THE INFORMATION RESOURCES on the Internet are a great boon to investors seeking to narrow down their fund choices. Before undertaking a search, however, it's important to determine what kind of investor you are or want to be. Do you want to engage in the thrills of trading, always hoping to be one profitable step ahead of the market, or do you want to simply buy and hold bond funds and get on with the rest of your life? We call the former an active investor and the latter a passive investor. An active investor seeks out actively managed total-return funds or no-load funds. The pitfalls of this strategy are potential loss of capital, higher expenses, and short-term capital gains that may be taxed as ordinary income. The passive investor seeks out and holds no-load index funds in order to pay minimal fees and negligible taxes.
You also need to consider your tax status. If you're in a high tax bracket and want to generate tax-free interest income, you may want to have municipal bond funds in your portfolio. If you're subject to the AMT, check out whether the funds buy municipal bonds subject to the AMT. If a fund holds taxable bonds, your income will be currently taxable, unless the funds are held in a tax-sheltered retirement account. Income dividends from non-AMT municipal bond funds will be exempt from federal tax but may be subject to state and local income taxes, depending on the laws of your state affecting income from municipal bonds.
In choosing the specific type of fund, you need to determine your level of credit risk tolerance and then match that with the fund categories we've described. You also need to determine the level of interest-rate risk you can tolerate. Finally, you should also review whether you need income for a short period, an income stream for many years, or just the knowledge that you'll be reaping income in the future.
There are various criteria you can use on Web sites to narrow your fund selection. Let's say, for example, that you would like to receive a safe, steady stream of taxable income that's slightly higher than that of a broad-market bond index. After reading the descriptions of the funds in chapters 14 and 15, you settle on a long-term, investment-grade corporate bond fund.
Your next step is to go on the Web and type www.yahoo.com, for example, or to your local library to find Morningstar reports. On Yahoo!, click on "Finance," then scroll down to find "Mutual Funds," then the mutual fund screener. You can then click on a number of settings to narrow your search. But the more specific you are, the less likely you'll be satisfied with the results.
We recommend choosing between taxable and tax free and focusing on fees. See what comes up. Then go back and experiment by narrowing your search criteria. We suggest that you always click on "no Load." We also strongly recommend that you buy only highly rated funds with low expense ratios. These funds, however, are not always easy to find.
Following the instructions in our example, we set the following parameters for our search:
Type: Bond, long term
Morningstar rating: Five stars
Load: none
Expense ratio: Less than 0.5 percent
Minimum investment: Less than $1,000
We then clicked on the "Find Funds" button and, to our dismay, learned that not a single fund fit our criteria. We then started to change the parameters here and there. Finally, when we reduced the rating to four stars, increased the minimum investment to less than $2,500, and increased the expense ratio to less than 1 percent, we located four funds that filled the bill. For each one of them, we could obtain a current quote, a chart, a profile, a performance review, a listing of the holdings, and a comparison with all others in its category. We could also choose to review some prospectuses. We did note, however, that there was no bond index fund listed in the group; for lower cost and higher yield, you could put on your Sherlock Holmes cap and sleuth the financial press. As an alternative to the global search, you might want to just check out the Web sites of the large and well-regarded fund families such as Fidelity, PIMCO, Vanguard, TIAA-CREF, T. Rowe Price, and American Century Funds. See the Appendix for Web addresses.
Yahoo! presents a wealth of information to help you make a knowledgeable decision about which bond fund to buy. Other helpful information sources that can augment your search are the Morningstar Web site, www.morningstar.com; the magazine and news sites of Forbes, www.forbes.com, (try Annual Fund Screen for best-performing funds); BusinessWeek at www.businessweek.com (Under Investor, go to Economy and Bonds); SmartMoney at www.smartmoney.com; Money Magazine at www.money.cnn.com/magazines, Kiplinger's Personal Finance at www.kiplinger.com, the Wall Street Journal at www.wsj.com, Barron's at www.barrons.com, and http://moneycentral.msn.com for investor information and fund research. The Wall Street Journal and Barron's sites are not free.
Why visit more than one site? Some of them have very annoying advertising that becomes nearly torturous after only a few minutes so you might want to vary the kind of headaches you'll experience. Also, the Web sites do not all profile the same funds or profile them in exactly the same way. The Forbes site, for example, tells how the funds perform in up and down interest-rate markets. It also assigns grades for tax and cost efficiency, and then gives an overall risk-adjusted rating, with number 1 being the best. This Web site also relays the Lipper Leader Scorecard, with a checkmark for the best score, replacing the number 1. The Lipper Leader Scorecard includes ratings for total return, consistent return, preservation, tax efficiency, and expense. This is very useful information to keep in mind so that there won't be any surprises. Some sites have a bond calculator, chat rooms, informative articles, and a variety of other interesting features.
We've mentioned Morningstar a number of times. Morningstar is a financial information company that analyzes funds and provides comprehensive data in an easily accessible format. Many online sites purchase their information from Morningstar although the data are not as complete as the data found on its own Web site. Formerly available only in libraries, Morningstar now offers its services online for an affordable price.
What Morningstar online gives you that the printed library version does not, is easy access from anywhere and the ability to sort the information based on your individual preferences. The first sort is based on the Morningstar star ranking. To be rated at all, a fund must be in existence for three years. Funds are rated against other funds in focused comparison groups. Within the group, there may be as many five-star as one-star funds because they will be arrayed along a bell curve. The ratings are adjusted for fund "loads," or sales charges. There are no guarantees, though, that a precipitous event might not catch the firm off guard, or that a fund that performed well in the past will continue to do so. However, Morningstar has changed its risk measure to reward consistent performance over a number of years rather than fiery flashes of brilliant returns.
In the free online version of Morningstar, the list of funds does not include all the funds it tracks. Also, exchange-traded closed-end funds and open-end mutual funds are mixed together. It's easy to be overwhelmed by the sheer amount of information presented. However, if you keep your perspective, you'll find your way. Most important are the fund fees, the kinds of bonds included in the fund, the duration of the fund assets, credit quality, and the table of annual returns. In addition to providing comprehensive information, Morningstar online also has some smart tools to enable you to compare your fund to other funds in the same category.
A feature added in 2006 provides dollar-weighted returns. It calculates a return based on cash flows in and out of a fund as opposed to the usual time-weighted returns, which show how a fund performed on an absolute basis. Thus, times when the fund has more money will get a heavier weight than the times it has less money. This measure was constructed in response to the growing understanding of how often individual investors have bad timing, going into a fund when its yields are peaking and pulling out when the yields drop. Timing is especially poor for the riskiest types of investments. In addition to the dollar-weighted return, each fund will have a "success ratio," which will represent the percentage of total returns captured by the dollar-weighted average.[138]
"Best Buy Funds are not only stingy with overhead costs, but also have done a decent job in delivering risk-adjusted returns over the long haul," Forbes tells investors on its Web site.[139] Found most frequently on the Forbes list, Fidelity and Vanguard funds are the persistent top performers in most bond fund families. Other top-performing bond funds include, American Century, Payden, TCW, T. Rowe Price, USAA, Bernstein, and Dodge and Cox. In the junk category, the top players are Westcore, Buffalo, neuberger Berman, and Fidelity. For long-term total return, the PIMCO Total Return bond fund (PTTDX), run by Bill Gross, beat the Lehman Aggregate Bond Index in nine of the ten years ending calendar year 2005.
Whoever said fund picking was quick and easy? It can, however, be both fun and profitable.
Chapter Notes