Fee-free selling: With an open-end fund, the value of a share (known as the net asset value) always equals 100 percent of what the fund’s investments (less liabilities) are currently worth. And you don’t have the cost and troubles of selling your shares to another investor as you do with a closed-end fund. Because closed-end funds trade like securities on the stock exchange and because you must sell your shares to someone who wants to buy, closed-end funds sometimes sell at a discount. Even though the securities in a closed-end fund may be worth, say, $20 per share, the fund may sell at only $19 per share if sellers outnumber buyers.You could buy shares in a closed-end fund at a discount and hold on to them in hopes that the discount disappears or — even better — turns into a premium (which means that the share price of the fund exceeds the value of the investments it holds). You should never pay a premium to buy a closed-end fund, and you shouldn’t generally buy one without getting at least a 5 percent discount (to make up for its deficiencies versus its open-ended peers, especially higher expenses).
Opting for Mutual Funds
To understand why the best funds may make sense for you, explore this section, which highlights what they may offer. (Funds, especially those that are mediocre or poor compared with their peers, also have their drawbacks — I cover those issues in the section “Addressing the Drawbacks,” later in this chapter.) In Part 2 of this book, I compare mutual funds to other investing alternatives so you can clearly understand when funds are and aren’t your best choice.
Fund managers’ expertise
Mutual funds are investment companies that pool your money with the money of hundreds, thousands, or even millions of other investors. The company hires a portfolio manager and a team of researchers whose full-time job is to analyze and purchase investments that best meet the fund’s stated objectives.
Typically, fund managers are Chartered Financial Analysts (CFAs) and/or graduates of the top business and finance schools in the country, where they study the principles of portfolio management and securities valuation and selection. In addition to their necessary educational training, the best fund managers typically have a decade or more of experience in analyzing and selecting investments.
Consider the following activities that an investor should do before investing in stocks and bonds of their own choosing:
Analyze company financial statements: Companies whose securities trade in the financial markets are required to issue financial reports every three months detailing their revenue, expenses, profits and losses, and assets and liabilities. Unless you’re a numbers geek, own a financial calculator, and enjoy dissecting tedious corporate financial statements, this first task alone is reason enough to invest through a fund and leave the driving to the fund management team.
Talk with the muckety-mucks: Most fund managers log thousands of frequent-flier miles and hundreds of hours talking to the folks running the companies they’re invested in or are thinking about investing in. Because of the huge amounts of money they manage, large fund companies even get visits from company executives, who fly in to grovel at the fund managers’ feet.
Analyze company and competitor strategies: Corporate managers have an irritating tendency to talk up what a great job they’re doing. Some companies may look as if they’re making the right moves, but what if their products are soon to lag behind the competition’s? The best fund managers and their researchers take a skeptical view of what a company’s execs say — they read the fine print and conduct other investigative work. They also keep on top of what competitors are doing. Sometimes they discover investment ideas better than their original ones this way.
Talk with company customers, suppliers, competitors, and industry consultants: Another way fund managers find out whether a company’s public relations story is full of holes instead of reality is by speaking with the company’s customers, suppliers, competitors, and other industry experts. These people often have more balanced viewpoints and can be a great deal more open about the negatives. These folks are harder to find but can provide valuable information.
Attend trade shows and review industry literature: It’s truly amazing how specialized the world’s becoming. Do you really want to subscribe to business newsletters that track the latest happenings with ball bearing or catalytic converter technology? They’ll put you to sleep in a couple of pages. Unlike popular mass-market publications, they’ll also charge you an arm and a leg to subscribe.
Take a disciplined approach: Another thing great managers do is bring a strict discipline that clarifies what makes a stock attractive and when it no longer is and should be sold. Lack of discipline is shown by countless studies to be highly associated with poor results, because without a clear process, the tendency is for inexperienced investors to buy high when everything feels good and sell low when everyone is fearful. Discipline and process provides skilled managers with a clear framework to take advantage of good opportunities that others miss, such as during the inevitable swings between fear and greed.
A (BRIEF) HISTORY OF MUTUAL FUNDS
Mutual funds date back to the 1800s, when English and Scottish investment trusts sold shares to investors. Funds arrived in the United States in 1924. They were growing in assets until the late 1920s, when the Great Depression derailed the financial markets and the economy. Stock prices plunged and so did mutual funds that held stocks.
As was common in the stock market at that time, mutual funds were leveraging their investments — leveraging is a fancy way of saying that they put up only, for example, 25 cents on the dollar for investments they actually owned. The other 75 cents was borrowed. That’s why, when the stock market sank in 1929, some investors and fund shareholders got clobbered. They were losing money on their investments and on all the borrowed money. But, like the rest of the country, mutual funds, although bruised, pulled through this economic calamity.
The Securities Act of 1933 and the Investment Company Act of 1940 established ground rules and oversight of the fund industry by the Securities and Exchange Commission (SEC). Among other benefits, this landmark federal legislation required funds to register and have their materials be reviewed by the SEC before issuing or selling any fund shares to the public. Funds were required to disclose cost, risk, and other information in a uniform format through a legal document called a prospectus (see Chapter 8). Over the decades, the SEC has further beefed up required disclosures in prospectuses.
During the 1940s, ’50s,