonds issued by municipalities throughout the country, and which generate federally tax-exempt income. GNMA (Government National Mortgage Association). Nicknamed Ginnie Mae, the Government National Mortgage Association is a govern- ment owned corporation with the authority to fully guarantee the full and timely payment of all monthly principal and interest payments on the mortgage backed securities collater- alized by registered holders. GLOBAL MUTUAL FUND A mutual fund that invests anywhere in the world, including within the United States. These can be either stock or bond funds. GOLD FUND A fund that invests primarily in securities associated with gold, including gold mining, refining and production concerns. Gold funds are also sometimes referred to as precious metals funds. GOVERNMENT INCOME FUND A fund that invests primarily in government fixed income securities, including U.S. Treasury bonds and notes, and federally guaranteed mortgage-backed securities. Because of the high quality of their portfolios, government income funds tend to be less risky than other income funds, but to also offer less yield. In general, government income funds seek to provide current income over growth of capital. GROWTH An investment objective of many stock funds. Current income, if considered at all, is a secondary concern for these funds. Capital growth is achieved when the market value of a fund’s holdings increases, causing the fund’s net asset value per share to increase. GROWTH FUND A fund that invests primarily in the stocks of companies whose long-term earnings are expected to grow significantly faster than the earnings of the market in general (as repre- sented by the S&P 500 Index). In general, growth funds seek to provide capital gains, rather than dividend income. GROWTH AND INCOME FUND A fund that seeks to provide both growth of capital and a stream of income. This is done by investing primarily in the common stock of companies that have had not only increas- ing share value, but also a solid record of paying dividends. GROWTH INDEX FUND A fund that invests primarily in growth stocks included in one of the major unmanaged stock indices. Growth index funds generally seek to match or exceed the investment per- formance of the targeted index. GROWTH INVESTING An investment strategy to increase capital by buying stocks the manager believes will go up in price, regardless of the stock’s current price relative to its underlying value. Growth investing is often discussed in contrast to value investing HEALTH AND BIOTECHNOLOGY FUNDS A fund that invests primarily in the stocks of companies in the medical industry. HEDGE FUND A mutual fund that uses futures to offset investment risk. Hedge funds are a rich man’s game. Investors put up minimums of $250,000 to $1 million. The funds promise high re- turns. But the big money goes to the managers in fees and 15 percent to 20 percent profit participations. In good year a manager can make tens of millions of dollars. But the risks are also high. Managers gamble with investors’ money, betting with derivatives, options, short-selling and leveraging for higher returns. So when the funds crash, they lose mega- bucks. Yet sadly, America’s 8,800 hedge funds remain largely unregulated. HIGH CURRENT YIELD FUND A fund that seeks to provide a relatively high current yield. High current yield funds tend to invest primarily in lower grade fixed income securities without any quality or maturity restrictions. HIGH-YIELD BOND FUND A fund that invests primarily in high yield bonds, also referred to as junk bonds. High yield bond funds generally seek high returns and tend to be one of the riskier bond fund investments. HISTORICAL YIELD Yield provided by a fund (typically a money market fund) over a specific time period. INCEPTION DATE The date a fund was first made available to investors. INCOME 1) Payments of dividends, interest, and/or short term capital gains earned by securities held by a fund. Income dividends are paid after deducting operating expenses. 2) An investment objective of many fixed income funds. Capital appreciation is not a consideration for these funds. INCOME FUND A fund that invests primarily in fixed income securities and/or high-yielding stocks. In general, income funds seek to provide current income rather than growth of capital. INDEX Indicators used to provide a point of reference for evaluating a fund’s performance. The most common indices for stock funds are the Dow Jones Industrial Average and the S&P 500 Index. For fixed-income funds it is the Lehman Brothers Aggregate Bond Index. INDEX FUND A fund that invests in a collection of securities intended to match that of a broad-based index (NOTE: It is not possible for investors to actually invest in the actual index, such as the S&P 500). In general, index funds seek the same or a slightly better return that the index they mirror. Index funds tend to charge low