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Bruce's Best Mutual Funds

Why Mutual Funds?

"There's strength in numbers," goes the adage, and that's true with mutual funds. These ever-popular financial instruments capitalize on the idea that individual investors have a hard time beating the market by themselves because of high costs, the difficulty in investing in more than a few stocks, and bad advice. There is a tendency for investors to trade too much. The more an investor trades, the less the investor makes.

If investors pool their resources, however, they can hire the best money managers in the world who know how to pick winners and gain the clout of the big boys. This is a very appealing scenario. So appealing, in fact, that roughly $7.5 trillion is invested in more than 10,000 mutual funds! Mutual funds are a highly beneficial investment for these three reasons:

• They are an easy way to diversify and maintain balance within your portfolio between asset classes whose prices can move opposite each other.
• They are easy to cash out of, so they are highly liquid.
• They can provide a source of income via dividends.

RATING SERVICES CAN HURT INVESTORS!!!

Many of the rating services out there can actually hurt investors because they don't tell you the whole story. They'll look at some short-term results and tell you that it is a great fund; ignoring the fact that it is a terrible fund in down markets. Or maybe they'll look at a fund's history and show you what a great fund it is... but what they won't tell you is that the fund manager, who "made" that great record, left last year! The fund is a new fund now. These examples are exactly why I think rating systems make major mistakes in the way they score funds. 

How I Pick the Winners.

There are many factors to consider when choosing the best mutual funds. Some basic information is readily available to anyone with a few minutes to spare and an Internet connection. Other information comes from having a dedicated and talented staff that can help track the constant changes made by the funds. But maybe the most difficult part of explaining how to choose the best funds comes from years of studying, monitoring, and analyzing the subtle differences in how the funds are managed and how they tend to react in certain economic conditions. Ultimately it is a "sense" of how all the factors work together in the desired asset class that makes the difference between the best and the mediocre funds. This "sense" is a far cry from picking up a magazine off the rack and seeing which funds made a killing in the last six months.

Vital Unavailable Information?!

This sounds like an oxymoron, but some of the most important decision-making information is generally not easily available to general public. One of the items that isn't easily available is the cost of stock and bond transactions in a mutual fund. Morningstar's expense ratio doesn't show the complete picture when it comes to fund expenses. I won't recommend a fund until I uncover the "complete picture" of a fund's expenses, which includes the transaction costs. 

Even more important is the "stability of the money flow." The stability of the money flowing into a particular mutual fund is a critical factor to consider when buying a mutual fund, that is, IF you can get the information.  One of the most important factors is the flow of money supply into mutual funds. If money is consistently flowing into funds during good or bad times, then the fund is likely to continue in a more consistent fashion. On the other hand, if a fund is susceptible to staggering swings of inflows and outflows as the fund gyrates with investors' emotions, then the fund is subject to a greater degree of risk. Studying the money flow into funds can provide valuable insightŠ if you can get the information.

Amazing True Story

Here's an example to illustrate the importance of the stability of the money flow. I recently had the opportunity to meet one of the best managers in the business. He manages the Safeco Growth Opportunities fund. He was Mutual Fund Manager of the year in 1998 and his fund grew from about $300 million to $1.8 billion in a matter of months. All of the sudden, he was forced to invest huge amounts of money over a very short period. He was forced to make investments that he probably wouldn't have made if he had more time to digest the funds growth over a longer time frame. His performance dropped and investors quickly pulled their money back out of the fund. He was forced to liquidate huge amounts of stock at an inopportune time in order to cover those who redeemed their shares. Soon afterwards, his assets dropped back to $800 million.  Being a fund manager can be ugly, even if you are one of the best.

Some of the information

Below I've put together some of the pieces of the puzzle that I use to make my decisions. I start with the mutual fund basics and move forward from there.

