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MUTUAL FUNDS MASTER CLASS

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Pick up any newspaper or magazine and you'll see advertisements for different mutual fund companies, all purporting to be the right investment for your money: safe, secure, and profitable. But with so many funds on the market, what makes one different from the rest, and are they all as good as they say they are? How can a novice investor make the right choice?

THAT MONEY SHOW asked Barbara Brotman, a well known financial reporter at the CHICAGO TRIBUNE, to sit in and act as a student during an impromptu master-class in mutual funds. Barbara runs her family like a business, and is responsible for many of their investment decisions. But by her own definition, this well seasoned reporter would rather sift through trash than read her 401k statement. To help her get a grip on just what her mutual funds are doing, she and Betsy Karetnick, host and managing editor of THAT MONEY SHOW, talked with Morningstar Funds Managing Director Don Philips about understanding how mutual funds work and how to tell the differences between them.

Why Choose Mutual Funds?

Brotman: Does anyone really know how to pick these things, or are dartboards the best way to choose?

Philips: I think we can figure out which characteristics different funds have and then work on finding the right match between you as an investor, your goals, and the many different funds.

Karetnick: Why would she want a mutual fund? Why not stocks or bonds?

Philips: I think there are three main advantages. First is instant diversification -- when you buy a stock, you're buying one company in one industry. Your fate is very much tied to a lot of thing that may be out of your control. Second is professional management -- someone who's doing the due diligience on these companies, presumably troubleshooting them, trying to identify the stronger and weaker companies. Third is simply the convenience of a mutual fund.

Setting Goals

Philips: What are you trying to achieve? Why are you an investor? What are you goals? What's your time horizon?

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Brotman: My goal is to make money and not put it all in a mattress. Doesn't everybody have the same goals?

Philips: Well, it depends. They have different time horizons certainly. Are you saving for retirement? Are you saving for a child's education? Are you saving to put a down payment on a house next year?

Brotman: I'm saving for my retirement and for my child's college education.

Philips: Then what you want to do is start to quantify what those goals are. When will your child go to college? Get some information on dollar amounts and make two different piles of money; one for your retirment goal, and one for your college goal.

Types of Mutual Funds

Karetnick: What are the differences in the types of assets we might find as we explore the world of more than 10,000 mutual funds?

Philips: So much of the focus the last couple of years has been on stock funds, but you also have fixed income funds, international funds, sector funds -- funds that invest in just one part of the economy -- and then you've got different styles of stock funds. You've got growth funds, value funds, large cap funds, and small cap funds. There are any number of gradations you can choose from.

Brotman: I was wondering if there was someone else who would do the allocation for me because that would certainly be the way I'd be interested in going.

Philips: Index funds are a great place to start. An index fund -- instead of having a manager who would decide one stock is better than another -- would go out and buy all of the stocks that are in a particular index, such as the S&P 500, which would be representative of the market as a whole, or some sub-set of the market. And the idea of an index fund is that you buy a little bit of everything. The advantage is that they generally are lower cost than actively managed funds because they don't have to pay for all those stock researchers.

A number of 401k plans include life cycle funds. They're becoming really popular. These are nice because they actually start out more heavily in stocks and progressively move to a more conservative positioning. There are others that are for more moderate investors, conservative investors, or aggressive investors. And those, in essence, will become asset allocation type funds.

Comparing Different Funds

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Brotman: How do you compare them? Different magazines all seem to have different rating systems, and they come out with articles claiming their choices are the most fabulous, top mutual funds.

Philips: Some folks or magazines might say which are the best funds of the last year. Others may look at the last five years. And still others might examine the last ten years. So, in other words, they're usually just comparing the highest returns. They often ignore the risk and volatility those funds experienced along the way, and those factors could make a fund less attractive than one with slightly lower returns, but a much smoother path.

Karetnick: That's where Morningstar really comes into play. Their famous mutual fund ratings stars are assigned (from one to five) on funds 3 years and older based on comparing risk to rewards, minus the expenses. Is that right?

Philips: We deduct all the fees to reveal what the investor actually got. So the way I think of the star ratings is they're like grades on a report card. It shows that over this semester this fund did a-level work, b-level work or c-level work.

Load vs. No-Load Funds

Brotman: Is there any reason to pay fees when so many funds are no-load?

Philips: A load goes to pay the person who sells you the fund. The fee that all funds have -- and which you cannot avoid -- is a management fee for operating expenses. That's what is called the expense ratio. You want to pay attention to the fees and expense ratios. If your fund earns a average of 5% a year, but you are paying 1.5% a year in fees, then 30% of your gain has been forfeited to fees. Sometimes you can have the best manager in the world, but if they're in an overpriced fund the returns that come back to you may not be that spectacular.

Summing Up

Karetnick: While we're at it, we should remember to check out that fund manager's track record. So how about it Barbara, are you up for the challenge?

Brotman: I like the idea of asset allocation funds. I think it's highly unlikely that I will become the kind of person who thinks all the time, "How can I make money?" I need to find something that is low maintenance and simple enough that I could do it.

Karetnick: When you buy a fund, imagine what might go right and what might go wrong. As many of us discovered the hard way, your fund can lose as much as 50% over a 12 month period. Also examine what's in your portfolio. You may think you're diversifed with half a dozen funds, but their investments could be very similar.




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