administrative expenses. INDIVIDUAL RETIREMENT ACCOUNT (IRA) A personal savings plan that offers tax advantages to save and invest for retirement. Con- tributions are often tax deductible in whole or in part, depending upon individual circum- stances, including compensation levels and participation in an employer sponsored quali- fied retirement plan. Income derived from investments in a traditional deductible or non- deductible IRA are tax deferred until withdrawn. Under certain circumstances, withdraw- als from a Roth IRA are tax free. Tax penalties may apply to IRA distributions taken be- fore age 59 1/2. Contributions to an IRA may not exceed $2,000 per year. Individuals with earned income may contribute up to $2,000 to the IRA of a non-employed spouse. INFLATION The rate at which the general level of prices for goods and services is rising. Inflation has an uncanny ability to erode the value of securities that don’t grow fast enough. That’s why investing only in a money market fund can be more risky than it appears on the sur- face. If inflation is rising at 3% a year and your money market is growing at 5% or 6%, you won’t have much money left over for your retirement. Measures of inflation include the consumer price index (CPI) and the producer price index (PPI). INFLATION RISK The possibility that the value of assets or income will be eroded by inflation (the rising cost of goods and services). Inflation risk is often mentioned in relation to conservative fixed income funds. While these types of fixed income funds may minimize the possibil- ity of losing principal, they expose an investor to inflation risk. INSURED BOND A guarantee on a municipal bond that interest and principal will be paid timely and in full. Insured bonds tend to carry a high credit rating but to pay a lower return than compa- rably rated uninsured bonds. The largest municipal bond insurers include: The Municipal Bond Investment Assurance Corp. (MBIA), Federal Guarantee Insurance Corp. (FGIC), and AMBAC Indemnity Corp. (AMBAC). INTERMEDIATE INVESTMENT GRADE BOND FUND A fund that invests primarily in investment grade fixed income securities with dollar- weighted average maturities of five to ten years. INTERMEDIATE U.S. GOVERNMENT FUND A fund that invests primarily in government guaranteed fixed income securities with a dollar-weighted average maturity of five to ten years. INTERMEDIATE U.S. TREASURY FUND A fund that invests primarily in U.S. Treasury bills, notes and bonds with a dollar- weighted average maturity of five to ten years. INTERNATIONAL FUND A fund that invests primarily in the securities of companies located outside of the United States. In general, international investing not only offers diversification and the potential for high returns, but also involves special risks, such as currency concerns, and rapidly changing political scenarios. INVESTMENT COMPANY An investment company invests the pooled funds of investors in securities appropriate for its stated investment objectives. For a fee, the investment company provides more diver- sification, liquidity, and professional management service than is normally available to individual investors. Mutual funds, known as open-end investment companies, have portfolios that can grow or be reduced, based upon market conditions and investor investment/redemption pat- terns. Hence the name: they have limitless numbers of shares outstanding. Closed-end funds, also called unit investment trusts, have a fixed portfolio, and a pre-set number of shares outstanding. INVESTMENT GRADE High quality bonds that are rated Baa or higher by Moody’s, or BBB or higher by Stan- dard & Poor’s. Investment grade bonds are considered safe, because the rating reflects the perceived financial stability of the issuer. Usually, however, the higher the bond’s rat- ing, the lower the interest it must pay to attract buyers. INVESTMENT OBJECTIVE A fund’s investment goal. For example, a growth fund typically has an investment objec- tive of providing long-term growth of capital. INVESTMENT STYLE A description of a fund’s investment strategy. For example, a growth fund might have a growth oriented style, a value-oriented style, or a blend of the two. Fixed-income funds tend to be managed with either an interest-rate sensitive style or a credit-sensitive style. IRA (Individual Retirement Account) A personal savings plan that offers tax advantages to save and invest for retirement. Con- tributions are often tax deductible in whole or in part, depending upon individual circum- stances, including compensation levels and participation in an employer sponsored quali- fied retirement plan. Income derived from investments in a traditional deductible or non- deductible IRA are tax deferred until withdrawn. Under certain circumstances, withdraw- als from a Roth IRA are tax free. Tax penalties may apply to IRA distributions taken be- fore age 59 1/2. Contributions to an