Mutual funds are very popular! 1 in 4 households own mutual funds. As mentioned above, there are over 10,000 mutual funds available and sifting through the funds to find the funds that will help you attain your financial dreams will take more than just a little effort. I've put together the information below to help you in your quest. Some inexperienced investors feel that a good way to pick a fund is to look at what did well last year. After reading the information below, you will understand why choosing last year's winning funds can be a really stupid way to spend your hard-earned cash.

Mutual means a sharing of interests -- and a mutual fund is a practical and efficient way for individuals with similar goals to pool money in an effort to achieve their goals. In a mutual fund, the combined dollars of many shareholders are invested in a diversified group of stocks or bonds so each individual's share of this portfolio represents a small proportional interest in many individual companies.

A mutual fund is an investment company that collects, usually in small dollar amounts, the savings of many individuals. It then invests these funds in various securities that meet the fund's objective. It is a convenient arrangement whereby the investment dollars of many small investors are pooled to become one large fund that is managed collectively for the benefit of all participants.

All mutual funds are managed by investment companies that charge a fee for their service. Normally, it is based on a percentage of total assets within the fund. This fee covers all expenses for the research and operation of the fund.

LOAD MUTUAL FUNDS

Load mutual funds are normally sold by an independent (not associated with just one family of funds) financial planner or broker who receives a fee for helping choose, set-up and manage the accounts. These fees can be a one-time fee or an ongoing fee.

NO-LOAD FUNDS

No-load funds are usually sold directly by the investment company and don't have the broker fees. Sometimes independent advisors will sell no-load funds and attach a fee for their management. No-load funds are specifically susceptible to problems when the market turns south. As the fund drops in value, many investors will bail out in a feeble attempt to "time" the market swings. No-load investors didn't pay to get into the fund and usually have no qualms about selling a fund. The problem is that as these "timing" investors pull out their funds, the mutual fund managers are forced to liquidate stocks to cover liquidations at exactly the time they would like to be buying more stock; when the stock prices are low. Load fund investors will typically hold the funds longer, giving the fund manager a longer term to work with the assets. Managers can generally be more concerned with longer-term returns and not taking on additional risk trying to get short-term results up. This is a generalization and there are some fantastic no-load funds, but finding the best funds requires a little more research.

Mutual Fund Investors typically enjoy five benefits over investors who buy individual stocks and bonds:

• Diversification.
• Professional management.
• Constant surveillance.
• The ability to invest in small amounts.
• The ability to make periodic withdrawals.

Some of the services offered include automatic reinvestment of both dividends and capital gain distributions, monthly investment plans, withdrawal plans, bank by telephone, quantity discounts, exchange privileges from one fund to another and, frequently, checking services.

Each mutual fund shareholder receives many advantages otherwise available to only wealthier and more sophisticated investors who have the resources to spread investments among many businesses.

Just as there are different goals, there are many types of mutual funds with different investment objectives. There are two major categories of investments:

• STOCKS -- when you have partial (share) ownership in a company.
• BONDS -- when you own part of a debt that a company is obligated to repay. Each bond will have a specific maturity and interest rate.

I am often asked, ³How do I compare mutual funds?" The first item to identify is "What is each fund's OBJECTIVE?" Below I've listed the objectives that we find in mutual funds. These objectives guide the manager's decision-making process and will tend to give us a general idea of the risk/return that can be expected from a fund.

MUTUAL FUND OBJECTIVES

AGGRESSIVE GROWTH FUNDS
These seek maximum capital gains as an investment objective. Current income is not a significant factor. Some may invest in stocks somewhat out of the mainstream, such as those in fledgling companies, new industries, companies fallen on hard times or industries temporarily out of favor. Some may also use specialized investment techniques, such as option writing or short-term trading.

GROWTH FUNDS
The primary investment objective of these funds is long-term growth of capital. To achieve this objective, they invest primarily in common stocks of well-established companies with growth potential. Their primary aim is to produce an increase in the value of the investments through capital gains, rather than a flow of dividends. This type of fund is appropriate for the investor who is not concerned with current income.

