Investment Strategies

The term “microcap stock” applies to companies with low or “micro” capitalizations — meaning the total value of the company’s stock. Microcap companies typically have limited assets. For example, in recent cases where the SEC suspended trading in microcap stocks, the average company had only $6 million in net tangible assets – and nearly half had less than $1.25 million. Microcap stocks tend to be low priced and trade in low volumes.

Many microcap stocks trade in the “over-the-counter” (OTC) market and are quoted on OTC systems, such as the OTC Bulletin Board (OTCBB) or the “Pink Sheets.”

• OTC Bulletin Board. The OTCBB is an electronic quotation system that displays real-time quotes, last-sale prices, and volume information for many OTC securities not listed on the NASDAQ or a national securities exchange. Brokers who subscribe to the system can use the OTCBB to look up prices or enter quotes for OTC securities.

Although the FINRA oversees the OTCBB, the OTCBB is not part of the NASDAQ. Wrongdoers often claim that an OTCBB company is a NASDAQ company to mislead investors.

• The “Pink Sheets.” The Pink Sheets – named for the color of paper they’ve historically been printed on – are a weekly publication of a company called the National Quotation Bureau. They are updated daily electronically. Brokers who subscribe to the Pink Sheets can find out the names and telephone numbers of the “market makers” in various OTC stocks – meaning the brokers who commit to buying and selling those OTC securities. Unless your broker has the Pink Sheets or you contact the market makers directly, you’ll have a difficult time finding price information for most stocks quoted in the Pink Sheets.

Microcap stocks differ from other stocks in a number of ways:

Lack of Public Information. The biggest difference between a microcap stock and other stocks is the amount of reliable, publicly available information about the company. Larger public companies file reports with the SEC that any investor can get for free from the SEC’s website. Professional stock analysts regularly research and write about larger public companies, and it’s easy to find larger companies’ stock prices. In contrast, information about microcap companies can be extremely difficult to find, making them more vulnerable to investment fraud schemes.

The SEC has proposed new rules that will increase the amount of information brokers must gather about microcap companies before quoting prices for their stocks in the OTC market.

No Minimum Listing Standards. Companies that trade their stocks on major exchanges and in the NASDAQ must meet minimum listing standards. For example, they must have certain minimums when it comes to net assets, and minimum numbers of shareholders. In contrast, companies on the OTCBB or the Pink Sheets do not have to meet any minimum standards.

Risk. While all investments involve risk, microcap stocks are among the most risky. Many microcap companies are new, with no track record. Some of these companies have no assets or operations. Others have products and services that are still in development or have yet to be tested in the market.

In general, the federal securities laws require all but the smallest of public companies to file reports with the SEC. A company can become “public” in one of two ways – by issuing securities in an offering or transaction that’s registered with the SEC or by registering the company and its outstanding securities with the SEC. Both types of registration trigger ongoing reporting obligations, meaning the company must file periodic reports that disclose important information to investors about its business, financial condition, and management.

This information is a treasure trove for investors: it tells you whether a company is making money or losing money and why.

You’ll find this information in the company’s quarterly reports on Form 10-Q, annual reports (with audited financial statements) on Form 10-K, and periodic reports of significant events on Form 8-K.

A company must file reports with the SEC if:

• It has 500 or more investors and $10 million or more in assets; or
• It lists its securities on the following stock markets:
• American Stock Exchange
• Boston Stock Exchange
• Cincinnati Stock Exchange
• Chicago Stock Exchange
• NASDAQ
• New York Stock Exchange
• Pacific Exchange
• Philadelphia Stock Exchange

Currently, only about half of the 6,500 companies whose securities are quoted on the OTCBB file reports with the SEC.

In January 1999, the SEC approved a new FINRA rule allowing the FINRA to require that all OTCBB companies file updated financial reports with the SEC or with their banking or insurance regulators. The new rule now applies to all companies on the OTCBB. Companies refusing to file with the SEC or their banking or insurance regulators cannot remain on the OTCBB.

With few exceptions, companies that file reports with the SEC must do so electronically using the SEC’s EDGAR system. EDGAR stands for electronic data gathering and retrieval. The EDGAR database is available on the SEC’s Web site at www.sec.gov. You’ll find many corporate filings in the EDGAR database, including annual and quarterly reports and registration statements. Any investor can access and download this information for free from the SEC’s Web site.

As with any information, SEC filings should be read with a questioning and critical mind.

Smaller companies – those with less than $10 million in assets – generally do not have to file reports with the SEC. But some smaller companies, including microcap companies, may choose voluntarily to register their securities with the SEC. As described above, companies that register with the SEC must also file quarterly, annual, and other reports.

Any company that wants to offer or sell securities to the public must either register with the SEC or meet an exemption. Here are two of the most common exemptions that many microcap companies use:

• “Reg. A” Offerings. Companies raising less than $5 million in a 12-month period may be exempt from registering their securities under a rule known as Regulation A. Instead of filing a registration statement through EDGAR, these companies need only file a printed copy of an “offering circular” with the SEC containing financial statements and other information.
• “Reg. D” Offerings. Some smaller companies offer and sell securities without registering the transaction under an exemption known as Regulation D. Regulation D exempts from registration companies that seek to raise less than $1 million dollars in a twelve-month period. It also exempts companies seeking to raise up to $5 million, as long as the companies sell to 35 or fewer individuals or any number of “accredited investors” who must meet high net worth or income standards. In addition, Regulation D exempts some larger private offerings of securities. While companies claiming an exemption under Reg. D don’t have to register or file reports with the SEC, they must still file what’s known as a “Form D” within a few days after they first sell their securities. Form D is a brief notice that includes the names and addresses of owners and stock promoters, but little other information about the company.

You may be able to find out more about Reg. D companies by contacting your state securities regulator.

Unless they otherwise file reports with the SEC, companies that are exempt from registration under Reg. A, Reg. D, or another offering exemption, do not have to file reports with the SEC.