IRA may not exceed $2,000 per year. Individuals with earned income may contribute up to $2,000 to the IRA of a non-employed spouse. JUNK BOND Bonds rated BB or below by Standard & Poor’s Corporation and Ba or below by Moody’s Investor Service. Junk bonds tend to be more volatile and higher yielding than bonds with higher quality ratings. JUNK BOND FUND A fund that invests primarily in lower rated bonds (BB or below by Standard & Poor’s Corporation and Ba or below by Moody’s Investor Service), also referred to as junk bonds. Junk bond funds generally seek high returns and tend to be one of the riskier bond fund investments. LADDER A fixed income investment strategy that seeks to reduce interest rate risk by investing in fixed income securities with a wide variety of maturities. Though this strategy assures continuous cash flow, there may be some sacrifice of total return, since shorter-term bonds tend to have lower yields than longer-term bonds. LARGE-CAPS Stocks of companies with market capitalizations of more than $1 billion. Large-caps tend to be well established companies, so that their stocks entail less risk than smaller-caps, but which also offer less potential for dramatic growth. LATIN AMERICAN FUND A fund that invests primarily in the securities of companies in Latin American countries. LETTER OF INTENT An agreement calling for an investor to invest a specific amount in a fund over a defined period in order to qualify for reduced sales charges. The reduced sales charge may apply to an individual fund or to all the funds operated by a single investment management firm. LIPPER INDICES The Lipper Analytical Indices are equally weighted indices of typically the 30 largest mutual funds within their respective investment objectives. Returns are adjusted for the reinvestment of capital gains distributions and income dividends. LIPPER ANALYTICAL SERVICES INC. A leading mutual fund research and tracking firm. Lipper categorizes funds by objective and size, and then ranks fund performance within those categories. LIQUIDITY The ease with which an investment can be converted into cash. Shares in a fund are gen- erally considered highly liquid investments because they can be sold on any business day for their then current value (which may be more or less than an investor’s original cost). LOAD A sales charge assessed by certain mutual funds (load funds) to cover selling costs. A front-end load is charged at the time of purchase. A back-end load is charged at the time of sale. LOW-LOAD A sales charge of 3% or less. LONG-TERM FUNDS All funds other than short-term funds (i.e., money market funds). MANAGEMENT FEE The amount a fund pays to its investment adviser for its services. The average annual fee industry wide is about one half of one percent of fund assets. A fund’s management fee must be listed in its prospectus. MANAGER The Firm that provides the fund with investment research and portfolio management ser- vices. MANAGER TENURE How long the portfolio manager has been responsible for a fund’s management. MARKET CAPITALIZATION Also referred to as “market cap.” Market capitalization is a measure of a corporation’s value, calculated by multiplying the number of outstanding shares of common stock by the current market price per share. Market capitalization is usually grouped into four main categories: large-cap, mid-cap, small-cap, and micro-cap. MARKET TIMING Attempting to time the purchase and sale of securities to coincide with ideal market con- ditions. Mutual fund investors may switch from stock funds to bond funds to money mar- ket funds as the strength of the economy and interest rate directions change. MATURITY DATE The date on which the principal amount of a bond is to be paid in full. MAXIMUM FRONT-END LOAD The fee an investor pays when purchasing shares of a fund. A fund has different load breakpoints depending on the purchase total. For example, a fund may charge: 4.5% to $100,000 4.0% to $250,000 3.0% to $500,000 2.0% to $1 Million 0.0% thereafter MICRO-CAPS A subset of small-caps. Stocks of companies with a market capitalization of less that $50 million are “micro caps.” Micro-caps tend to be new, relatively untested corporations that can offer greater growth potential than larger caps, but also entail greater risk. MID-CAPS Stocks of companies with a medium market capitalization, usually defined as between $500 million and $3-5 billion. Mid-caps are often considered to offer more growth poten- tial than larger-caps (but less than small caps) and less risk than small-caps (but more than large-caps). MID-CAP FUND A fund that invests primarily in the stocks of companies with a medium market capitali- zation (mid caps). MINIMUM PURCHASE The smallest investment amount a fund will accept to establish a new account. Most fund groups also impose a minimum for additional purchases to an existing account. MONEY MARKET FUND Money market funds seek to