GROWTH AND INCOME FUNDS
These funds invest in common stocks of companies that have had increasing share value, but also have a solid record of paying dividends. The purpose is to provide shareholders with attractive monthly income and also with the opportunity to increase the value of investments through long-term growth.

BALANCED FUNDS
These generally have a three-part investment objective:

1. To preserve principal
2. To pay current income
3. To promote long-term growth of both principal and income

These funds have an investment policy of "balancing" the portfolio between bonds, preferred and common stocks, as they believe market conditions dictate.

MONEY MARKET FUNDS
The primary objective of these funds is to make higher interest securities available to the average investor who wants immediate income, daily liquidity and high investment safety. This is achieved through the purchase of high yield government or government backed notes. These are generally the safest, most stable securities available, and include Treasury bills, certificates of deposit of large banks and commercial paper (the short-term IOUs of large U.S. corporations). These funds generally offer checking and wire transfer services, and a few even offer a credit card that debits the account balance.

INCOME FUNDS
For individuals whose primary investment objective is current income rather than growth of capital, income funds can offer generous monthly income. These funds usually invest in stocks and bonds that normally pay high dividends and interest.

OPTION INCOME FUNDS
For investors seeking a high current return, these funds invest primarily in dividend paying common stocks on which call options are traded on national securities exchanges. Current return generally consists of dividends, premiums from expired options, net short-term gains from sales of portfolio securities on exercises of options, and any profits from closing purchase transactions.

INCOME (BOND) FUNDS
These funds seek a high level of current income for shareholders by investing at all times in a mix of corporate and government bonds. If invested in long-term bonds, the income might remain fairly constant, but the market value will fluctuate with changes in interest rates.

INCOME (EQUITY) FUNDS
Seek a high level of current income for shareholders by investing primarily in equity securities of companies with good dividend paying records. The objective is to provide an income that gradually increases each year.

INCOME (MIXED) FUNDS
Seek a high level of current income for shareholders by investing in income producing securities, including both equity (stocks) and debt (bonds) instruments.

BOND FUNDS
The types of organizations that issue bonds fall into three broad categories:

1. Publicly or closely traded for-profit corporations
2. The federal government and its agencies
3. State or local government agencies - This also includes non-profit organizations. Each of these is subject to somewhat different tax treatment. This tax treatment has an effect on the price of the bonds and the bond interest (coupon) rate. Bonds issued directly by corporations are fully taxable to individuals at both state and federal level. For that reason the rate must be higher. Bonds issued by the federal government are frequently exempt from state income tax, but are taxable by the federal government. Bonds issued by state or local agencies are exempt from federal tax and may also be exempt from taxation at the state level.

CORPORATE BOND FUNDS
These funds seek to generate a high level of current income by investing primarily in the senior securities of profit corporations. Some funds concentrate primarily on high-grade bonds and thus are able to provide shareholders with a greater degree of safety, but usually with less income than bond funds that may have a mixture of high, medium and lower grade bonds. Some of the portfolio may be in U.S. Treasury bonds or bonds issued by a federal agency.

HIGH YIELD BOND FUNDS
These funds specialize in selecting rated bonds to insure the highest yield possible with a reasonable degree of safety. This type of fund appeals to individuals who seek high current income or desire to reinvest dividends and capital gain distribution, thus compounding income at a high rate of return. Usually, these funds maintain at least two-thirds of the portfolio in lower rated corporate bonds (Baa or lower by Moody's rating service and BBB or lower by Standard and Poor's rating service). In return for a higher yield, investors must bear a greater degree of risk than for higher rated bonds.

MUNICIPAL BOND FUNDS
These funds invest in a broad range of tax-exempt bonds issued by states, cities and other local governments. Interest obtained from the bonds is passed through to shareowners free of federal tax.

LONG-TERM MUNICIPAL BOND FUNDS
Invest in bonds issued by states and municipalities to finance schools, highways, hospitals, airports, bridges, water and sewer works, and other public projects. In most cases, income earned on these securities is not taxed under state and local laws. For some taxpayers, portions of income earned on these securities may be subject to the federal alternative minimum tax.

