In This Chapter

Socially responsible investors use mutual funds more than any other investment product—and with good reason. Mutual funds make it easy to invest by doing all of the hard work (research, monitoring, buying, selling) for you. That professional help is valuable, but it comes with a price and, if you’re not careful, expenses can cut deeply into any profits. For many investors, reasonable expenses are a small price to pay for the professional management and ease of investment that mutual funds offer.

Investors can choose from a wide variety of mutual funds with different investment styles and objectives. Many investment companies manage families of funds to attempt to provide a cross section of offerings to keep as many of the investor’s dollars as possible. Socially responsible mutual funds offer investors many opportunities, however, their offerings do not compare in scope with traditional mutual funds. Some investors find that they cannot meet all of their investment needs with just SRI mutual funds and must use traditional funds to complete their portfolios (this is another reason it is important to understand proxy voting by traditional mutual funds). Socially responsible investing is still investing, so it is important to understand that part of the process. While mutual funds make the investing process easy, not all funds are the same. An informed socially responsible investor is more likely to reach both goals of affecting change and meeting financial objectives.

Mutual funds are the single most popular investment product on the market and with good reason. Investors pool their money and a team of professionals manages it for them. The investors share in any profits or losses. Mutual funds come in different investment styles and with different objectives, so investors can find one that matches their needs and aligns with their tolerance for risk. Mutual funds invest in stocks, bonds, cash, or all three, depending on the fund’s objectives. Some funds invest for growth, while others focus on income, and others still blend both growth and income. Finding a mutual fund that fits most reasonable investment needs is almost a certainty. SRI mutual funds can be found that fall into most of the standard categories, however, you will have fewer to choose from than out of the universe of traditional funds.

Mutual funds are not risk-free investments, however, you do enjoy the benefits of professional management making the decisions about when to buy and when to sell. Mutual funds also give you easy and quick access to your money should you need to pull out some cash for an emergency or to pay large bill like college tuition. Mutual funds also let you invest incrementally in whole dollars, which is what you do if you contribute to a company-sponsored retirement plan such as a 401(k).

Mutual funds benefit the millions who invest in them either on the open market or through a company-sponsored retirement plan. Socially responsible investors will find many of these benefits especially important to them. Mutual funds take most, but not all of the work of investing off the investor and turn it over to professional money managers. Investors still have a responsibility to monitor their investments periodically and make necessary adjustments as warranted by changes in fund performance and their own life circumstances. The three main benefits to investing through mutual funds are professional management, diversification, and convenience.

Mutual funds are managed by investment professionals who typically have years of experience in the stock market. An investment management company hires researchers, analysts, portfolio managers, and others to run the mutual funds it offers. Most mutual funds belong to a family of funds that is managed by an investment management company, which can spread the expense of the financial professionals over all the funds it offers. Professional management is one of the distinguishing features of mutual funds because it is a value-added service that offers investors access to research and expertise that would be too expensive for most individual investors to afford privately.

Portfolio managers have different styles and approaches to investing. Some are more aggressive and trade frequently, while others tend to be on the conservative side with fewer trades. The portfolio manager’s investment style should match the mutual fund’s goals. Socially responsible funds typically require more research than most traditional funds, so the investment management team is important to the financial performance, as well as meeting the SRI goals.

One benefits of investing in mutual funds is easily achieved diversification. Diversification is the spreading of your investment dollars over a number of stocks or bonds so a poor performance by one investment has little effect on the total holdings. Simply stated: Don’t put all your eggs in one basket. A mutual fund may own 40 to 60 different stocks (or more). Few individual investors can own that many different stocks.

You do need to exercise caution when buying multiple mutual funds, however. If several mutual funds own essentially the same stocks, you haven’t diversified as much as you might think. For example, if you owned three different mutual funds, but all invested heavily in technology stocks, you would be vulnerable if that sector of the economy was depressed. You should be diversified by industry sector as well as by number.

The mutual fund industry has made it easy to become an investor. You can begin investing in many mutual funds with as little as $1,000 to open an account and some offer even lower minimums. Subsequent contributions can be as low as $25. Most mutual funds can set up an automatic debit to your checking account so that each month an amount you specify is withdrawn by the fund and deposited into your account. This is a painless and effective way to have a regular investment plan. You can change the amount invested at any time.