maintain a stable net asset value by investing in the short- term, high-grade securities sold in the money market. These are generally the safest, most stable securities available, including Treasury bills, certificates of deposit, and commer- cial paper. Money market funds limit the average maturity of their portfolio to 90 days or less. They seek to generate monthly income, and to maintain a stable $1.00 per share net asset value. Some money market funds offer check writing privileges. No fees are gener- ally charged to purchase or redeem shares in a money market fund. Several different port- folio types are available: Taxable, taxable government securities, and national or state tax-free. MORNINGSTAR An independent mutual fund rating agency that tracks over 7,200 mutual funds. Of those, Morningstar publishes full-page research reports on 1,500. Morningstar’s rating system calls for the awarding of between 1 (the lowest) and five (the highest) stars to a fund for its risk adjusted performance over a 3, 5, and 10-year period. Approximately 10% of the funds rated earn five stars. Star ratings are recalculated monthly. MORTGAGE-BACKED SECURITY A security that returns principal and interest monthly as payments are received on the un- derlying mortgages. They are made up of individual home mortgages guaranteed by the government agencies. The mortgages are packaged into pools by agencies such as: • Government National Mortgage Assn. (GNMA) • Federal National Mortgage Assn. (FNMA) • Federal Home Loan Mortgage Corp. (FHLMC) Unscheduled repayment of principal can shorten the maturity of the bonds. (See “Pre- payment Risk.”) MUNICIPAL BOND A bond issued by a municipality to finance schools, highways, hospitals, airports, bridges, water and sewer works, and other public projects. MUTUAL FUND An open-end investment company that combines the money of thousands of people and invests it in a variety of securities in an effort to achieve a specific objective over time. Mutual funds offer the benefits of portfolio diversification (which provides greater safety and reduced volatility), professional management, and stand ready to buy back its shares at the current net asset value. Every fund’s prospectus details information on the fund’s objectives, fees, the management company, and more NASDAQ An electronic stock market run by the National Association of Securities Dealers. Bro- kers get price quotes through a computer network and trade via telephone or computer network. The index that covers all the stocks that trade on this market is called the NASDAQ Composite Index. Since there is no centralized exchange, NASDAQ is some- times referred to as an over-the-counter market, or a negotiated marketplace. Many of the stocks traded through NASDAQ are in the technology sector. NATURAL RESOURCES FUND A fund that invests primarily in securities of companies that own, process, transport, or market natural resources, which can include metals, minerals, and forest products. NET ASSET VALUE (NAV) The current market worth of a mutual fund’s share. A fund’s net asset value is calculated daily by taking the funds total assets, securities, cash and any accrued earnings, deducting liabilities, and dividing the remainder by the number of shares outstanding. NET ASSETS The net worth of a fund. NO LOAD FUND A fund that sells its shares directly to investors without a sales charge. OBJECTIVE A fund’s investment objective states the financial goals it is aiming for, such as “growth,” or “income.” OFFERING PRICE Also known as the “ask” price, the offering price is the amount at which a mutual fund’s shares can be purchased. To calculate the offering price, add a fund’s current net asset value per share to its sales charge, if any. OPEN-END FUND (Also known as “mutual fund.”) An investment company that pools money from share- holders and invests in a variety of securities, including stocks, bonds, and money market instruments. They offer growth, income, or both, and the opportunity to invest in every- thing from a country or industry to the movements of the markets themselves. A mutual fund continually sells new shares to investors and redeems those that are tendered by shareholders. OPERATING EXPENSES The normal costs a mutual fund incurs in conducting business, such as the expenses asso- ciated with maintaining offices, staff, and equipment. There are also expenses related to maintaining the fund’s portfolio of securities. These expenses are paid from the fund’s assets before any earnings are distributed. OPTION FUND A fund which trades options to increase the value of its shares. The fund may either be conservative or aggressive. A conservative fund, commonly called an “option income fund,” may buy stocks and increase shareholders’ income through the premium earned by writing options on the stocks within the portfolio. An aggressive fund, commonly called an “option growth fund,” may buy options