SHORT-TERM MUNICIPAL BOND FUNDS
Invest in municipal securities with relatively short maturities. They are also known as tax-exempt money market funds. For some taxpayers, portions of income earned on these securities may be subject to the federal alternative minimum tax.

STATE MUNICIPAL BOND FUNDS
These funds contain either short-term or long-term portfolios of bonds. They work just like other municipal bond funds (see above) except their portfolios contain the issues of only one state. A resident of that state has the advantage of receiving income free of both federal and state tax. For some taxpayers, portions of income earned on these securities may be subject to the federal alternative minimum tax.

U.S. GOVERNMENT INCOME FUNDS
Invest in a variety of government securities. These include U.S. Treasury bonds, federally guaranteed mortgage backed securities, and other government notes.

GNMA OR GINNIE MAE FUNDS
Invest in mortgage securities backed by the Government National Mortgage Association (GNMA). To qualify for this category, the majority of the portfolio must always be invested in mortgage-backed securities. In some cases, these funds make distributions that are both principal and income.

INTERNATIONAL FUNDS
Invest in equity securities of companies located outside the U.S. Two-thirds of the portfolios must be so invested at all times to be categorized here.

GLOBAL BOND FUNDS
Invest in debt securities (bonds) of companies and countries worldwide. Some funds invest in U.S. Bonds, and others do not.

GLOBAL EQUITY FUNDS
Invest in securities traded worldwide, including the U.S. Compared to direct investments, global funds offer investors an easier avenue to investing abroad. The professional money managers of each fund handle the trading and record keeping details and deal with differences in currencies, languages, time zones, laws and regulations and business customs and practices. In addition to another layer of diversification, global funds add another layer of risk -- exchange rate risk.

GLOBAL COUNTRY OR REGION FUNDS
These invest in the securities of corporations or governments in a specific country or region. Thus, the owner has two areas of risk that also means two areas of opportunity:

1. Growth in market value.
2. Currency changes.

Thus, it is possible for a "Japan Fund" to increase in share value and at the same time increase in value to the U.S. fund owner if the yen/dollar rate change is also favorable.

PRECIOUS METALS/GOLD FUNDS
These funds maintain two-thirds of the portfolios in securities associated with mining or processing of gold, silver and other precious metals.

Other types of mutual funds include:

• Special area funds, such as chemicals.
• Special philosophy funds, social purpose, etc.

You may have heard someone refer to a "FAMILY OF FUNDS." These are a group of the above funds all managed by the same organization. Their structure permits investors to switch funds from one fund to the other for a nominal fee or none at all.

NOW THAT YOU UNDERSTAND THE BASICS, let's move to the next level. We divided the above categories by objective and found that there are at least 25 possible objectives for mutual funds. Many companies that rank funds tend to lump all Domestic Stocks into one group. This makes comparing funds difficult if they are driven by different objectives. Make sure that when you compare funds that they are in the same general OBJECTIVE and INVESTMENT STYLE. Don't just look at some star rating by itself and think you've found the right fund.

INVESTMENT STYLE

A company named Morningstar created an investment style box that has become widely used by investors and advisors. It helps to qualify the type and objective of the funds. For stock funds, the box is divided into nine smaller boxes as follows:

The top 3 boxes are "Large Caps," the middle three boxes are "Mid Caps" and the bottom three boxes are "Small Caps." This refers to the size of the average company held in the fund. They currently define Large Caps as companies that have a market capitalization of over $5 billion, Small Caps are under $1 Billion and Mid Caps are between $1 and $5 billion.

The three left boxes are GROWTH, the three right boxes are VALUE and the middle three boxes are BLEND (part growth, part value). This refers to the type of stocks that are most common within the fund. To simply define growth versus value stocks -- a growth stock's purchase is based more on future potential and a value stock is based more on current earnings and ratios.