Another convenient feature of mutual funds is their liquidity. You can usually convert your shares to cash within two business days without penalty as long as you are not withdrawing from a retirement account prematurely. This liquidity means you have access to your money if you need it for an unexpected major bill or if you have been saving for a major expense (such as college).

You buy mutual funds in whole dollars unlike stocks, which are bought in number of shares. With mutual funds, it is okay to own fractional shares, so investments and redemptions are in whole dollars (the only exception would be if you completely liquidated your account and owned fractional shares, those would be converted to cents).

Mutual funds calculate a share price called the Net Asset Value (NAV) at the close of trading each day the market is open. The NAV is the fund’s assets minus its liabilities and divided by the number of outstanding shares. This gives you a per-share price or NAV. This is what you pay if you buy shares and what you receive if you sell shares—less any fees or expenses.

Investing ideally obtains the most reward for the least amount of risk. Another way of saying that is investors should expect a reward that is proportional to the amount of risk assumed. A high-risk investment like a futures contract should pay a larger reward than buying a risk-free U.S. Treasury Note. If the potential reward is not appropriate for the amount risked (the chance is that you will not achieve your financial goal or lose money), investors would be wise to look for someplace else to invest their money. Investors can take steps to minimize risk in their portfolio. Even if all your investments are in mutual funds, you still need to examine the composition of the funds, their goals, and investment styles to manage your risk.

We have already noted that diversification is one benefit of owning a mutual fund. Most mutual funds own a large number of stocks and/or bonds, so a few clunkers won’t dramatically change the performance of the fund. If you own more than one fund, compare the holdings of the two for overlap. You may find that you own two funds, but they own essentially the same stocks. You can avoid this by checking the types and styles of funds before you buy to make sure all your purchases aren’t falling in the same categories.

Investment styles are very important ways to diversify. The three that are commonly recognized are growth, value, and blend. We’ll discuss them in detail later in this chapter. One way to diversify is to buy funds in several different investment style categories. Market conditions sometimes favor one style over the other for a period, but may swing back and favor a different style. Being invested in all the major styles can protect you from market swings.

Investment styles are often combined with company size to create a way to talk more specifically about investments. The most common way investment professionals measure a company’s size is by market capitalization or “market cap.” This calculation produces a comparable number that is a way to compare companies in any industry. You calculate market capitalization by taking the current per-share price and multiplying it by the outstanding shares of stock. For example, if a company had 70 million shares of stock outstanding and the current per-share price was $50 per share, the market cap would be $3.5 billion (70,000,000 × $50 = $3,500,000,000). The $3.5 billion represents how much money is would take to buy the company for cash on the open market if you could purchase all the shares at once for the same price. Obviously, a company’s market cap changes with its stock price, but this method reduces the value of all companies to a single number.

Many mutual funds invest according to market cap as well as investment styles. Companies are assigned to large, mid, or small cap categories and then by investment styles. There is no universal agreement on where the size categories break, but this is one way to consider them:

Just as market condition sometimes favor one style, they may also favor a particular size company. You want some diversification in your holding by size, also.

Large cap stocks are often older, more mature companies that offer more stability—although with the way some high tech companies take off, a number of young companies have made it to the large cap category very quickly. This category is misleading in that a large number of companies have market caps well over $50 billion. For example, the average market cap of the Dow in the spring of 2007 was $147 billion. It takes some more investigation to see if a fund that claims to be investing in large cap stocks is buying the largest cap stocks or those near the cutoff point of $10 billion—it makes a difference.

On the other end of the size spectrum, small cap stocks may represent young emerging companies that have potential for tremendous growth, but also come with a much higher degree of risk. Smaller companies must grow or capture a niche so small and specialized that it doesn’t attract competition, in which case it likely will never grow. Larger companies have greater resources to overtake smaller competitors and either buy them or drive them out of the market. Smaller companies have a much higher failure rate than mid or large cap stocks. The point is investing in small cap stocks should produce a higher return than an investment in a large cap stock—if not, the investor is taking too much risk for too little reward.