in securities that the fund manager thinks will fall or rise sharply in the near term. PACIFIC BASIN FUND A fund that invests primarily in the stocks of companies located in the Pacific Basin, which includes Australia, Hong Kong, Japan, Malaysia, New Zealand, Singapore, and Taiwan. PACIFIC EX JAPAN FUNDS A fund that invests primarily in the stocks of companies whose primary trading markets or operations are concentrated in the Pacific region (including Asian countries), and which specifically does not invest in Japan. PAYMENT DATE The day on which a mutual fund pays income dividend or capital gains distributions to its shareholders. PENALTY PLAN A mutual fund accumulation plan in which sales fees for the entire obligation are de- ducted from shares purchased in the first few years that the plan is in effect. In the event that the investors redeem the shares after a short time, only a small portion of the pur- chase price will be refunded. Sales charges and penalty plans are regulated by the In- vestment Company Amendments Act of 1970. PERIODIC PAYMENT PLAN A plan in which an investor agrees to make monthly or quarterly investments in a mutual fund as a method of accumulating shares over a period of years. Fixed periodic contribu- tions result in dollar cost averaging. PERFORMANCE A measure of how well a fund is doing. Two commonly used mutual fund performance measures are yield (which measures dividends) and total return (which measures divi- dends plus changes in net asset value). POOLING Pooling is the basic concept behind mutual funds. A fund pools the money of thousands of individual and institutional investors who share common financial goals. The fund uses this pool to buy a diversified portfolio of investments PORTFOLIO A collection of securities owned by an individual or an institution (like a mutual fund). A fund’s portfolio may include a combination of stocks, bonds, and money market securi- ties. PORTFOLIO MANAGER The individual who is responsible for managing a mutual fund’s assets. PORTFOLIO TURNOVER A measure of the trading activity in the fund’s portfolio of investments. In other words, how often securities are bought and sold. PRECIOUS METALS FUND A fund that seeks an increase in the value of its holdings by investing at least two-thirds of its portfolio in securities associated with gold, silver, and other precious metals. Also known as “gold funds.” PREPAYMENT RISK The possibility that, as interest rates fall, homeowners will refinance their home mort- gages, resulting in the prepayment of GNMA securities, and possible decline in net asset values of GNMA Funds. PRINCIPAL The basic amount actually invested, exclusive of earnings. PROFESSIONAL MANAGEMENT The pool of shareholder dollars invested in a fund is managed by full-time, experienced professionals who decide which securities to hold, when to buy, and when to sell. PROSPECTUS The official document that describes a mutual fund. It contains information required by the Securities and Exchange Commission on such subjects as the fund’s investment ob- jectives, policies, services and fees. A prospectus must be given to every investor. A more detailed document, known as “Part B” of the registration statement, (or “Statement of Additional Information,”) is available at no charge upon request. R-SQUARED The degree to which an asset’s correlation with “the market” has explained its fluctua- tions over a specified period of time. Alpha and beta coefficients are calculated using a procedure known as “regression analysis,” where points in a system of coordinates are generated by measuring “market” movements (the “independent variable”) along the horizontal “X” axis and correlating them with movements in the asset (the “dependent variable”) measured along the vertical “Y” axis. If the plot points clearly defines a straight line, the model will have an R-squared value of close to 1.0, meaning that fluctuations in the market explain close to 100% of the relative volatility in the asset. If the pattern of plot points is largely random, the R-squared value will be near zero, meaning that fluctuations in the market explain virtually nothing about fluctuations in the asset. REAL ESTATE FUND A fund that invests primarily in stocks of companies that participate in the real estate in- dustry, such as mortgages and real estate investment trusts, but not real estate itself. REAL ESTATE INVESTMENT TRUST (REIT) A publicly traded company that manages a portfolio of real estate to earn profits for shareholders. Patterned after mutual funds, REITs hold a diverse portfolio of real estate such as apartment buildings, offices, industrial warehouses, shopping centers, hotels and nursing homes. Shareholders receive income in the form of dividends from the rents re- ceived on the property. To avoid taxation at the corporate level, 75% or more of a REIT’s income must come from real property and 95% of its net earnings