It is important to review how each fund compares to others with the same investment style, category or sector.

PORTFOLIO

As mentioned above, each mutual fund is made up of a number of stocks and/or bonds. By reviewing the top holdings, you will learn a lot about how the manager has invested.

TURNOVER RATIO

Consider the turnover rate of a mutual fund. A fund's turnover rate refers to the number of times the investment portfolio is bought and sold annually. If a fund holds 150 stocks at any time, and during the previous year bought and sold 90 stocks, its turnover rate is 60 percent. On average, this fund trades 60 percent of its stocks a year. A turnover rate of 200 percent in a stock fund is too high. A high turnover ratio increases fund costs (and the cost of the turnover isn't even included in the "expense ratio") and implies that the fund is more actively managed as opposed to a more passive approach. The more a stock fund trades, the more it resembles a speculator rather than an investor. I generally encourage using funds that have a 30 percent asset turnover rate if you want low risk, and up to 100 percent turnover if you want a little higher level of risk. However, a reasonable turnover will vary depending on the type of fund you are buying; specifically the fund's style, sector, size and objective.

YIELD

Another point to consider is the "Yield" of the fund (if it has one). The yield is the sum of the fund's income distributions over the past 12 months, divided by the previous months Net Asset Value price. A higher yield will typically mean it is a value stock.

SECTOR WEIGHTINGS

Once you see how a fund is weighted by sector, you will generally understand why it has performed the way it has over the past few months. For example, if a company is 65% invested in the tech sector, it will obviously react very differently than a stock with 65% in financials. This review can be taken a step further by reviewing the "Industries" that are used within each sector.

This information really helps us to understand why a fund had more or less volatility than the "market" or why the returns where higher or lower than the market.

ASSET ALLOCATION

The "Asset Allocation" of each fund shows another way of categorizing how the fund is invested by showing the broad categories and the percentage of stocks invested in foreign companies.

COMPARING HISTORIC RETURNS

Look at the fund's long-term track record. Over and over, I stress the importance of the buy-and-hold strategy and nowhere is this truer than with mutual funds. In many categories, the best funds are the ones that have a track record over 10 to 15 years. A good 15-year track record limits your risk exposure. You might hold a fund for 20 or 30 years and want to use that as a yardstick, but not many funds have track records that long. So, 10 years or more is a reasonable time frame to get a feel for how a fund will do over the long term. Once again, the historic returns will often vary due to the sector, style, and objective. It isn't always possible to find a fund that has exactly what we are looking for in every category (see the summary at the end of this article).

Mutual Fund Managers

Each mutual fund is managed by one or more managers who decide which stocks (or bonds) will be a part of their fund. The manager(s) is obviously very important to the success of a fund.

One of the most common mistakes made by novice investors is basing their investment decisions on a fund's history that was made by a different manager. A number of years ago, Peter Lynch was the very successful manager of the Fidelity Magellan fund. When he gave up the manager position, the Magellan Fund was in effect, a new fund with no track record! Yes, the fund continued as if it were business as usual, but the person "pulling the trigger" on the investments was new. The NEW manager may use similar tools to choose investments; however, the results will be different with each manager. Investors must recognize the critical difference between a manager's history and the fund's history. Also, if a manager moves from a small-cap growth fund to manage a large-cap value fund, you'd be better off waiting until he/she creates a new history before jumping into their fund. DON'T BASE YOUR DECISION TO INVEST ON A FUND'S HISTORY THAT WAS MADE BY A PAST MANAGER.

Multiple Managers or a "Star"

Look at the mutual fund's management. There is, in fact, a "star" system where many funds seek to create a star manager in the hope that he or she will produce a great track record and attract investors. Beware! Stars can eventually leave the team, so it is best to NOT depend on the star system. If possible, I'll choose a "multiple manager fund" over a similar fund managed by a "star" every time.

The difference between a good manager and an average manager becomes apparent OVER TIME and especially over DOWN TIMES. Every manager has an objective and investment style that helps me to determine when I think a manager is doing well or not.

