Picking the right mutual fund can be daunting even for streetwise investors. And if you aren’t familiar with the financial terminology used in fund reports and online databases, it can be downright frustrating.
Can you tell a 12b-1 from a B-1 bomber? Are alpha and beta just Greek to you? Not to worry. Here’s our guide to the 10 terms most likely to trip you up. Knowing them will help you pick the best mutual fund for your needs — and reap richer returns, to boot.
The expense ratio is what it costs to operate the fund — money that is collected through management fees, administrative fees and other asset-based charges. The expense ratio is revealed as a percentage of the fund’s average net assets, and it is deducted before you are paid any return
High expense ratios eat up investors’ profits. Here’s why: Let’s say Mutual Fund A and Mutual Fund B each has a 10 percent return before expenses. If Fund A’s expense ratio is 2 percent higher than Fund B’s, you lose an extra 20 percent of your expected returns each year when your money is in A. Ouch!
Generally speaking, you want to pay 1 percent or less in expense ratios. A high expense ratio doesn’t mean better results. For instance, Vanguard Capital Opportunity Index managed a return of more than 30 percent through the first three months of 2000 while keeping an expense ratio of 0.94 percent. Why pay more?
12b-1 fees pay funds’ marketing, promotion and distribution expenses. The fee is named for the line of legislation that made it possible. The 12b-1 fee is included in the expense ratio, so you shouldn’t worry about it, right? Ha! The 12b-1 lowers your overall return, and not all funds charge such fees. The argument for these fees is that they are used to sell the fund, which results in more people putting more money into the fund. This allows the fund to lower its cost ratio.
By law, the 12b-1 fee can be no more than 1 percent. Don’t rule out a fund because it has a 12b-1 fee, but choose funds that charge a 12b-1 of no more than 0.25 percent.
Alpha is a measure of the difference between a fund’s expected return and its real return. Alpha must be evaluated in the context of a fund’s beta (volatility) and R-squared (benchmark index).
A high alpha (more than 1) is a good thing. A negative alpha means the fund under performed.
Beta is a fund’s volatility measured against the S&P 500 index, which has a set beta of 1. Therefore, if a fund has a beta higher than 1, it means it’s moving up and down more than the rest of the market. A fund with a beta of 2 will move up 20 percent when the S&P rises 10 percent.
Use a beta this way: In good times, look for funds with a higher beta because you’ll get higher returns. In bear markets, look for funds with betas lower than 1. That way, your fund won’t have losses larger than the average for the market.
R-squared measures a fund’s movements against its particular benchmark index on a scale ranging from 1 to 100. An S&P 500 index fund will have an R-squared very close to 100 because the fund mirrors the index. A fund with a low R-squared number is moving out of sync with its index.
A high R-squared means the beta on a fund is actually a useful measurement. A low R-squared means ignore the beta.
Loads are sales fees. Most common are front-end loads and back-end loads. Let’s say you invest $5,000 in a fund with a front-end load of 5 percent. Automatically you pay $250 and your investment is cut to $4,750. If you are in a fund with a back-end load, you’ll be hit with a sales fee when you sell your shares. Some funds claim to be “no load” but charge reinvestment fees when distributions are reinvested in a fund.
If you’re a do-it-yourself investor, avoid funds that charge loads. No-load funds generally outperform load funds for the simple reason that the sales fee adds to the cost — and therefore lower returns.
A redemption fee is charged when you withdraw money from a fund. It’s different from a back-end load in that a redemption fee goes back into the fund while a back-end load profits the fund company. Some funds will charge you both! A redemption fee is typically charged only if you withdraw your money before a set period. This is done to discourage investors from constantly moving money in and out of funds.
However, some funds waive the redemption fee when you move your money from one fund to another in the same family. Adding to the confusion, some stocks in a family may have a redemption fee while others don’t. Finally, some families of funds charge an exchange fee when you shift money from one fund to another. Ask about this before you invest in a fund.
A contingent deferred sales load is charged by some mutual funds to customers who sell their shares within five or six years of making their investment. Some funds charge a 6 percent penalty if you withdraw in the first year, 5 percent if you leave in the second year, and so on.
Some companies base their contingent load not on your original investment but on the amount you have in the fund when you withdraw.
If you’re thinking of investing in a fund, ask if they have a contingent deferred sales load. If they do and you might need your money before the time limit is up, don’t invest in that fund.
Commonly written as NAV, Net Asset Value is the current dollar value of a single share in a mutual fund. It’s the fund’s assets minus its liabilities divided by the number of outstanding shares. A fund’s NAV is calculated at the end of each business day.
You can track a fund’s NAV like you would the price of an individual stock. If the NAV goes down over time, it’s bad; if it goes up, it’s good.
Turnover is a measure of a fund’s trading activity based on the number of times a year that an average dollar of assets is reinvested. If a fund has $100 million in assets and sells $50 million worth of securities, the turnover ratio is 50 percent.
High turnover can lead to high tax bills, which take a big bite out of your bottom line, unless the mutual fund is in your IRA (and therefore tax-exempt). If your investment is taxable, look for tax-efficient funds.