must be distributed to shareholders annually. Because REITs must distribute most of their earnings, REITs pay high yields of 5% to 10% or more. REAL RETURN The actual return earned on an investment after factoring in the rate of inflation. RECORD DATE The date on which a shareholder must officially own a stock’s shares in order to receive a company’s declared dividend or to vote on company issues. REDEEM To cash in shares by selling them back to the mutual fund. Mutual fund shares are re- deemable on any business day. REDEMPTION FEE A fee charged by some funds when shares are sold (redeemed). REDEMPTION PRICE The price at which a mutual fund’s shares are redeemed (bought back) by the fund. The value of the shares depends on the market value of the fund’s portfolio of securities at the time. This value is the same as “net asset value per share.” In the newspaper, this amount is shown as the “bid” price. REINSTATEMENT PRIVILEGE A shareholder who redeems fund shares, and then changes his or her mind, may have a onetime privilege of reinstating the investment by investing the proceeds of the redemp- tion at net asset value (with no sales charge). There is generally a 30-day time limit for this service. REPURCHASE AGREEMENT (REPO) A contract under which an investor sells a United States security to a bank or Corpora- tion, and agrees to repurchase the security later at a specified time and price. Purchaser earns interest competitive with money market rates. REVENUE BOND A municipal bond used to finance public works such as bridges, tunnels, or sewers. Prin- cipal and interest on the bond are paid directly from the revenues of the project, such as tolls. (Opposite: G.O., or General Obligation Bond, which relies on the taxpayers of a municipality to repay the debt.) RIGHT OF ACCUMULATION (ROA) A right granted by some mutual funds that allows a shareholder to count existing hold- ings of the fund along with new purchases in determining the size of the sales fee on the new shares. This right applies to funds that offer discounts on high-volume investments. Thus the fee charged on succeeding purchases is determined by all purchases, past and present, not just by new purchases. ROA Right of Accumulation. A right granted by some mutual funds that allows a shareholder to count existing hold- ings of the fund along with new purchases in determining the size of the sales fee on the new shares. This right applies to funds that offer discounts on high-volume investments. Thus the fee charged on succeeding purchases is determined by all purchases, past and present, not just by new purchases. ROLLOVER The reinvestment of funds into another, often similar, investment. Often used when secu- rities are maturing, or when moving an Individual Retirement Account RUSSELL 2000 INDEX A market-capitalization weighted index that is the best known benchmark of small-cap stocks. It measures the 2,000 smallest companies in the U.S. market. These stocks repre- sent only about 8% of the total market’s capitalization (as represented by the broader Russell 3000 Index). As of the latest reconstitution, the average market capitalization of the Russell 2000 was approximately $526.4 million. The largest company in the index had an approximate market capitalization of $1.3 million. There are a number of index funds that track the Russell 2000. S&P 500 An unmanaged group of stocks often considered representative of the stock market in general. This index is composed of 400 industrial, 20 transportation, 40 utility, and 40 financial companies. S&P 500 INDEX FUND A fund that invests primarily in the stocks included in the S&P 500 Index. Sometimes referred to as “blue-chip” stocks, they tend to be of large, well-established companies. S&P 500 INDEX (MONTHLY REINVESTMENT) A broad-based measurement of changes in stock market conditions based on the average performance of 500 widely held common stocks. Performance figures assume that all dividends are reinvested. SAI (Statement of Additional Information) An attachment to the fund’s prospectus that contains more detailed, supplementary in- formation. Also referred to as “Part B,” the SAI is available at no charge upon request from a fund. SALES CHARGE An amount charged to purchase shares in many mutual funds sold by brokers or other sales agents. The maximum allowable charge is 8.5% of the initial investment. SCIENCE & TECHNOLOGY FUND A fund that invests primarily in the stocks of companies engaged in science and technol- ogy industries. SEC YIELD A standardized calculation that the Securities and Exchange Commission requires mutual funds to use when advertising rates of income return. This standardized rate ensures that investors are comparing “apples to apples” when comparing ads from different mutual fund companies. SECTOR FUND A fund that invests primarily in securities of companies engaged in a specific investment segment. Sector funds entail more