Elizabeth P. is a fifty-something widow in Madison, N.J., who is now controlling the mutual-fund portfolio she and her late husband put together over the last two decades.
She owns the funds but doesn’t really understand what she’s got or how they work.
Her tax paperwork from 2012 has her confused, she doesn’t quite seem sure how funds work, and she was ready to sell some holdings because ordinary events that would not faze a savvy investor had her thinking something nefarious or criminal was going on.
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You don’t need to know anything about funds — or pass some test — in order to buy them.
There is, however, a minimum amount of knowledge investors should have in how traditional funds and exchange-traded funds (ETFs) work, and with April being National Financial Literacy Month, it’s as good a time as any to review the absolute basics.
Thus, class is now in session, and you’re getting a pop quiz on basic things all fund shareholders should know.
The questions are not designed to stump you, just to test your level of knowledge and awareness; knowing the answers does not guarantee you will pick better mutual funds or ETFs, but should make you more able to understand what is happening in your funds, and to avoid the unpleasant surprises that come with not understanding how funds really work.
Good luck. Here are your questions:
1. You invest in a general-equity fund called ABC Aggressive Growth. What percentage of the fund can be concentrated in any one sector or specialty, such as technology stocks or real-estate investment trusts?
(a) 25 percent
(b) 65 percent
(c) 80 percent
2. You own the XYZ Utilities fund. How much of that fund MUST be invested in utility stocks?
(a) 100 percent
(b) 80 percent
(c) 65 percent
(d) 25 percent
3. True or false: A diversified mutual fund cannot invest more than 5 percent of its assets in any one stock or security.
4. What is the minimum number of positions a mutual fund must have in order to be considered “diversified”:
5. True or false: You can lose money in a fund during a calendar year, but still owe capital-gains taxes on the investment profits realized by the fund during the year.
6. True or false: Every time a fund pays shareholders a capital gain or dividend distribution, its share price falls by the amount of that payout.
7. Which of these fees is a no-load mutual fund allowed to charge investors: a) termination fee, b) short-term redemption fee, c) low-balance fee, d) management fee, e) 12b-1 fee, f) all of the above.
8. Of the following items, which are not included when a fund calculates its total expense ratio?
a) Brokerage/trading costs.
b) Management fees.
c) 12b-1 fees for sales and marketing of the fund.
d) Front- or back-end sales charges.
e) Shareholder mailings.
f) Interest expenses a fund incurs when borrowing money.
g) Account maintenance fees.
9. True or false: A fund that invests only in insured bonds or U.S. government bonds cannot lose money.
10. A mutual fund you buy this year goes up by 15 percent. Next year, it loses 15 percent. Have you broken even?
Now it’s time to check your answers:
1. (d). Unless constrained by rules laid out in its prospectus — which is rare — a broad-based fund can go wherever management wants, provided that it pursues its stated investment goal.
Thus, an aggressive-growth fund could go all-in on a single hot sector, because that move could be considered an aggressive pursuit of growth.
2. (b). If a fund is named for a specific investment or asset class, it must keep at least 80 percent of the portfolio in the assets for which it is named.
3. False. Diversified funds aren’t supposed to put more than 5 percent of assets into one security, but the rule applies to just 75 percent of the portfolio; the remaining 25 percent of assets all can go into one stock.
4. (a). While some people think 30 — the number of stocks in the Dow Jones industrial average — or 500 (for the Standard & Poor’s 500 index), the math from question 3 holds the key.
If a fund says it is “diversified,” it could put 5 percent of its assets into 15 different securities (accounting for 75 percent of the portfolio), plus one holding the remaining 25 percent of the assets.
Thus 16 holdings is the least a fund could have to earn the diversified label, though the vast majority of diversified funds hold far more than that and some hold thousands of different issues.
5. True. Funds are “pass-through” investment vehicles, meaning whatever capital gains they realize get passed on to you (even if you simply hold the fund and do not trade out of it); as a result, if the manager sells past winners and the fund also suffers through a down period, investors can suffer both a tax liability and a loss in the same year.
6. True. Accumulated capital gains and dividends are part of the share price until they are paid out.
If a fund trades at $10 per share and pays a $1 distribution, its net asset value will fall to $9 when the payout is made.
Elizabeth P. thought something had gone awry with her funds when the shares fell sharply, especially on a fund that was down last year (she would have gotten questions 5 and 6 wrong).
7. (f). “No-load” is about sales charges. Fees for closing accounts, quick redemptions, falling below minimum account size or management of the fund have no bearing on the load. The 12b-1 fee — for “sales and marketing” — is trickier, but so long as it does not exceed 0.25 percent, regulators say a fund can be described as “no-load.”
8. (a), (d), (f) and (g). Trading costs, interest expenses, and any fees that are neither predictable nor associated with day-to-day fund management are omitted from the expense ratio, even though they ultimately are paid by shareholders.
9. False. Every fund has investment risk. If interest rates rise, the market value of a bond fund’s holdings decline.
That drops the value of the fund’s shares, and can result in a loss, even if the fund holds only guaranteed bonds.
10. No. The gain and loss seem to cancel out, until you check the math. Your $1,000 investment becomes $1,150 at the end of the first year, but loses $172.50 in the second, leaving you just $977.50.
Chuck Jaffe is senior columnist for MarketWatch. He can be reached at email@example.com or at P.O. Box 70, Cohasset, MA 02025-0070.
Copyright, 2013, MarketWatch