Many of the microcap companies that don’t file reports with the SEC are legitimate businesses with real products or services. But the lack of reliable, readily available information about some microcap companies can open the door to fraud. It’s easier to manipulate a stock when there’s little or no information available about the company.

Microcap fraud depends on spreading false information. Here’s how some perpetrators carry out their scams:

• Questionable Press Releases. Con artists often issue press releases that contain exaggerations or lies about the microcap company’s sales, acquisitions, revenue projections, or new products or services.
• Paid Promoters. Some microcap companies pay stock promoters to recommend or “tout” the microcap stock in supposedly independent and unbiased investment newsletters, research reports, or radio and television shows. The federal securities laws require the newsletters to disclose who paid them, the amount, and the type of payment. But many con artists fail to do so and mislead investors into believing they are receiving independent advice.
• Internet Fraud. Con artists often distribute junk e-mail or “spam” over the Internet to spread false information quickly and cheaply about a microcap company to thousands of potential investors. They also use aliases on Internet bulletin boards and chat rooms to hide their identities and post messages urging investors to buy stock in microcap companies based on supposedly “inside” information about impending developments at the companies.
• “Boiler Rooms” and Cold Calling. Dishonest brokers set up “boiler rooms” where a small army of high-pressure salespeople use banks of telephones to make cold calls to as many potential investors as possible. These strangers hound investors to buy “house stocks” – stocks that the firm buys or sells as a market maker or has in its inventory.

Never buy stock in response to a cold call.

Microcap fraud schemes can take a variety of forms. Here’s a description of the two most common:

The Classic “Pump and Dump” Scheme. It’s common to see messages posted on the Internet that urge readers to buy a stock quickly or to sell before the price goes down, or a telemarketer will call using the same sort of pitch. Often the promoters will claim to have “inside” information about an impending development or to use an “infallible” combination of economic and stock market data to pick stocks. In reality, they may be company insiders or paid promoters who stand to gain by selling their shares after the stock price is pumped up by the buying frenzy they create. Once these con artists sell their shares and stop hyping the stock, the price typically falls, and investors lose their money.

The Off-Shore Scam. Under a rule known as “Regulation S,” companies do not have to register stock they sell outside the United States to foreign or “off-shore” investors. In the typical off-shore scam, an unscrupulous microcap company sells unregistered Reg. S stock at a deep discount to con artists posing as foreign investors. These con artists then sell the stock to U.S. investors at inflated prices, pocketing huge profits, which they share with the microcap company insiders. The flood of unregistered stock into the U.S. eventually causes the price to plummet, leaving unsuspecting U.S. investors with enormous losses.

The SEC recently strengthened Reg. S to make this type of fraud harder to conduct.

If you’re working with a broker or an investment adviser, you can ask your investment professional if the company files reports with the SEC and to get you written information about the company and its business, finances, and management. Be sure to carefully read the prospectus and the company’s latest financial reports.

You can also get information on your own from these sources:

• From the company. Ask the company if it is registered with the SEC and files reports with us. If the company is small and unknown to most people, you should also call your state securities regulator to get information about the company, its management, and the brokers or promoters who’ve encouraged you to invest in the company.
• From the SEC. A great many companies must file their reports with the SEC. Using the EDGAR database, you can find out whether a company files with the SEC, and get any reports you’re interested in. For companies that do not file on EDGAR, check with the SEC’s Public Reference Room to see whether the company has filed an offering circular under Reg. A.
• From your state securities regulator. We strongly urge you to contact your state securities regulator to find out whether they have information about a company and the people behind it. Look in the government section of your phone book or visit the website of the North American Securities Administrators Association to get the relevant name and phone number. Even though the company does not have to register its securities with the SEC, it may have to register them with your state. Your regulator will tell you whether the company has been legally cleared to sell securities in your state.
• From other government regulators. Many companies, such as banks, do not have to file reports with the SEC. But banks must file updated financial information with their banking regulators.

• From reference books and commercial databases. Visit your local public library or the nearest law or business school library. You’ll find many reference materials containing information about companies. You can also access commercial databases for more information about the company’s history, management, products or services, revenues, and credit ratings. But there are a number of commercial resources you may consult, including: Bloomberg, Dun & Bradstreet, Hoover’s Profiles, Lexis-Nexis, and Standard & Poor’s Corporate Profiles.
• The Secretary of State Where the Company Is Incorporated. Contact the secretary of state where the company is incorporated to find out whether the company is a corporation in good standing. You may also be able to obtain copies of the company’s incorporation papers and any annual reports it files with the state.

If you’ve been asked to invest in a company but you can’t find any record that the company has registered its securities with the SEC or your state, or that it’s exempt from registration, call or write your state’s securities regulator or the SEC immediately with all the details. You may have come face to face with a scam.

To invest wisely and avoid investment scams, research each investment opportunity thoroughly and ask questions. These simple steps can make the difference between profits and losses:

1. Find out whether the company has registered its securities with the SEC or your state’s securities regulators.
2. Make sure you understand the company’s business and its products or services.
3. Read the most recent reports the company has filed with its regulators and pay attention to the company’s financial statements, particularly if they are not audited or not certified by an accountant. If the company does not file reports with the SEC, be sure to ask your broker for what’s called the “Rule 15c2-11 file” on the company. That file will contain important information about the company.
4. Check out the people running the company with your state securities regulator, and find out if they’ve ever made money for investors before. Also ask whether the people running the company have had run-ins with the regulators or other investors.
5. Make sure the broker and his or her firm are registered with the SEC and licensed to do business in your state. And ask your state securities regulator whether the broker and the firm have ever been disciplined or have complaints against them.

Also, watch out for these “red flags”:

• SEC Trading Suspensions. The SEC has the power to suspend trading in any stock for up to 10 days when it believes that information about the company is inaccurate or unreliable. Think twice before investing in a company that’s been the subject of an SEC trading suspension.