risk, but may offer greater potential returns than funds that diversify their portfolios. For example, a sector fund may limit its holdings to securi- ties from a particular country or geographic region, or it may specialize in the securities of energy-related firms, or in companies that produce precious metals. SERIES FUNDS Funds that are organized with separate portfolios of securities, each with its own invest- ment objective. SETTLEMENT DATE The date agreed upon by the parties to a transaction for the payment of funds and the de- livery of securities. SHAREHOLDER An investor. The shareholder is the owner of shares of a mutual fund. SHORT-TERM FUND A fund that invests primarily in securities with maturities of less than one year. Short- term funds include taxable money market funds and tax-exempt money market funds (also known as short-term municipal bond funds). SIGNATURE GUARANTEE A stamp or seal given by a bank or member of a domestic stock exchange that authenti- cates a signature. A signature guarantee is typically required by a mutual fund sponsor to conduct certain transactions, such as the change in ownership of an account. SMALL-CAPS Shorthand for small capitalization stocks, small-caps usually have a market capitalization of $500 million or less. In general, small caps tend to be less established companies that offer more growth potential than larger capitalized companies, but which also entail greater risk. SMALL COMPANY GROWTH FUND A fund that seeks aggressive growth of capital by investing primarily in stocks of rela- tively small companies with the potential for rapid growth. SPREAD-LOAD CONTRACTUAL PLAN A contractual plan for purchasing shares of a mutual fund in which sales charges are not concentrated in the first payment or in the first few payments made by the investor. STANDARD DEVIATION A measure of the degree to which a fund’s return varies from the average of all similar funds. STATE MUNICIPAL BOND FUNDS These funds invest in bonds issued by municipalities located all in one particular state. Residents of that state earn income that is exempt from federal, state, and sometimes city income taxes. STATEMENT OF ADDITIONAL INFORMATION (SAI) An attachment to the fund’s prospectus that contains more detailed, supplementary in- formation. Also referred to as “Part B,” the SAI is available at no charge upon request from a fund. STOCK FUND A fund that invests primarily in stocks. STRIP A brokerage house practice of separating a bond into two separate securities: a principal portion (PO) and an interest portion (IO). A variation known by the acronym “STRIPS” (Separate Trading of Registered Interest and Principal of Securities) is a stripped zero- coupon bond that is a direct obligation of the U.S. Treasury. Other strips include Treasur- ies stripped by brokers, such as TIGERS, and Salomon Brothers’ tax-exempt M-CATS. SWITCHING The movement of assets from one fund to another. Also know as “exchanging.” An in- vestor will switch mutual funds when their investment objectives change or because of market conditions. This is usually done within a family of funds, but can be done be- tween different fund families. There usually is no charge for a certain number of transac- tions per year, after which a transaction fee may apply. SYSTEMATIC WITHDRAWAL SYSTEM An optional service often available to shareholders that would arrange for a fixed amount to be redeemed from an account and sent to the shareholder on a regular basis (usually monthly, quarterly, or semi-annually). SYMBOL The 5-digit identifier code assigned to each mutual fund by NASDAQ. This code is used to identify the correct fund in all transactions. This symbol may only loosely resemble the newspaper listing--these tend to be phonetic abbreviations of fund names. TARGET MATURITY FUND A fund that invests primarily in zero coupon U.S. Treasury securities, or in coupon- bearing U.S. government securities targeted to mature in a specific year. TAX-EXEMPT BOND FUND A fund that invests in municipal bonds. While investors do not pay federal income taxes on the income from these funds, they may be subject to state or local taxes. TAXABLE EQUIVALENT YIELD The yield that would have to be earned on a security to pay as much, after tax, as what is earned from a tax-exempt bond. T-BILL (Treasury Bill) A fixed-income security issued by the U.S. Government. TECHNOLOGY FUND A fund that invests primarily in the stocks of companies engaged in the technology indus- try. TELEPHONE SWITCHING The movement of an investor’s funds from one mutual fund to another on the basis of an order given via telephone. TOP DOWN An investment approach that first seeks to define major economic and industry trends, and then proceeds to identify specific companies that are likely to benefit from those trends. (See also “bottom-up.”) TOTAL RETURN A measure of a fund’s performance that takes three factors into account: income