For example, in 1998 large cap value funds didn't have as good of a year as large cap growth funds. So to compare them head to head is not a fair comparison. Conversely, there have been many years where large cap value funds have easily beat growth funds. Learning how to compare apples to apples takes more effort than a quick review of returns.

FEES AND EXPENSES

Fees and expenses take away from a fund's potential returns. "Total Expense Ratio" is a very important statistic. If a fund has a total expense ratio of 1.06%, then for every $100 invested for a year, $1.06 goes to cover expenses. International funds will normally be more expensive to manage than their domestic counterparts. International funds' expenses average about 1.5% per year. Small-cap funds, average about 1.35% per year and are typically a little more expensive than large-cap funds and bond funds (averaging approximately 0.7%).

Some mutual funds with a small asset base have suffered from poor returns and when investors hit the exits, the fund's expenses compared to assets under management (expense percentage) skyrocket as there are less and less assets to cover the managers' fees. I've seen funds that have had expense ratios of over 20% per year! "How can a fund make money for their clients if they are charging such high expenses?" Well, THEY CAN'T! DON'T INVEST IN FUNDS WITH VERY LOW "NET ASSETS" OR EXCESSIVE EXPENSE RATIOS.

RISK AND RETURN - STANDARD DEVIATION

Comparing fund's returns cannot be done without understanding the corresponding risk they've taken to get the return. Standard Deviation is a measurement of volatility. Compare the fund's standard deviation to the S&P 500 to get an idea of the funds risk to return. Compare the fund to other funds in the same category to get a good feel of its risk.

OTHER FACTORS TO CONSIDER

Sharpe Ratio
The higher the Sharpe Ratio, the better the historical risk-adjusted performance."

Bear Market Decile Rank
Listed by Morningstar, the lower the number, the better the fund has done in bear markets.

R-Squared
This is a number that, like many other statistics, means something only when used in correlation with other statistics. If the R-Squared is relatively high (75 or higher), then it means that its fluctuations are determined primarily by the benchmark index (the benchmark index is the average for a category -- such as the S&P 500 or the Lehman Brothers Aggregate Bond index). A high R-Squared number means that the Beta will be a useful number.

Beta
The Beta is a valuable statistic that is misunderstood by many investors who believe it is a measurement of risk that stands on its own. It is dependent on a high R-squared number for its reliability.

Alpha
The alpha is a great tool in determining the efficiency of the manager. You could describe it as how well the fund did as compared to how it should have done. Anything over 1 is good, and anything below 1 is bad. This figure is partly based on the beta, so make sure that the r-squared is high before depending on the alpha.

Best-Fit Index
This is another Morningstar statistic. The best-fit index compares the fund to the closest matching index based on R-squared. For example, the best-fit index may be the S&P 500 and it helps in comparing funds.

Would you ever buy into a tax burden without the benefit of receiving the gains? Well, if you've bought a mutual fund outside of a retirement account, then you probably have.

Above we've covered a lot of information that will help you compare mutual funds. But many people forget to look at ONE OF THE MOST IMPORTANT FACTORS when buying and managing their funds -- TAXES. The higher your tax bracket, the more important it is to pay attention to this article. For many people, variable annuities can be a better alternative to mutual funds. Take a look at our section on annuities in this website.

Let's say you researched mutual funds and you found that XYZ fund has been great. Its averaged over 18% annually for the last 10 years and you think it will be a great addition to your portfolio, so you buy $10,000 worth of XYZ in your taxable (not a retirement) account. The XYZ fund currently owns a lot of stock in companies that have done very well recently.

HERE'S THE PROBLEM

Many of these stocks were purchased years ago and have doubled or tripled in value. The fund manager will eventually want to sell these "winners" and put the money in other stocks. When the manager sells, the tax burden flows out to the shareholders for taxation. Mutual funds by law must pay out at least 90% of their income and capital gains annually to the shareholders to avoid taxation at the corporate level.

