Over the next few weeks, most mutual fund investors will receive — and ignore — important documents.
They’ll focus on their annual statement — the one showing how well or poorly they did in 2007 — without bothering to look at the annual report or their tax paperwork.
They are missing out on a resource, particularly after a year like 2007 when many performance trends took a turn for the worse and left shareholders nervous about the future.
Going through fund paperwork can take only a few minutes if you know what to look for and if you examine those items with the following question in mind: “Did my fund and my manager do what I would have expected them to do in this kind of investment environment?”
Armed with that question, look through the annual report (and any proxies or tax forms) for these items:
• Performance. Funds must compare returns to at least one benchmark, either the particular market index they try to beat or the average performance of the asset class. Good annual reports show both. Find out why the fund has beaten or lagged its benchmarks.
• Statements from management. Funds should provide candid, clear explanations of what happened, what to expect and why. Management should say what it plans to do with your money. At a bare minimum, it should answer questions that any normal, curious shareholder would have, such as how the fund’s strategy jibes with current market conditions and what to expect in the next 12 months. If management says, “Don’t worry, be happy,” you should “get nervous, be angry.”
• The fund’s portfolio. Although the portfolio is out-of-date by the time the semi-annual report is printed, a fund’s holdings give a glimpse of strategy and performance.
Look for a portfolio that is consistent with your expectations in terms of diversification, international exposure and size of companies. If holdings are concentrated in a few stocks or industries, the fund might be more volatile than its peers. Volatility is not a problem, so long as you know to expect it. If all of your funds have similar holdings, your portfolio has an overlap problem, and you might be less diversified than you think.
• Expenses and portfolio turnover. Dig into the “financial highlights” to get these telling numbers. A fund with high or rising expense ratios is not maximizing your returns. High turnover can lead to big capital gains tax liabilities, which you end up paying.
• Asset growth. A fund that is shrinking or standing still is losing either money, investors or both. That is one investment trend that, eventually, you might want to follow.
• The auditor’s report. Don’t bother reading it, just count the paragraphs. If there are more than three, there could be trouble. Avoid any fund that has real auditing problems. (Some large fund firms add a fourth paragraph naming all of their funds.)
• Changes in structure. If your fund sends a proxy, it might give you a glimpse of what management wants to do next.
• Taxable gains. Investors in taxable accounts must pay the taxes due on any capital gains they receive from the fund, even if they reinvest the proceeds. A fund that is tax inefficient — where the bulk of its returns come from trading profits and dividends rather than long-term buy-and-hold investing — forces an investor to pay taxes for big chunks of their gains annually, while a fund that is tax-efficient can delay those taxes indefinitely.
Frequently, however, investors hold onto funds thinking that a sale would mean a big tax hit. That is true with a tax-efficient fund but usually wrong when a fund makes big, regular payouts. In the latter case, an investor has been paying the taxes all along, which means they might be able to dump the fund without unleashing the tax man.
Chuck Jaffe: cjaffe@marketwatch.com