Many investment professionals believe maintaining a proper asset allocation is the single most important key to investment success. Asset allocation is the process of deciding how to apportion your investment dollars among the three major classes of assets: stocks, bonds, and cash. Some add real estate as the fourth asset class. These asset classes represent the spectrum of where you can place your investing dollars. How you split up your investments among these assets is the allocation part. Defining the asset classes is straightforward:

Asset allocation is important because each of these classes of assets performs differently and what weight you give to each determines how aggressive or conservative your investment strategy is. This is particularly important for people planning for, nearing, or entering retirement. By changing the asset mix, you can be more proactive in building a nest egg early in life and more conservative in protecting it later in life.

A younger investor may want to be more aggressive and allocate more of her assets to stocks and less to bonds and cash. As she nears retirement age, it makes sense to “dial back” the aggressive position by decreasing the amount allocated to stocks and increasing the amount designated to bonds and cash. At retirement, she will still want some of her assets in stocks, but the majority of her holdings should be in some form of bonds and cash. Here’s how that might look:

Building to retirement:

Nearing retirement:

At Retirement:

These are illustrative guides only. How you divide your assets among the classes depends on your personal situation and your tolerance for risk. In a thorough analysis of asset allocation, consider the degree of risk and composition of the stock and bond classes at each stage. Appendix A has resources for more information on asset allocation and other considerations.

Mutual funds come in a variety of types that you can fit into your asset allocation plans. All of these types apply to socially responsible funds, but some obscure traditional fund types aren’t be found among SRI funds. The investments the portfolio manager makes determines fund types. There has been controversy about funds taking names that makes them sound like one type of fund, but their investment patterns don’t reflect that definition. Funds are supposed to follow their stated investment guidelines, but again this hasn’t always been the case. The lesson is: be aware of what the fund is buying and how closely it sticks to its stated purpose. Here are the main types of mutual funds:

Most stock funds look to grow their value (price) over time, although the larger, more mature stocks combine this with dividend income. Smaller stocks tend toward growth and seldom pay dividends. Stock funds are also characterized by where they invest. Domestic equity funds buy U.S. stocks. International funds buy stocks in foreign companies, while global equity funds buy stock in foreign and U.S. companies.

Portfolio managers focus on achieving the best investment results possible for the funds they manage. There is no single road to investment success. Some investment professionals choose a strategy known as value investing that seeks out undervalued stocks and holds them for the appreciation they hope will occur when the stock market recognizes their true value. Other professionals look for growth stocks that have the potential to grow at a faster rate than the market in general. These stocks can experience rapid growth for short or long periods depending on the company and industry. Then, others blend both methods for their funds. At times, market conditions have favored one strategy over the other. Value investors have the edge by many calculations over long periods, while growth investors can score major returns over shorter periods. Of the two, pursuing a growth strategy is the most risky.

Growth mutual funds look for stocks with a higher than average growth rate. Ideally, the fund will spot the stock before everyone else does and be able to buy before the price starts moving up. The primary concern for investing in a growth stock is how much more can it grow. Fund managers set their own expectations for growth rates and those expectations will vary depending on the size of the company, the industry, and the risk factor. A small, high-risk technology stock would be expected to grow at a phenomenal rate quarter-to-quarter. An older, but still growing company might not have the same expectation. The danger in investing in growth companies is that at the first sign growth is slowing or stopping, investors will bail out of the stock, and the price will fall sharply. With growth stocks, knowing when to sell is as important as knowing when to buy.

Value investing does not focus on buying stocks with low per share prices, but invests in companies that the stock market has undervalued. Value investors spend a great deal of time analyzing a company’s financials to determine a fair market value. This gives them an idea of what the stock should be selling for on the market. If the stock is under priced, it could be because the company is in an industry that is out of favor with investors or some bad news has tainted all stocks in the industry. Value investing buys stocks at a bargain price and waits for the market to correct its pricing, which will give the fund a nice profit. Value funds are typically long-term investments.

Blended funds combined both strategies of value and growth, choosing investments rather than strategies to guide purchases. With an adept manager, these funds can shift investments to value or growth depending on where the market is paying the biggest rewards.