• High Pressure Sales Tactics. Beware of brokers who pressure you to buy before you have a chance to think about and investigate the “opportunity.” Dishonest brokers may try to tell you about a “once-in-a-lifetime” opportunity or one that’s based on “inside” or “confidential” information. Don’t fall for brokers who promise spectacular profits or “guaranteed” returns. These are the hallmarks of fraud. If the deal sounds too good to be true, then it probably is.
• Assets Are Large But Revenues Are Small. Microcap companies sometimes assign high values on their financial statements to assets that have nothing to do with their business. Find out whether there’s a valid explanation for low revenues, especially when the company claims to have large assets.
• Odd Items in the Footnotes to the Financial Statements. Many microcap fraud schemes involve unusual transactions among individuals connected to the company. These can be unusual loans or the exchange of questionable assets for company stock, which may be discussed in the footnotes.
• Unusual Auditing Issues. Be wary when a company’s auditors have refused to certify the company’s financial statements or if they’ve stated that the company may not have enough money to continue operating. Also question any change of accountants.
• Insiders Own Large Amounts of the Stock. In many microcap fraud cases – especially “pump and dump” schemes – the company’s officers and promoters own significant amounts of the stock. When one person or group controls most of the stock, they can more easily manipulate the stock’s price at your expense. You can ask your broker or the company whether one person or group controls most of the company’s stock, but if the company is the subject of a scam, you may not get an honest answer.

Don’t deal with brokers who refuse to provide you with written information about the investments they’re promoting.

Never tell a cold caller your social security number or numbers for your banking and securities accounts.

Be extra wary if someone you don’t know and trust recommends foreign investments.

Once you determine your asset allocation model, you can implement the recommended portfolio with mutual funds. You need only six to ten funds to achieve diversification and your asset allocation objectives, as opposed to having to buy many more individual securities to achieve the same results.

Caution: Keep in mind that mutual funds ALWAYS carry investment risks. Some carry more risk than others; a higher rate of return typically involves a higher risk. don’t buy a fund without knowing–and being willing to accept–the risk. The types of risks that attend a mutual fund depend on the type of fund. Risks are discussed later in the section on “Types of Mutual Funds and Their Varying Risk Factors.”

Once you identify the asset classes that will be represented in your portfolio, it’s time to select specific funds in those categories-i.e., funds that meet your investment goals. To choose wisely, it’s necessary to assess:

• A fund’s risk/reward history and characteristics, which should match your own financial profile;
• A fund’s philosophy and investment style, which should match your own investment goals;
• A fund’s costs, including loads and ongoing expenses; and
• The customer service available from the fund.

Tip: Find out whether the fund will stop offering shares to the public once its assets have grown to a certain point (sometimes the case with small-cap funds).

Most sources of mutual fund recommendations are inadequate. They either depend solely on past performance or fail to take into account your particular needs. Newsletters and magazines, for example, often simply recommend last year’s hot fund-which, even though it may remain hot for the current year, may be totally wrong for you.

A fund’s past performance is not as important as you might think. Advertisements, rankings, and ratings tell you how well a fund has performed in the past. But studies show that the future is often different. This year’s “No. 1” fund can easily become next year’s dog.

Tip: Although past performance is not a reliable indicator of future performance, past volatility is a good indicator of future volatility.

Here are some tips for comparing fund performances:

• Check the fund’s total return. You will find it in the Financial Highlights of the prospectus (near the front). Total return measures increases and decreases in the value of the investment over time, after subtracting costs. This is just one of many return measures.
• Find out how the fund ranked in its investment category class. There are various rating systems available to show how a fund ranked among its peers.
• See how the total return has varied over the years. The Financial Highlights in the prospectus show yearly total return for the most recent 10-year period. An impressive 10-year total return may be based on one spectacular year followed by many average years. Looking at year-to-year changes in total return is a good way to see how stable the fund’s returns have been.
• Check the fund’s Sharpe ratio. The Sharpe ratio is intended to give investors an understanding of the fund’s performance relative to the risk. The Sharpe ratio is calculated by subtracting the average monthly return of the 90-day Treasury Bill-basically a risk-free return-from the average monthly return of the fund. The difference-the “excess” return- is then annualized and divided by the fund’s annual standard deviation (a common measure of volatility).

Tip: Mathematical theory aside, the important point is that the higher the Sharpe ratio, the higher the fund’s performance with less of a risk.

Costs are important because they lower your returns. A fund that has a sales load and high expenses will have to perform better than a low-cost fund, just to stay even.

Find the fee table near the front of the fund’s prospectus, where the fund’s costs are laid out. You can use the fee table to compare the costs of different funds.

The fee table breaks costs into two main categories:

• Sales loads and transaction fees (paid when you buy, sell or exchange your shares) and
• Ongoing expenses (paid while you remain invested in the fund).

Sales Loads

The first part of the fee table will tell you if the fund charges any sales loads. No-load funds by definition, do not charge sales loads. There are no-load funds in every major fund category. Even no-load funds have ongoing expenses, however, such as management fees.

A sales load usually pays for commissions to the brokers who sell the fund’s shares to you, as well as other marketing costs. Sales loads buy you a broker’s services and advice; they do not assure superior performance.

Front-end load: A front-end load is a sales charge you pay when you buy shares. This type of load, which by law cannot be higher than 8.5 percent of your investment-although in practice are often much less-reduces the amount of your investment in the fund.

Back-end load: A back-end load (also called a deferred load) is a sales charge you pay when you sell or exchange your shares. It usually starts out at 5 or 6 percent for the first year and gets smaller each year after that until it reaches zero say, in year six or seven year of your investment.

Example: You invest $1,000 in a mutual fund with a 6 percent back-end load that decreases to zero in the seventh year. Let’s assume that the value of your investment remains at $1,000 for seven years. If you sell your shares during the first year, you will get back only $940 (the $60 will go to pay the sales charge). If you sell your shares during the seventh year, you will get back $1,000.