Assuming that 35% of XYZ fund's assets are made up from unrealized capital gains -- in other words, the fund's tax basis is only 65% of the overall value (which isn't that unusual considering the great returns funds have enjoyed over the last few years). So, if the manager sells the winners, you get the tax, even if you didn't enjoy the past gains.

Back to our example -- so this $10,000 purchase could potentially go down in value the month after purchase, then the manager could sell the winners and you would receive a 1099-DIV for the huge gains, but have an investment that had actually lost money. What a deal! This happened to a lot of investors in the emerging market funds last year. The funds had a lot of gains built up and they had to liquidate "winners" in order to give the "selling" shareholders their money from redemptions.

Yes, you get "credit" for paying taxes when you go to sell out your position in the fund; but paying taxes on money you haven't even made is frustrating at best and it hurts the bottom line amount of money you have compounding.

On the other hand, what happens if your fund had stocks that were losers in their fund that they sold at a loss? You would probably think that could write them off as losses in the year they were "realized," it only makes sense. But no, those losses can only be used offset future gains.

TYPES OF TAXATION ON MUTUAL FUNDS

CAPITAL GAINS
Capital Gain taxes are due if a mutual fund manager bought a stock (or a bond) for a lower price than they eventually sold it. Actually, all the gains and losses are netted together and at least 90% of income and gains must be distributed to shareholders. The shareholders receive a 1099-DIV at year-end that states the taxable amount of distributions.

DIVIDEND AND INTEREST INCOME
Dividends and interest are also reported on the 1099-DIV form. Dividends are payment of cash from a company's profits to shareholders. Interest comes from payment on bonds or other debt instruments. In the case of a mutual fund, the fund is the shareholder of the stocks. The fund receives the dividends and interest and then in turn pays it out to its shareholders.

WHAT IS A 1099-B?

A 1099-b form reports the gross proceeds of sales (redemptions) of mutual fund shares (note that even tax-free municipal bond funds can have taxable gains when sold). Money market funds and retirement accounts won't ever have 1099-b reporting. So, if you bought a fund for $10,000, paid 1099-DIV taxes of $1,000 and sold the fund for $15,000 -- then you (or your mutual fund company) would need to provide the IRS with a 1099-B form. Be careful not to DOUBLE pay taxes. In this example, make sure that you don't show $5,000 gain instead of $4,000 -- you've already paid $1,000 of 1099-DIV taxes over the years.

WHAT ARE THE NEW TAX RATES ON LONG-TERM AND SHORT-TERM GAINS?

The Taxpayer Relief Act (doesn't that sound nice?) of 1997 and the IRS Restructuring and Reform Act of 1998 reduced the tax rates on capital gains.

• Gains on securities held more than one year are considered long-term capital gains. They are currently taxed at a maximum rate of 15%. If you were in the 15% federal tax bracket, then your gains would be taxed at 8%.
• Gains on securities held less than a year are considered short-term capital gains and are taxed as ordinary income. For those in the top tax bracket, it would be taxed at 35%.

It is hard to discuss mutual fund taxation without leading into a discussion on the benefits of compounding of interest on money that would have gone to the IRS.

The next few paragraphs are from an earlier Financial Keys article on Retirement Planning. We discussed compounding interest and tax-deferral and think it is worth repeating.

GOOD TAX PLANNING IS "EASY MONEY"

Some of the easiest money you will ever "make" is made simply by having "Quality Tax Information." You have to do a little homework to find out what strategies work best for your situation. One of the most common tax strategies is the use of tax-deferred investments like IRA's (Individual Retirement Account), variable annuities or 401(k)s (a type of company retirement plan).

I've heard a lot of people say "We have to pay the taxes on our retirement accounts when we retire anyway, so why not pay the taxes now instead of later? We are probably going to be in the same tax bracket at retirement, so it all works out the same, doesn't it?"

