Demystifying the Mutual Fund, Part 2

Investors often steer toward mutual funds so they don't have to delve into the dark side of stock ratios and company balance sheets. Yet funds have their own bewildering vernacular. Knowing what key terms mean, and what's good performance and bad performance, can help you compare funds and pick the best one.

Part one of Demystifying the Mutual Fund covered a few essential basics -- total return, fund categories and styles, index benchmarks. Now we'll go over some fund lingo that investors need to know.

Weigh the cost

Buying a mutual fund is kind of like hiring your own money manager to put together a portfolio of stocks. But you don't get all that work done for you free of charge, which is why funds have expense ratios.

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The largest expense is the marketing and management fee. There are also charges for trading costs, legal fees and shareholder services. And some funds (usually those sold by brokers and financial planners) assess a 12b-1 fee that covers promotional and brokerage costs.

The average expense ratio for a U.S. stock fund is 1.43%, says Morningstar fund analyst Peter Di Teresa. The average is higher for foreign funds (1.82%), because it's generally more expensive to invest overseas. The average for bond funds is 1.1%.

Expenses are deducted before a fund reports its annual results to shareholders. Say, for example, you bought a fund with a 1% expense ratio and at the end of the year it returned 10%. Actually, you would have earned 11%, had the expenses not been taken from your original investment.

Some fund families, including Vanguard, pride themselves on keeping expense ratios low.

Bottom line: "Cheaper funds, on average, beat more expensive funds over the long haul," says Di Teresa. The difference can quickly add up into the thousands of dollars.

Understand the sales fees

Watch out for load funds -- funds that charge commissions in addition to regular expenses. Essentially, loads are fees for a broker's or planner's advice.

Funds that have share classes (A, B or C) usually assess loads. A shares generally charge a front-end load, in which the commission is sliced from your initial investment. Other share classes charge back-end loads that take the commission when you sell shares. Loads are expressed as percentages -- typically between 4% and 5%.

Some fund families (T. Rowe Price and American Century, for example) offer "adviser" share classes with a higher 12b-1 fee that in essence masks a load charge, or money that it pays out to brokers to sell the fund.

Bottom line: You can almost always find a no-load fund that's comparable to a load fund. If you're doing the research yourself, there's no reason to buy a load fund.

Check the stocks' shelf life

A fund's turnover ratio tells you how frequently the manager buys and sells stocks. A turnover rate of 100% means that on average, every stock in the fund is sold within a year's time. A turnover rate of 20% means stocks in the fund have a shelf life of about five years.

"The turnover rate tells you a lot about the fund's style," says David Scott, co-manager of Chase Growth fund. "And it helps you understand the manager's strategy."

Turnover ratios trend higher under certain conditions -- like now, when the markets are volatile. And that's perfectly acceptable because "locking in gains and stopping losses is critical," says Scott. But what you want to look out for is a turnover rate that's not consistent with the fund's style or strategy. High turnover is most closely associated with and tends to work best for small-company-stock and other aggressive-growth funds.

High turnover rates don't necessarily translate into sky-high expenses, but they do carry tax implications. When a fund cashes in winners it distributes capital gains, and you pay taxes on the gains when you file your return.

Bottom Line: Look at the turnover ratio to make sure it's in line with the fund's style.

Size matters

The size of a fund -- or its total assets under management -- can say a lot about style and performance. It's especially important for small-company-stock (usually high-growth) funds.

That's because, when assets (money from investors) grow too quickly, funds that buy very small stocks get hobbled, says Scott. With all that money to work with, it's easy to get too big a position in a stock. In other words, if the fund buys too many shares of one stock, its market capitalization no longer fits the fund's style.

With too much money, says Scott, funds that used to hold only 20 or so small stocks now have to buy 40 or even 80 stocks, and then the fund's returns are no longer driven by individual stock selection. Many funds close their doors to investors to keep assets to a manageable size.

Shriveling assets, on the other hand, indicate that investors are bailing because of poor performance. The fund's type of investing could be out of favor on Wall Street, but it's often symptomatic of something gone wrong with management and its strategy.

Bottom line: Small-stock funds with mushrooming assets may have trouble sticking to their style and delivering good performance. Shrinking funds are probably best avoided. Keep an eye on the fund's size.