A pop quiz for fund investors who may learn by taking it

Your Funds

Dollars & Sense

March 04, 2001|By CHARLES JAFFE

IN THE roaring stock market of the late 1990s, what you didn't know about mutual funds probably didn't hurt you.

Regardless of a fund's particular shortcomings, the rising tide of the market lifted almost everyone to profitability.

But that tide ebbed about a year ago, and lots of investors have since found themselves exposed in many cases by what they didn't know about how their funds work.

With that in mind and in an effort to help investors pick up the small details of fund ownership, here is a pop quiz on some basic concepts all shareholders should know. The questions are not designed to stump you, but to test your knowledge and awareness.

1. You invest in the XYZ Internet fund. How much of that fund must be invested in Internet stocks? a. 100 percent. b. 80 percent. c. 65 percent. d. 25 percent.

2. You invest in a general equity fund called ABC Aggressive Growth.

What percentage of the fund's assets can be concentrated in any one sector or specialty, such as Internet stocks? a. 25 percent. b. 65 percent. c. 80 percent. d. unlimited.

3. True or false: A diversified mutual fund cannot invest more than 5 percent of its assets in any one stock.

4. True or false: To be considered "diversified," a mutual fund must own at least 16 stocks.

5. True or false: You can lose money in a fund over the course of a year, but still owe capital gains taxes on the investment profits the fund realized during that year.

6. True or false: When a mutual fund portfolio manager quits, the fund company must immediately notify shareholders.

7. Does your fund need your approval to change investment styles and policies?

8. True or false: If a fund company goes bankrupt, its shares become worthless and you lose all the money in your account.

9. Which of the following three characteristics is least important when evaluating a bond fund? a. yield. b. total return. c. expenses

Here are the answers:

1. (b) Until just a few weeks ago, the answer would have been 65 percent, but the Securities and Exchange Commission changed this standard to get funds to practice what they preach. If a fund is named for a specific investment or asset class, the new SEC rule states that it must keep at least 80 percent of the portfolio in the assets for which it is named.

2. (d) Unless constrained by rules laid out in its prospectus - and managers loathe such self-imposed restraints - a broad-based fund can go wherever the manager wants, provided that it pursues its stated investment goal. As a result, an aggressive growth fund could be completely invested in a single hot sector, because such moves are indeed the aggressive pursuit of growth.

3. False. By rule, diversified funds are not supposed to put more than 5 percent of assets into one stock. But that rule applies to just 75 percent of the fund's portfolio; the remaining 25 percent of assets all can go into one stock.

4. True. Picking up where the last question left off, if 25 percent of the fund goes into one stock and the rest is divided evenly, you get 15 holdings with 5 percent of the fund, plus the one big holding for a minimum of 16 issues.

5. True, as many investors discovered during 2000. A fund is a "pass-through" vehicle, meaning whatever capital gains it realizes get passed on to you, so that you can pay the taxes.

In a market downturn, a fund may sell stocks to capture long-term profits. The gains from these sales are your tax headache, regardless of whether the fund is up or down for the year. A fund can have short-term losses but distribute long-term gains, giving you both a tax bill and a loss in the same year.

6. False. There is no rule requiring funds to notify you of a change in managers. The fund need only tell you about the switch in its next regular mailing, in which it might bury the news at the back of a semiannual report.

7. Maybe, but probably not. "Fundamental issues" require shareholder approval, but many funds have rewritten their prospectuses so that investment policy is considered nonfundamental. Anything with that lesser status can be changed without a shareholder vote, with fund owners notified only after the change is made.

8. False. If the assets of the fund still have value, your shares do, too. The state of the management company is irrelevant; your fund shares become worthless only if all underlying assets lost all of their value simultaneously.

9. (a) Yield is just a flat percentage of your principal, which is why total return is a better measure of how much you can expect a bond fund to deliver. Expenses, critical to all investment decisions, are particularly important in bonds, since funds with higher costs are virtually guaranteed to produce lesser returns than their low-cost counterparts.

Chuck Jaffe is mutual funds columnist at the Boston Globe. He can be reached by e-mail at jaffe@globe.com or at the Boston Globe, Box 2378, Boston, Mass. 02107-2378.

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