 

Tip: Many funds allow you to exchange your shares for those of another fund managed by the same adviser. The first part of the fee table will tell you if there is any exchange fee.

Ongoing Expenses

The second part of the fee table tells you the kinds of ongoing expenses you will pay while you remain invested in the fund. It shows expenses as a percentage of the fund’s assets, generally for the most recent fiscal year. Here, the table will tell you the management fee for managing the fund’s portfolio, along with any other fees and expenses.

Caution: Check the fee table to see if any part of a fund’s fees or expenses has been waived. If so, the fees and expenses may increase suddenly when the waiver ends (the part of the prospectus after the fee table will tell you by how much).

High expenses do not assure superior performance. Higher-expense funds do not, on average, perform better than lower-expense funds. But there may be circumstances in which you decide it is appropriate to pay higher expenses. For example, you can expect to pay higher expenses for certain types of funds that require extra work by managers, such as international stock funds, which require sophisticated research.

Caution: You may also pay higher expenses for funds that provide special services, like toll-free telephone numbers, check-writing and automatic investment programs.

A difference in expenses that may look small to you can make a big difference in the value of your investment over time.

Example: You invest $1,000 in a fund, which yields an annual return of 5 percent before expenses. If the fund has expenses of 1.5 percent, after 20 years you would end up with roughly $2,012. If the fund has expenses of 0.5 percent, you would end up with more than $2,455 – a 22 percent difference. If your investment is $100,000 instead of $1,000, that means a difference of more than $44,000.

Rule 12b-1 fee: One type of ongoing fee that is taken out of fund assets has come to be known as a Rule 12b-1 fee. It most often is used to pay commissions to brokers and other salespersons, and occasionally to pay for advertising and other costs of promoting the fund to investors. It usually is between 0.25 percent and 1.00 percent of assets annually.

Funds with back-end loads usually have higher Rule 12b-1 fees. If you are considering whether to pay a front-end load or a back-end load, think about how long you plan to stay in the fund. If you plan to stay in for six years or more, a back-end load will usually cost less than a front-end load.

Caution: Yet, even if your back-end load has fallen to zero, you could pay more in Rule 12b-1 fees over time than if you paid a front-end load.

Here are some suggestions for examining a fund’s approach to investing.

1. Determine the fund’s overall investment objectives.

Tip: Morningstar’s system of rating mutual funds includes 40 investment objectives. This extensive list can be helpful in narrowing the comparison of funds’ objectives. Morningstar’s style boxes can also be used to compare funds’ styles.

2. Determine whether the fund’s portfolio matches its stated investment objectives. The fund should fully reveal how it invests.

Tip: Morningstar’s “style boxes” are extremely useful in determining (1) whether a fund’s investment approach has a low, moderate, or high risk/return profile and (2) the types of securities invested in.

3. Determine whether the fund invests overseas.

Caution: Generally, international equities are a longer-term, higher-risk investment.

4. For an equity fund, determine the industry sectors in which it’s invested.

5. For a bond fund, determine the years to maturity of its holdings and whether it holds any tax-exempt bonds.

6. Find out how long the fund’s management has been in place and whether one particular manager has been responsible for the success of the fund.

Caution: If the manager is relatively new, this may add risk to the fund, unless the manager has had experience elsewhere.

You’ll want to find out what services the fund offers. Among the questions you should ask are:

1. How long does it take to reach a representative?
2. Which account options does the fund offer?
3. How quickly are questions about returns or investments answered?

 

You take risks when you invest in any mutual fund. You may lose some or all of the money you invest (your principal) because the securities held by a fund go up and down in value. What you earn on your investment (dividends and interest) also may go up or down. The various types of risk are:

• Volatility: The unpredictability of changes in stock prices.
• Interest-rate risk: The fluctuation in bond prices due to interest rate changes.
• Credit risk: The likelihood that payments of bond interest and principal will not be made as promised.
• Inflation risk: The risk that the lowered purchasing power of the dollar will erode your return.

Each kind of mutual fund has different risks and rewards. Generally, the higher the potential return, the higher the risk of loss. The following discussion of risk for the various types of funds is intended to aid you in choosing a fund that meets your requirements as an investor.

Money Market Fund Risks

Money market funds are relatively low risk compared to other mutual funds. They are limited by law to certain high-quality, short-term investments. They try to keep their net asset value (NAV) at a stable $1.00 per share.

Caution: Contrary to popular belief, NAV may fall below $1.00 if the funds’ investments perform poorly. Although investor losses have been rare, they are possible.

 

Caution: Banks now sell mutual funds, some of which carry the bank’s name. But mutual funds sold by banks, including money market funds, are not bank deposits. Don’t confuse a “money market fund” with a “money market deposit account.” The names are similar, but they are completely different:

• A money market fund is a type of mutual fund. It is not guaranteed, and comes with a prospectus.
• A money market deposit account is a bank deposit. It is guaranteed, and comes with a “Truth in Savings” form.

Caution: Many bank funds are just “private label” funds, i.e., run by a fund family for the bank. This adds an extra layer of cost.

Bond Fund Risks

Bond funds (also called fixed-income funds) have higher risks than money market funds, but usually pay higher yields. Unlike money market funds, bond funds are not restricted to high-quality or short-term investments. Because there are many different types of bonds, bond funds can vary dramatically in their risks and rewards.

Most bond funds have credit risk, the risk that companies or other issuers whose bonds are owned by the fund may fail to pay their bond holders. Some funds have little credit risk, however, such as those that invest in insured bonds or U.S. Treasury bonds. Keep in mind that nearly all bond funds have interest rate risk, which means that the market value of their bonds will go down when interest rates go up. Because of this, you can lose money in any bond fund, including those that invest only in insured bonds or Treasury bonds. Long-term bond funds invest in bonds with longer maturities (the length of time until the final payout). The net asset values (NAVs) of long-term bond funds can go up or down more rapidly than those of shorter-term bond funds.

