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Choose Mature Noload Mutual Funds

Investing in more mature stock and bond mutual funds and exchanged-traded funds (ETFs) allows you to evaluate the historical consistency of a fund’s record.

On average, the future portfolio returns of more mature funds are probably no more predictable than for very young funds with a similar style or strategy. However, the record of accomplishment of a more mature fund can provide more confidence in its commitment to its strategy and in its ability to remain in business. While there is no guarantee that an older fund will not fail, you have a better chance to avoid involuntary participation in the frenetic birth and death process of many infant stock and bond mutual funds.

Very young mutual funds simply lack records of accomplishment. Therefore, very young stock and bond mutual funds are more likely to put you into the position of being an experimental guinea pig of mutual fund companies and the ETF industry. Concerning screening criteria, simply set a minimum age for mutual funds and ETFs that you are willing to have in your investment portfolio. Three years should be adequate, and there is probably no reason to have a higher minimum. The point is simply to avoid allowing ETF and mutual fund companies to experiment with your money. Choose low cost that have been around for at least three years.

The financial securities industry is clever and tries very hard to attract your investment mutual fund and ETF dollars.

For example, data from Lipper, Inc. indicated that 1,460 new mutual funds were started in 2003, 2,309 in 2002, and 2,392 in 2001.1 The actual number of truly new and distinct funds is smaller, because Lipper counts different share classes as separate funds.

Differences between share classes have nothing to do with the management of a fund’s portfolio. Instead, these share class differences are due to the structure of the sales compensation paid to the investment counselor or financial advisor who convinces you to invest in stock and bond mutual funds. Different share classes simply assess higher or lower front-end and back-end sales load charges and higher or lower annual expense ratios.

Mutual fund companies and ETF companies might argue that they are trying to offer innovative new stock and bond mutual funds to meet evolving investor demands.

This answer is largely rubbish. Mutual fund companies and ETF companies are trying to get your assets into their funds. A true innovation motive is quite unlikely, because tens of thousands of funds of all types already exist worldwide. For example, there are almost as many different US domestic stock mutual funds, as there were U.S. publicly traded companies (This counts only U.S. firms that are traded on public exchanges and excludes over the counter (OTC) penny stocks.)

A more cynical view of this frenetic fund birthing process is that mutual fund companies and ETF companies recognize that fund performance is much more a matter of luck than skill. If fund families keep forming new funds, then some of these new funds will perform better by chance than the average fund within the particular investment style category.

The large number of new funds launched annually indicates that barriers to entry are very low. Fund families can launch a new fund and use their existing operations to support the new fund. If early fund returns happen to exceed its benchmark, then the fund family has a new fund to sell with a short but apparently superior performance record.

Small new mutual funds with stellar investment fund performance records attract investor assets

Sometimes, new fund managers will get lucky by taking positions in smaller firms with more volatile stock prices, or they may pick some larger capitalization firms whose stocks might appreciate dramatically in the short run. The very short, but apparently stellar, record of accomplishment of some new funds makes it much easier to attract investors. These funds can live to see other days, if new assets flow in fast enough.

You should pay close attention the expense ratios of a very young fund and the expense-related footnotes in its prospectus. It is common for fund families to subsidize the management expenses of new funds for a time. By keeping the down, the funds can temporarily inflate performance.

If the fund’s securities selection is lucky, then more investors may come running. If the asset base grows quickly enough then could enable the new fund to grow its management expenses without increasing its annual .

However, if a mutual fund is not so lucky, its standalone management expenses will not disappear. Fund families do not want to subsidize costs of their small, languishing funds for an extended period, and the pressure will be on for the fund to “stand on its own.” Therefore, you need to watch for upward creep in the of a very young fund over time. Note also that the higher a fund’s expenses, the more likely it is that the fund’s net returns will fall short, when compared to a passive market index benchmark.