divi- dends, capital gains distributions, and share price appreciation/depreciation. TRADE DATE The date on which a purchase or redemption of mutual fund shares is conducted. TRANSFER The process of changing ownership of an account within the same fund. TRANSFER AGENT The organization employed by a mutual fund to prepare and maintain records relating to the accounts of its shareholders. Some funds serve as their own transfer agents. TREASURIES Fixed income securities issued by the U.S. government. Debt securities issued by the U.S. Department of the Treasury. Because principal and interest is backed by the U.S. gov- ernment, Treasuries are viewed as having no credit risk. Treasuries include: • Treasury Bills (T-Bills) have maturities of one year or less. Maturities for T-bills are usually 91 days, 182 days or 52 weeks. Unlike Treasury bonds and notes, which pay interest semiannually, Treasury bills are issued at a discount from their face value. Interest income from Treasury bills is the difference between the pur- chase price and the Treasury bill’s face value. Bills are issued in denominations of $10,000 with increments of $5,000 for amounts above $10,000. Treasuries are widely regarded as the safest bond investments, because they are backed by the “full faith and credit” of the U.S. • Treasury Notes (T-Notes) have maturities of two to 10 years. Treasury notes pay interest semiannually and can be purchased in minimum denominations of $1,000 or multiples thereof. Treasury note yields typically are lower than Treasury bonds, which have longer maturities, but notes typically are about half as volatile as long bonds. • Treasury Bonds (T-Bonds) have maturities of 10 to 30 years. Treasury bonds pay interest semiannually and can be purchased in minimum denominations of $1,000 or multiples thereof. Until recently, the 30-year Treasury bond was considered the benchmark bond in determining trends in interest rates. (It was replaced by the 10-year Treasury note.) It typically has a higher interest rate than other Treasuries, but more inflation and credit risk. But as a group, Treasuries are regarded as the safest bond investments, because they are backed by “full faith and credit” of the U.S. government. TRIPLE TAX-EXEMPT FUND A municipal bond mutual fund whose dividends and interest are exempt from federal, state and local income taxes for residents of a particular state. TURNOVER RATE The rate at which the fund buys and sells securities each year. For example, if a fund’s assets total $100 million and the fund bought and sold $100 million of securities that year, its portfolio turnover rate would be 100%. 12b-1 FEE The fee--named for an SEC rule--charged by some funds to pay for distribution costs, such as advertising and dealer compensation. The fund’s prospectus outlines 12b-1 fees, if any. UNDERWRITER The organization that acts as the distributor of a mutual fund’s shares to broker/dealers and investors. UNREALIZED GAIN OR LOSS Increases or decreases in the prices of securities held by the fund. U.S. TREASURY FUND A fund that invests primarily in financial instruments issued or guaranteed by the U.S. Treasury or its agencies. UTILITY FUND A fund that invests primarily in securities issued by companies in the utilities industry. VALUE INVESTING The investment style of attempting to buy under priced stocks that have the potential to perform well and increase in price. VARIABLE ANNUITY A type of insurance contract that guarantees future payments to the holder, or annuitant. Capital accumulates tax-free, often through investment in a mutual fund, and is converted to an income stream at a future date (usually retirement). All monies held in the annuity accumulate on a tax-deferred basis. VOLATILITY The amount by which the price of a security fluctuates as market conditions change. VOLUNTARY ACCUMULATION PLAN A plan to acquire additional shares in a mutual fund on a more or less regular basis, at the discretion of the shareholder. WITHDRAWAL PLAN A program in which shareholders receive payments from their mutual fund investments at regular intervals. YIELD Current income (interest or dividends) paid by a fund, expressed as a percentage of the investment’s price. YIELD CURVE A graph depicting yield as it relates to maturity. If short-term rates are lower than long- term rates, it is called a positive yield curve. If short-term rates are higher, it is called a negative, or inverted, yield curve. If there is little difference, it is called a flat yield curve. YIELD TO MATURITY (YTM) The effective annual rate of return earned by a bond if held to maturity. This rate takes into account the amount paid for the bond, the length of time to maturity, and assumes coupon payments can be reinvested at the yield to maturity. ZERO COUPON BOND Bond issued at a discount which accrues interest that is paid in full at maturity.
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