Tip: Morningstar’s rating system uses specific times to maturity to distinguish between long-term, short-term and medium-term bonds. This system can help you choose the bond fund that is most suitable with regard to interest-rate risk.

Stock Fund Risks

Stock funds (also called equity funds) generally involve more risk-volatility-than money market or bond funds, but they also offer the highest returns. A stock fund’s value can rise and fall quickly over the short term, but historically stocks have performed better over the long term than other types of investments.

Mutual fund rating companies use “beta” to measure risk. Beta measures a fund’s price fluctuations relative to those of the whole market-that is, its sensitivity to market movements.

Not all stock funds are the same. For example, growth funds focus on stocks that may not pay a regular dividend but have the potential for large capital gains. Others specialize in a particular industry segment such as technology stocks.

The level of volatility in a stock fund depends on the fund’s investments, e.g., small-cap growth stocks are more volatile than large-cap value stocks. The level of volatility is also affected by industry sector. Also, international stocks are generally more volatile than domestic stocks.

The foregoing generalizations are intended only as such. It is important, when examining a fund for risk/reward characteristics, to analyze each fund on a case-by-case basis.

Caution: Funds that invest in derivatives face special risks. Derivatives – which come in many different types and have many different uses – are financial instruments whose performance is derived, at least in part, from the performance of an underlying asset, security or index. Their value can be affected dramatically by even small market movements, sometimes in unpredictable ways. However, they do not necessarily increase risk, and may in fact reduce risk. A fund’s prospectus will disclose how it may use derivatives. You may also want to call a fund and ask how it uses these instruments.

There are a number of sources of information that you should explore before investing in mutual funds. The most important of these is the prospectus, which is the fund’s selling document and contains information about costs, risks, past performance and the fund’s investment goals. Request the prospectus from the fund or from a financial professional if you are using one. Read the prospectus, and exercise your judgment carefully, before you invest.

Read the sections of the prospectus that discuss the risks, investment goals and investment policies of the fund you are considering. Funds of the same type can have significantly different risks, objectives and policies.

All mutual funds must prepare a Statement of Additional Information (SAI, also called Part B of the prospectus). It explains a fund’s operations in greater detail than the prospectus. If you ask, the fund must send you an SAI.

You can get a clearer picture of a fund’s investment goals and policies by reading its annual and semi-annual reports to shareholders. If you ask, the fund will send you these reports. You can also research funds at most libraries or by using an on-line service.

• The SEC

The SEC has public reference rooms at its headquarters in Washington, D.C., and at its Northeast and Midwest Regional offices. Copies of the text of documents filed in these reference rooms may be obtained by visiting or writing the Public Reference Room (at a standard per page reproduction rate) or through private contractors (who charge for research and/or reproduction).

Other sources of information filed with the SEC include public or law libraries, securities firms, financial service bureaus, computerized on-line services, and the companies themselves.

Most companies whose stock is traded over the counter or on a stock exchange must file “full disclosure” reports on a regular basis with the SEC. The annual report (Form 10-K) is the most comprehensive of these. It contains a narrative description and statistical information on the company’s business, operations, properties, parents, and subsidiaries; its management, including their compensation and ownership of
company securities: and significant legal proceedings which involve the company. Form 10-K also contains the audited financial statements of the company (including a balance sheet, an income statement, and a statement of cash flow) and provides management’s discussion of business operations and prospects for the future.

Quarterly financial information on Form 8-K may be required as well.

Anyone may obtain copies (at a modest copying charge) of any corporate report and most other documents filed with the Commission by visiting the SEC website

American Association of Individual Investors (offers an annual guide to low-load mutual funds):

625 North Michigan Avenue
Chicago, IL 60611
Tel: 800-428-2244

Investment Company Institute (a trade association of fund companies that publishes an annual directory of mutual funds):

1401 H Street NW, Suite 1200
Washington, DC 20005
Tel: 202-326-5800

Mutual Fund Education Alliance (publishes an annual guide to low-cost mutual funds:

Many investors who trade through online brokerage accounts assume they have a direct connection to the securities markets. But they don’t. When you press “enter,” your order is sent over the Internet to your broker – who in turn decides which market to send it to for execution. A similar process occurs when you call your broker to place a trade.

While trade execution is usually seamless and quick, it does take time. And prices can change quickly, especially in fast-moving markets. Because price quotes are only for a specific number of shares, investors may not always receive the price they saw on their screen or the price their broker quoted over the phone. By the time your order reaches the market, the price of the stock could be slightly – or very – different.

No SEC regulations require a trade to be executed within a set period of time. But if firms advertise their speed of execution, they must not exaggerate or fail to tell investors about the possibility of significant delays.

To avoid buying or selling a stock at a price higher or lower than you wanted, place a limit order rather than a market order. A limit order is an order to buy or sell a security at a specific price. A buy limit order can only be executed at the limit price or lower, and a sell limit order can only be executed at the limit price or higher. When you place a market order, you can’t control the price at which your order will be filled.

You want to buy the stock of a “hot” IPO that was initially offered at $9, but don’t want to end up paying more than $20 for the stock. Place a limit order to buy the stock at any price up to $20. By entering a limit order rather than a market order, you will not be caught buying the stock at $90 and then suffering immediate losses as the stock drops later in the day or the weeks ahead.

Your limit order may never be executed because the market price may quickly surpass your limit before your order can be filled. But by using a limit order you also protect yourself from buying the stock at too high a price.

Just as you have a choice of brokers, your broker generally has a choice of markets in which to execute your trade:

• For a stock listed on an exchange, such as the New York Stock Exchange (NYSE), your broker may direct the order to that exchange, to another exchange (such as a regional exchange), or to a firm called a “third market maker.” A “third market maker” is a firm that stands ready to buy or sell a stock listed on an exchange at publicly quoted prices. As a way to attract orders from brokers, some regional exchanges or third market makers will pay your broker for routing your order to that exchange or market maker – perhaps a penny or more per share for your order. This is called “payment for order flow.”