The new mutual fund grindhouse: Toss ‘em out — Chew ‘em up

In the Warner Brothers movie 300, the Spartans tossed to their deaths those babies whom they deemed to be inferior. Mutual fund companies also are Spartan in this respect. Unfortunately, most mutual fund companies do not extend this Spartan mentality to the management expense ratios that they charge investors across all their funds.

A new mutual fund that does poorly will often be put out of its misery, although this mortality process will do nothing for the misery of the mutual fund’s investors. Most of these under performing fund dogs (or puppies) either will be shut down or will be merged into larger funds. For example, “according to data from Lipper Inc. 870 U.S. mutual funds were merged into other funds (in 2003), while 464 were liquidated. The pace is similar to 839 mergers and 555 liquidations in 2002, and 956 mergers and 433 liquidations in 2001.”2

As noted previously in this article, 1430 mutual funds were created in 2003. When 2003’s 870 mergers and 464 liquidations are combined with these new funds, then the net number of new mutual funds was just 96! Fund financial innovation certainly seems like an awfully harsh process, through which many investors find themselves being dragged. The cynic would say that the mutual fund industry’s rapid birth and infanticide cycle simply allows some of the fund industry’s inferior performance history to be swept under the carpet and obscured or erased.

Mutual fund companies tend to merge new, under performing mutual funds into their inferior mature mutual funds

Furthermore, to the chagrin of participating investors, when unsuccessful young mutual funds are merged, there also is evidence that the older mutual funds — into which these young, failed funds tend to be merged — will usually have inferior characteristics from the investor’s perspective. The larger and older existing funds into which new and unsuccessful funds are merged have a higher tendency to be both more risky and poorer performing than the average mutual fund.3

Apparently, many mutual fund companies do not want to lose the assets that they already have captured in their inferior new funds by liquidating them and issuing refunds. However, at the same time, they also appear not to want to merge these failed young funds with their more successful older funds and thereby drag down the performance history of these more successful older funds. Instead, they usually merge their sick puppies with their older dogs, which are large enough to stay alive within the cost structure of the mutual fund companies.

1) Hayashi, Yuka. “More Mutual Funds are Disappearing Despite Market Recovery.” Dow Jones Newswires. February 26, 2004.
2) ibid
3) Edwin J. Elton, Martin J. Gruber, and Christopher R. Blake. “Survivorship Bias and Mutual Fund Performance.” Review of Financial Studies, Winter 1996, Vol. 9, No. 4: pp 1097-1120

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The Best Mutual Funds Have NO Sales Loads and NO 12b-1 Fees

Sales loads and other 12b1 fees just pay financial advisors to recommend more expensive mutual funds and ETFs

There is no good evidence that investment sales loads and other 12b-1 sales fees charged to investors result in higher mutual fund and ETF performance. In fact, the opposite has repeatedly been shown to be true.

Mutual funds have a long performance history to evaluate. Investment research shows that brokers and financial advisers do not pick better funds. Instead, they try to sell you the more expensive funds that they are paid to promote. By promoting more expensive funds, these higher fees actually reduce performance. Paying a load just means that you are throwing your hard-earned money down a hole.

Front-end and back-end loads, 12b-1 fees, and other sales compensation charges only ensure that an advisor and his/her advisory firm will be compensated for guiding you to select funds that will pay these fees. Front end sales loads reduce the amount that will be invested in the fund on your behalf. You will have less money invested and fewer assets upon which to earn a return.

Back end sales loads allow funds to take away a share of your future returns. Funds with front-end and back-end loads also tend to charge higher annual fees. Marketing fees sometimes known as 12b-1 fees are additional periodic sales charges that further reduce your ongoing returns. Assessed over time, 12b-1 fees pay a sales agent for periodic “servicing.”

Front end sales loads, back end sales load, and 12b1 charges pay advisers. They are not used to improve ETF and mutual fund investment performance.

There is zero connection between the management of the fund and the extra front end sales loads, back end sales loads, higher management expenses, and 12b-1 marketing fees that you pay, when you buy through a financial counselor. There is absolutely no reason to believe that the fund will perform any better to compensate for these charges.

