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Elizabeth P. is a 50-something widow in Madison, N.J., who is controlling the mutual fund portfolio she and her late husband put together over the last two decades.
She owns the funds, but doesn't really understand what she's got or how they work. Her tax paperwork from 2012 has her confused, she doesn't quite seem sure how funds work, and she was ready to sell some holdings because ordinary events that would not faze a savvy investor had her thinking something nefarious or criminal was going on.
You don't need to know anything about funds - or pass some test - to buy them.
There is, however, a minimum amount of knowledge investors should have in how traditional funds and exchange-traded funds work, and with April being National Financial Literacy Month, it's as good a time as any to review the absolute basics.
Thus, class is now in session, and you're getting a pop quiz on basic things all fund shareholders should know.
1. You invest in a general-equity fund called ABC Aggressive Growth. What percentage of the fund can be concentrated in any one sector or specialty, such as technology stocks or real estate investment trusts?
2. You own the XYZ Utilities fund. What percentage much of that fund MUST be invested in utility stocks?
3. True or false: A diversified mutual fund cannot invest more than 5 percent of its assets in any one stock or security.
4. What is the minimum number of positions a mutual fund must have in order to be considered "diversified?"
5. True or false: You can lose money in a fund during a calendar year, but still owe capital gains taxes on the investment profits realized by the fund during the year.
6. True or false: Every time a fund pays shareholders a capital gain or dividend distribution, its share price falls by the amount of that payout.
7. Of the following items, which are not included when a fund calculates its total expense ratio?
a) brokerage/trading costs
b) management fees
c) 12b-1 fees for sales and marketing of the fund
d) front- or back-end sales charges
e) shareholder mailings
f) interest expenses a fund incurs when borrowing money
g) account maintenance fees
8. A mutual fund you buy this year goes up by 15 percent. Next year, it loses 15 percent. Have you broken even?
Now it's time to check your answers:
1. (d) Unless constrained by rules laid out in its prospectus a broad-based fund can go wherever management wants, provided that it pursues its stated investment goal.
2. (b) If a fund is named for a specific investment or asset class, it must keep at least 80 percent of the portfolio in the assets for which it is named.
3. False. Diversified funds aren't supposed to put more than 5 percent of assets into one security, but the rule applies to just 75 percent of the portfolio.
4. (a) While some people think 30 (the number of stocks in the Dow Jones Industrial Average) or 500 (for the Standard & Poor's 500), if a fund says it is "diversified," it could put 5 percent of its assets into 15 different securities, plus one holding the remaining 25 percent of the assets. Thus 16 holdings is the least a fund could have to earn the diversified label.
5. True. Funds are "pass-through" investment vehicles, meaning whatever capital gains they realize get passed on to you (even if you simply hold the fund and do not trade out of it); as a result, if the manager sells past winners and the fund also suffers through a down period, investors can suffer both a tax liability and a loss in the same year.
6. True. Accumulated capital gains and dividends are part of the share price until they are paid out. If a fund trades at $10 per share and pays a $1 distribution, its net asset value will fall to $9 when the payout is made. Elizabeth P. thought something had gone awry with her funds when the shares fell sharply, especially on a fund that was down last year (she would have gotten questions 5 and 6 wrong).
7. (a), (d), (f) and (g). Trading costs, interest expenses, and any fees that are neither predictable nor associated with day-to-day fund management are omitted from the expense ratio, even though they ultimately are paid by shareholders.
8. No. The gain and loss seem to cancel out, until you check the math. Your $1,000 investment becomes $1,150 at the end of the first year, but loses $172.50 in the second, leaving you just $977.50.