Sounds reasonable enough, but no, it's not the same. If you are paying taxes on the gains on a yearly basis rather than having all taxes deferred until you withdraw the money, then every year you are giving money to the IRS. If you were using a tax-deferred account, that money could be compounded year after year in your account. For example, if you made 10% ($1,000) on your $10,000 investment, and you had to pay 28% taxes (assumed rate), then you would only have $10,720 working for you the next year instead of the full $11,000. This compounding on "extra" money ($280 in the first year, $308 in the second etc...) is what makes the tax deferral so powerful over the years. Tax-deferral and compounding of interest work hand in hand to provide a solid base for retirement investing.

For example, if we assumed:

TAX MANAGED FUNDS

There are funds that specialize in "Tax Managed Funds" where the manager tries to keep year-end taxes to a minimum. These funds will generally provide very low taxation for a period of years for two reasons:

1. Low turnover within the fund (if a manager doesn't ever sell investments with gains, then they'll be no capital gains) and
2. When the manager does sell, an effort is made to net gains against losses in the same year. Over the long term, I see these funds having difficulty avoiding a large build up of gains.

Index funds (which inherently have low turnover) are known for having potential future problems in this area. We called Vanguard and found that the 500 Index fund currently has 39% UNREALIZED CAPITAL GAINS. So far, their shareholders really haven't had much of a problem because the fund continues buying more of the same stocks as new money comes in and they don't sell too often because most of the stocks in the "index" stay the same.

If you subscribe to the Morningstar Premium Service, you can see under tax analysis how "tax efficient" the fund has been in the past. However, in the future, if we had massive sell-offs and these funds actually became smaller, managers would be forced to sell off more of their winners to provide their shareholders liquidation. Shareholders could then be affected. Mutual fund managers intend to sell off using LIFO (last in, last out) type of accounting which means that they would sell off their most recent purchases of stock, rather than the first purchases. This is a good way to reduce current taxation, but still leaves the potential future problem.

IN SUMMARY, WHAT CAN YOU DO?

As in many problems, there may not be an easy fix; however, the following ideas may be helpful.

BEFORE YOU BUY A MUTUAL FUND IN A TAXABLE ACCOUNT, ASK THE MUTUAL FUND COMPANY WHAT AMOUNT OF UNREALIZED CAPITAL GAINS ARE BUILT UP IN THE FUND. I am not saying that you should completely avoid funds that have large "unrealized capital gains," but I am saying that you should go in with your eyes open to the possible problems. Realize that any fund with a good track record will probably have significant "unrealized capital gains."

REMEMBER THAT EVERY TIME YOU BUY AND SELL A FUND, YOU WILL BE LIABLE FOR TAXES ON GAINS BEYOND THOSE THAT YOU HAVE PAID ANNUALLY BASED ON THE 1099-DIV. SO KEEP GOOD TRACK OF PURCHASES AND SALES -- ESPECIALLY IF YOUR MUTUAL FUND DOESN'T DO IT FOR YOU.

EVALUATE IF TAX DEFERRAL IS IMPORTANT FOR YOU. TALK TO YOUR ACCOUNTANT OR FINANCIAL PLANNER TO DETERMINE WHICH TAX PLANNING STRATEGIES MAKE SENSE FOR YOUR INDIVIDUAL SITUATION. You may feel comfortable building your own stock portfolio based on the portfolio mix of one of your favorite funds, or maybe using a variable annuity to provide tax deferral is worth consideration. Think about how each investment in your portfolio is taxed and how it fits in your overall tax strategy.

There are so many variables and it takes extensive effort to find the best funds. Many times, we are unable to find exactly what we are looking for in a fund. This is where experience and knowledge come into play. My staff and I work to find the best funds in each category after considering all the factors.

CLICK HERE to see the list of "Bruce's Best" Mutual Funds; If you would like to find out if mutual funds are an appropriate investment for you, call my office (801-486-9000 or 800-422-9997) we will arrange a time for us to talk. I look forward to our discussion.

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