Mutual funds are managed using one of two styles: active or passive management. A fund manager using active management believes he can pick stocks that will achieve the best returns for his fund. The manager may buy and sell stocks as their return changes. Some managers turnover 100 percent of the stocks in their portfolio each year in search of the highest return for the fund. Actively managed funds incur more expenses due to research and trading costs. Passively managed funds are typically thought of as index funds that buy a group of stocks based on a stock market index and hold that group until the index changes its composition. Passively managed funds usually have lower expenses because little research or trading is involved. Most SRI funds fall into the actively managed funds category to the extent that stocks are researched and screened for social and environmental factors and then analyzed for financial soundness. Although SRI index funds can be considered passively managed, they are not completely on automatic. Companies in the index are still screened for social and environmental policies. A serious lapse in one areas could drop them off.

Investment management companies that run actively managed funds believe it is possible to outperform the market or passively managed index funds by selectively buying and selling stocks. Some actively managed funds do beat the market as measured by indexes such as the S&P 500, however, very few beat it consistently. A fund manager’s approach to stock selection may fit a particular set of economic and market conditions producing superior results. When those economic and market conditions change, as they always do, the winning strategy may fall apart. In addition, actively managed funds have the increased trading expenses and taxes dragging down gains that passive index funds don’t bear. For SRI funds, actively managed doesn’t necessarily mean excessive trading. SRI funds are more actively managed for social and environmental factors than economic or market changes.

Mutual funds feature professional managers who do the research, screening, and make investment decisions for fund investors. This expertise comes with a price tag as you might expect. It is reasonable to pay for these services, however, you should be cautious because long-term investment success is directly tied to expenses and fees charged by mutual funds. The higher the expenses charged to shareholders, the lower the chances you will achieve the return you need. The funds you must consider include a sales fee, called a load, and the actual expenses of the fund, which is known as the expense ratio. Some funds have no sales fee or load and are cleverly known as no-load funds. This doesn’t mean they don’t charge you expenses, but they don’t charge a sales fee or load. Stock mutual funds also make capital gains distributions, which are tax bills they incur when the sell a stock for a profit. Some gains will be short-term, while others could be long-term. The tax treatment is quite different.

There are several ways to buy mutual funds. Many no-load (no sales charge) funds can be bought directly from the management company, although some discount brokers sell them, also. No-load funds mean just that—you do not pay a sales commission to buy or sell the fund. This lowers you cost of getting into and out of the fund, which increases your profits or reduces your losses. Many financial experts urge investors to stick with no-load funds for this reason.

Loaded funds charge a sales fee that goes to the person who sold you the fund. The person is usually a stockbroker or other investment professional. Many of these mutual funds are sold only through financial professionals. The two types of sales loads are a front-end load and a back-end load.

disappeared if you held the fund until the seventh year. Although this fee sounds like a better deal if you plan to hold the fund for a long time, it can be very expensive if you decide to sell before the load has expired. The reason is you pay the percentage on the fund balance, not the original amount. If the fund has gone up since you bought it, taking 3 or 4 percent off the profits may be a big hit.

Sales commissions are defended as the price for the salesperson’s help in selecting the right fund for you. But you should be aware that no empirical evidence supports that claim and salespeople only recommend funds that pay them commissions, so you aren’t getting a look at all the options.

One expense you can’t avoid is the expense ratio. This is the fee you pay the investment management company that runs the mutual fund. The fee covers administrative costs, research expenses, trading fees, the fund manager’s fee, and 12B-1 fees. The 12B-1 fee is a neat little charge where the mutual fund can charge shareholder for advertising itself.

Index funds with their passive management have the lowest expense ratios thanks to the low cost of operating these funds. An expense ratio of 0.2 percent of assets for passive index funds is among the lowest, while an actively traded stock fund might run as high as 2 percent. The higher the fees, the less likely the fund is to beat the S&P 500 or any other stock index.

Mutual funds that buy and sell stocks may generate long or short-term capital gains tax liabilities. These are distributed to shareholders, usually toward the end of the year. Actively managed funds are less tax friendly because of the number of trades they make. Most of the gains they distribute are short-term, which means they are taxed as ordinary income to taxpayers. Long-term capital gains are taxed at a more favorable rate. Passively managed funds seldom distribute capital gains because there is little trading in the fund. Most of the gains these funds distribute will be long-term capital gains.