Upon the opening of a new account and on an annual basis, firms must inform customers in writing whether they receive payment for order flow and, if they do, a detailed description of the type of payments. Firms must also disclose on trade confirmations whether they receive payment for order flow and that customers can make a written request to find out the source and type of the payment as to that particular transaction.

• For a stock that trades in an over-the-counter (OTC) market, such as the NASDAQ, your broker may send the order to a “NASDAQ market maker” in the stock. Many NASDAQ market makers also pay brokers for order flow. Note: A “market maker” is a firm that stands ready to buy and sell a particular stock on a regular and continuous basis at a publicly quoted price. You’ll most often hear about market makers in the context of the NASDAQ or other “over the counter” (OTC) markets. Market makers that stand ready to buy and sell stocks listed on an exchange, such as the New York Stock Exchange, are called “third market makers.” Many OTC stocks have more than one market-maker.

Market-makers generally must be ready to buy and sell at least 100 shares of a stock they make a market in. As a result, a large order from an investor may have to be filled by a number of market-makers, perhaps at different prices.

• Your broker may route your order – especially a “limit order” – to an electronic communications network (ECN) that automatically matches buy and sell orders at specified prices. A “limit order” is an order to buy or sell a stock at a specific price.
• Your broker may decide to send your order to another division of your broker’s firm to be filled out of the firm’s own inventory. This is called “internalization.” With this option, your broker’s firm can make money on the “spread” – the difference between the purchase price and the sale price.

Many firms use automated systems to handle the orders they receive from their customers. In deciding how to execute orders, your broker has a duty to seek the best execution reasonably available for its customers’ orders. That means your broker must evaluate the orders it receives from all customers in the aggregate and periodically assess which competing markets, market makers, or ECNs offer the most favorable terms of execution.

The opportunity for “price improvement” – which is the opportunity, but not the guarantee, for an order to be executed at a better price than what is currently quoted publicly – is an important factor a broker should consider in executing its customers’ orders. Other factors include the speed and the likelihood of execution.

You enter a market order to sell 500 shares of a stock. The current quote is $20. Your broker may be able to send your order to a market or a market maker where your order would have the possibility of getting a price better than $20. If your order is executed at $20 1/16, you would receive $10,031.25 for the sale of your stock – $31.25 more than if your broker had only been able to get the current quote for you.

Of course, the additional time it takes some markets to execute orders may result in your getting a worse price than the current quote – especially in a fast-moving market. So your broker is required to take into account any trade-off between providing its customers’ orders with the possibility of better prices and the extra time it may take to do so.

If for any reason you want to direct your trade to a particular exchange, market maker, or ECN, you may be able to call your broker and ask him or her to do this. But some brokers may charge for that service.

Some brokers now offer active traders the ability to direct orders in NASDAQ stocks to the market maker or ECN of their choice.

On November 15, 2000, the SEC adopted new rules aimed at improving public disclosure of order execution and routing practices. Beginning April 2001, all market centers that trade national market system securities must make monthly, electronic disclosures of basic information concerning their quality of executions on a stock-by-stock basis, including how market orders of various sizes are executed relative to the public quotes and information about effective spreads – the spreads actually paid by investors whose orders are routed to a particular market center. In addition, market centers will disclose the extent to which they provide executions at prices better than the public quotes to investors using limit orders.

The new rules also require brokers that route orders on behalf of customers to disclose quarterly the identity of the market centers to which they route a significant percentage of their orders. In addition, the rule mandates that brokers respond to the requests of customers interested in learning where their individual orders were routed for execution during the previous six months.

With this information now readily available, you can better learn where and how your firm executes its customers’ orders and what steps it takes to assure the best execution.

Ask your broker about the firm’s policies on payment for order flow, internalization, or other routing practices – or look for that information in your account agreement. You can also write to your broker to find out the nature and source of any payment for order flow it may have received for a particular order.

If you’re comparing brokerage firms, ask each how often it obtains price improvement on customers’ orders. And then consider that information in deciding with which firm you will do business.

Let’s say you buy a stock for $50 and the price of the stock rises to $75. If you bought the stock in a cash account and paid for it in full, you’ll earn a 50 percent return on your investment. But if you bought the stock on margin – paying $25 in cash and borrowing $25 from your broker – you’ll earn a 100 percent return on the money you invested. Of course, you’ll still owe your brokerage $25 plus interest.

The downside to using margin is that if the stock price decreases, substantial losses can mount quickly. For example, let’s say the stock you bought for $50 falls to $25. If you fully paid for the stock, you’ll lose 50 percent of your money. But if you bought on margin, you’ll lose 100 percent, and you still must come up with the interest you owe on the loan.

Caution: In volatile markets, investors who put up an initial margin payment for a stock may, from time to time, be required to provide additional cash if the price of the stock falls. Investors have been shocked to learn that a broker has the right to sell the securities that were bought on margin – without any notification, and at a potentially substantial loss to the investor.

Caution: If your broker sells your stock after the price has plummeted, then you’ve lost out on the chance to recoup your losses if the market bounces back.

Margin accounts can be very risky and they are not for everyone. Before opening a margin account, be aware that:

• You can lose more money than you have invested;
• You may have to deposit additional cash or securities in your account on short notice to cover market losses;
• You may be forced to sell some or all of your securities when falling stock prices reduce the value of your securities; and
• Your brokerage firm may sell some or all of your securities without consulting you to pay off the loan it made to you.

You can protect yourself by knowing how a margin account works and what happens if the price of the stock purchased on margin declines.

Tip: Your broker charges you interest for borrowing money; take into account how that will affect the total return on your investments.

Tip: Ask your broker whether it makes sense for you to trade on margin in light of your financial resources, investment objectives, and tolerance for risk.