Because securities markets are generally efficient, superior performance is largely due to luck rather than skill and superior performance tends not to persist. On average across funds, front end and back end sales loads are a dead weight loss to you due to market efficiency and the fact that the loads you pay are not even applied toward improving performance.

All a front-end sales load or back-end sales load will guarantee is that there will be a paid sales person to tell you that the fund that they are trying to get you to purchase is a “better” fund. While advisors will most often be careful to avoid making specific promises about future performance, they will not hesitate to provide materials that suggest that the fund has had superior past performance and perhaps a 4-star or 5-star Morningstar Rating.

This game is easy to play, because only those mutual funds and ETFs with past “superior” performance will be promoted by the commissioned financial advisor. Other less expensive and will be conveniently ignored. When superior performance stops in the future, then new “better” funds will be promoted instead. Past “better” funds that do not turn out to be better will be shelved. The securities industry has been playing this superior investment performance shell game for decades. Unfortunately, you get stuck with mediocre future performance and higher investment costs.

When choosing stock and bond mutual funds, eliminate ALL front end and back end loaded mutual funds from consideration.

There are thousands of fine no-load funds available. Ignore the sales pressure of any financial counselor or investment advisor who pushes stock and bond mutual funds with loads, marketing charges, and higher expenses. You can buy directly from no load mutual fund families. You can buy exchange traded funds through discount brokers and then hold them for a very long term to amortized your trading costs.

Note that certain very limited back-end loads can sometimes be beneficial to you, but only if they expire quickly and are designed to prevent costly active trading in and out of the fund by other investors who exploit buy and hold investors. Accept short duration back-end redemption fees that are unlikely to affect you (months and not years). Also, you should be reasonably certain that you can stay invested in the fund long enough for the redemption penalty period to expire.

Do not accept back end load charges. These back end charges should not be paid to an investment adviser or to the fund promoter. Instead, these back end charges should be in the form of a redemption fee that is paid only to the shareholders who remain in the mutual fund. Before buying, ensure that all redemption proceeds from early-exit investors will be returned the fund’s investment pool for the benefit of its longer-term shareholders.

Do not pay brokerage account wrap-fees that are charged by retail “full-service” stock brokers.

It is unnecessary to pay wrap fees to purchase good and and low fee ETFs. Buy-and-hold individual investors do not have to pay high (or any) percent of assets wrap account fees to buy and hold mutual funds and ETFs. Buy them yourself directly and avoid wrap accounts that bleed your personal investment portfolio year after year after year.

If you have sufficient personal initiative to research low cost index mutual fund alternatives, then you can get a very large extra financial payoff by purchasing directly from the mutual fund. Investing directly in funds that you select yourself is very straightforward. It really does not take much time and your “hourly wage” for buying low cost and ETFs is huge.

All mutual fund families that allow direct investments have toll free customer service telephone numbers to request forms to be sent through the mail. Telephone representatives will tell you how to invest. No load funds dealing directly with the public also have easily downloadable and printable forms on their websites.

Filling out and mailing in these noload fund investment forms is only mildly tedious. However, when you do it yourself and you do not pay a commission to purchase through an investment advisor, you pay yourself a very high hourly wage for this relatively quick and painless process of purchasing directly from the mutual fund.

Exchange-traded funds are very easy to acquire, but just hold your ETFs and do not trade frequently.

Just use a discount broker to keep your transaction costs down. Furthermore, to amortize these brokerage transactions costs only buy broadly diversified, very low fee, index ETFs that you intend to hold for a long time. While somewhat different, ETFs and mutual funds share many similar characteristics.

However, one disturbing trend with ETFs has been the far more frequent trading of ETFs, which drives up your trading costs and your short term capital gains taxes and long term capital gains taxes unnecessarily. Do not get caught up on trading ETFs. Buy the broadest market index exchanged traded funds and just hold on to them. Do not trade. Brokers want to trade ETFs to drive up commissions. Just say no and sit tight. Passive buy and hold investors are far more likely to do better in the long run compared to active investors who chase the latest hot investment sector.

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