To open a margin account, you must sign a margin agreement. The agreement may either be part of your account agreement or separate. The margin agreement states that you must abide by the rules of the Federal Reserve Board, the New York Stock Exchange, the Financial Industry Regulatory Authority (FINRA), and the firm where you have set up your margin account.

Caution: Carefully review the agreement before signing.

As with most loans, the margin agreement explains the terms and conditions of the margin account. The agreement describes how the interest on the loan is calculated, how you are responsible for repaying the loan, and how the securities you purchase serve as collateral for the loan. Carefully review the agreement to determine what notice, if any, your firm must give you before selling your securities to collect the money you have borrowed.

The Federal Reserve Board and many self-regulatory organizations (SROs), such as the NYSE and FINRA, have rules that govern margin trading. Brokerage firms can establish their own requirements as long as they are at least as restrictive as the Federal Reserve Board and SRO rules.

Here are some of the key rules you should know:

Before You Trade – Minimum Margin. Before trading on margin, the NYSE, and FINRA, for example, requires you to deposit with your brokerage firm a minimum of $2,000 or 100 percent of the purchase price, whichever is less. This is known as the “minimum margin.” Some firms may require you to deposit more than $2,000.

Amount You Can Borrow – Initial Margin. According to Regulation T of the Federal Reserve Board, you may borrow up to 50 percent of the purchase price of securities that can be purchased on margin. This is known as the “initial margin.” Some firms require you to deposit more than 50 percent of the purchase price.

Tip: Not all securities can be purchased on margin.

Amount You Need After You Trade – Maintenance Margin. After you buy stock on margin, the NYSE and FINRA require you to keep a minimum amount of equity in your margin account. The equity in your account is the value of your securities less how much you owe to your brokerage firm. The rules require you to have at least 25 percent of the total market value of the securities in your margin account at all times. The 25 percent is called the “maintenance requirement.” In fact, many brokerage firms have higher maintenance requirements, typically between 30 to 40 percent and sometimes higher, depending on the type of stock purchased.

Example: You purchase $16,000 worth of securities by borrowing $8,000 from your firm and paying $8,000 in cash or securities. If the market value of the securities drops to $12,000, the equity in your account will fall to $4,000 ($12,000 – $8,000 = $4,000). If your firm has a 25 percent maintenance requirement, you must have $3,000 in equity in your account (25 percent of $12,000 = $3,000). In this case, you do have enough equity because the $4,000 in equity in your account is greater than the $3,000 maintenance requirement.

But if your firm has a maintenance requirement of 40 percent, you would not have enough equity. The firm would require you to have $4,800 in equity (40 percent of $12,000 = $4,800). Your $4,000 in equity is less than the firm’s $4,800 maintenance requirement. As a result, the firm may issue you a “margin call,” since the equity in your account has fallen $800 below the firm’s maintenance requirement.

If your account falls below the firm’s maintenance requirement, your broker generally will make a margin call to ask you to deposit more cash or securities into your account. If you are unable to meet the margin call, your firm will sell your securities to increase the equity in your account up to or above the firm’s maintenance requirement.

Tip: Your broker may not be required to make a margin call or otherwise tell you that your account has fallen below the firm’s maintenance requirement. Your broker may be able to sell your securities at any time without consulting you first. Under most margin agreements, even if your firm offers to give you time to increase the equity in your account, it can sell your securities without waiting for you to meet the margin call.

• Margin accounts involve a great deal more risk than cash accounts, where you fully pay for the securities you purchase. You may lose more than your initial investment when buying on margin. If you cannot afford to do so, then margin buying is not for you.
• Read the margin agreement, and ask your broker questions about how a margin account works and whether it’s appropriate for you to trade on margin. Your broker should explain the terms and conditions of the margin agreement.
• Know how much you will be charged on money you borrow from your broker, and know how these costs affect your overall return.
• Remember that your brokerage firm can sell your securities without notice to you when you don’t have sufficient equity in your margin account.

Asset allocation is based on the proven theory that the type or class of security you own is much more important than the particular security itself. Asset allocation is a way to control risk in your portfolio. The risk is controlled because the six or seven asset classes in the well-balanced portfolio will react differently to changes in market conditions such as inflation, rising or falling interest rates, market sectors coming into or falling out of favor, a recession, etc.

Asset allocation should not be confused with simple diversification. Suppose you diversify by owning 100 or even 1,000 different stocks. You really haven’t done anything to control risk in your portfolio if those 1,000 stocks all come from only one or two different asset classes–say, blue chip stocks (which usually fall into the category known as large-capitalization, or large-cap, stocks) and mid-cap stocks. Those classes will often react to market conditions in a similar way they will generally all either go up or down after a given market event. This is known as “correlation.”

Similarly, many investors make the mistake of building a portfolio of various top-performing growth funds, perhaps thinking that even if one goes down, one or two others will continue to perform well. The problem here is that growth funds are highly correlated-they tend to move in the same direction in response to a given market force. Thus, whether you own two or 20 growth funds, they will tend to react in the same way.

Not only does it lower risk, but asset allocation maximizes returns over a period of time. This is because the proper blend of six or seven asset classes will allow you to benefit from the returns in all of those classes.

Asset allocation planning can range from the relatively simple to the complex. It can range from generic recommendations that have no relevance to your specific needs (dangerous) to recommendations based on sophisticated computer programs (very reliable although far from perfect). Between these extremes, it can include recommendations based only on your time horizon (still risky) or on your time horizon adjusted for your risk tolerance (less risky) or any combination of factors.

Tip: Most mutual fund families, brokerage firms and financial service companies offer computerized asset allocation analysis. Unfortunately, many of them, in recommending a specific portfolio of mutual funds or stocks, include only funds in their family (in the case of fund families) or those on which they receive the highest commissions (in the other cases). However, these may not be the best-performing investments. Don’t undercut the benefit of a sophisticated asset allocation analysis by allowing yourself to be steered into funds or stocks that are based on biased recommendations.

Computerized asset allocations are based on a questionnaire you fill out. Your answers provide the information the computer needs to become familiar with your unique circumstances. From the questionnaire will be determined:

• Your investment time horizon (mainly, your age and retirement objectives).
• Your risk threshold (how much of your capital you are willing to lose during a given time frame), and
• Your financial situation (your wealth, income, expenses, tax bracket, liquidity needs, etc.).
• Your goals (the financial goals you and your family want to achieve).

The goal of the computer analysis is to determine the best blend of asset classes, in the right percentages, that will match your particular financial profile.

At this point, the “efficient frontier” concept comes into play. It may sound complex, but it is a key to investment success.

Note: For an in-depth discussion of this important concept, see The Efficient Frontier, below.

The securities that exist in today’s financial markets can be divided into four main classes: stocks, bonds, cash, and foreign holdings, with the first two representing the major part of most portfolios. These categories can be further subdivided by “style.” Let’s take a look at these classes in the context of mutual fund investments:

Equity Funds: The style of an equity fund is a combination of both (1) the fund’s particular investment methodology (growth-oriented, value-oriented or a blend of the two) and (2) the size of the companies in which it invests (large, medium and small). Combining these two variables – investment methodology and company size – offers a broad view of a fund’s holdings and risk level. Thus, for equity funds, there are nine possible style combinations, ranging from large capitalization/value for the safest funds to small capitalization/growth for the riskiest.

Fixed Income Funds: The style of a domestic or international fixed-income fund is to focus on the two pillars of fixed-income performance – interest-rate sensitivity (based on maturity) and credit quality. Thus, fixed-income funds are split into three maturity groups (short-term, intermediate-term, and long-term) and three credit-quality groups (high, medium and low). These groupings display a portfolio’s effective maturity and credit quality to provide an overall representation of the fund’s risk, given the length and quality of bonds in its portfolio.

Simply stated, financial advisors build asset allocation models by (1) taking historic market data on classes of securities, individual securities, interest rates, and various market conditions; (2) applying projections of future economic conditions and other relevant factors; (3) analyzing, comparing and weighting the data with computer programs; and (4) further analyzing the data to create model portfolios.

There are three key areas that determine investment performance for each asset class:

1. Expected return. This is an estimate of what the asset class will earn in the future-both income and capital gain-based on both historical performance and economic projections.
2. Risk. This is measured by looking to the asset class’s past performance. If an investment’s returns are volatile (vary widely from year to year), it is considered high-risk.
3. Correlation. Correlation is determined by viewing the extent in which asset classes tend to rise and fall together. If there is a high correlation, a decision to invest in these asset classes increases risk. The correct asset mix will have a low correlation among asset classes. Correlation coefficients are calculated by looking back over the historical performance of the asset classes being compared.

Tip: The ideal asset allocation model for you will change over time, due to changes in your portfolio, market conditions and your individual circumstances. There will probably be shifts in the percentages allocated to asset classes, and possibly some changes in the asset classes themselves.

It’s important to be informed about asset allocation so as to avoid the “cookie cutter” approach that many investors end up accepting. Many of the asset allocations performed today take this “one size fits all” approach.

There are all sorts of investment recommendations, but the question is whether they are suitable for you. Regardless of the approach you take, be sure that an asset allocation takes into account your financial profile to the extent feasible.

The “efficient frontier” concept is a key to investment success. A graph demonstrating the efficient frontier is shown below.

Any expected return (left side of graph) carries with it an expected risk (bottom of graph). This risk-reward relationship varies from individual to individual. Conservative investors cannot tolerate more than a low level of risk, and are willing to accept a return commensurate with that level of risk. More aggressive investors are willing to tolerate higher levels of risk in the expectation of higher returns.

The efficient frontier is a line on the graph that represents a series of optimal risk-return relationships. That is, every dot on the line represents the highest return for a given level of risk or, stated conversely, the lowest risk for a given rate of return. Conservative investors will aim for a spot on the left side of the efficient (low return, low risk) while aggressive investors will aim for the right side (high return, high risk). If your portfolio (present or proposed) falls on the efficient frontier line, it has an optimal risk-return relationship, but nonetheless still may not be suitable for you because it may be too aggressive or too conservative. Your portfolio should be at that spot on the efficient frontier that approximates your particular risk-return goal.

Note: The efficient frontier is the result of mathematical calculations of expected risk and return. Risk is shown in levels of standard deviation, a commonly used measure of volatility.

As shown on the graph, if you are willing to tolerate an expected risk (standard deviation) of, say, 12, then you can reasonably (not definitely) expect an approximate return of 10 percent over a period of time (Portfolio C) – if your portfolio is efficient.

It is unlikely, over time, that returns will be higher than those shown on the efficient frontier. Of course, you may, in specific instances, achieve a higher return than that shown, but your average return over time will generally not exceed the amount shown.

If your portfolio falls below the efficient frontier, then it is “inefficient” in that it exposes you to too much risk for the specified return or, conversely, provides too low a return for the specified risk. Unfortunately for investors, most portfolios fall substantially below the efficient frontier.

Example: Portfolio A represents an inefficient portfolio in that it falls below the efficient frontier, meaning that the investor might reasonably expect a return of 10 percent for a risk of 25. However, if the investor is comfortable with that risk level, he can theoretically increase his return to 12 percent with no increase in risk by making his portfolio efficient (i.e., modifying it to resemble Portfolio B, which is on the efficient frontier). Conversely, if he wants to lower his risk, he can maintain the 10 percent return while reducing the risk to 12 (by modifying his portfolio to resemble Portfolio C on the efficient frontier).

Portfolio D is also efficient (as are B and C, all on the efficient frontier), but represents a portfolio that will enjoy a lower return with lower risk.

Caution: A diversified portfolio does not assure a profit or protect against loss in a declining market.

Caution: Asset allocation will not guarantee a profit or protect you from loss however, it may provide a hedge against risk and create opportunities in both bull and bear markets.