Dear Dagen: SEC's Fund Advice Needs More Spice

Novice investors need more specifics and plainer language.
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If

Securities and Exchange Commission

chairman Arthur Levitt wants to retire with the reputation as a great consumer advocate, he'll need to deliver more than a few generic caveats about buying fiery funds.

The SEC issued some

cautionary advice for investors this week, urging them to look beyond short-term performance when picking a fund.

The agency, which regulates the mutual fund industry, has some understandable worries stemming from the record number of funds producing triple-digit returns in 1999 -- 177, to be exact.

"High-performing funds often fail to repeat their gains, and investors who switch in and out of funds typically experience significantly lower returns than those realized by 'buy and hold' investors," the release reads.

Fair enough.

Unfortunately, the SEC's platitudes are too broad and banal and fail to give investors any practical guidelines on picking a fund.

Let's take a look at what the SEC said -- and what Levitt and his staff left out of their release.

Scrutinize the fund's sales charges, fees and expenses.

"A fund with high costs must perform better than a low-cost fund to generate the same returns for you," says the SEC.

That's true. When buying a fund, cost is obviously key. However, this general rule doesn't tell you how to compare one fund with another or how much is too much to pay in fees.

You should know that the average large-cap growth fund carries an annual expense ratio of 1.48%. In simple terms, that means expenses for running the fund will cost you $148 a year on a $10,000 investment. Anything well in excess of that number may be too costly.

But investors should allow for higher expenses in certain specialized categories. The average technology fund, for example, charges 1.77% in annual expenses.

Index funds are cheaper because they aren't actively managed. The average

S&P 500

index fund has an expense ratio of 0.6%.

The SEC's

Web site offers a

mutual fund cost calculator that spits out the amount of money you'll lose in fees over the time you hold a fund. To use this calculator, however, you'll have to plug in an expected rate of return. Good luck guessing.

Know how the fund affects your tax bill.

That's substantive.

"If you receive a capital gains distribution, you will likely owe taxes on it -- even if the fund has had a negative return since you invested in it," reads the

SEC's release.

True, it's unacceptable if your fund is making a distribution and it delivered a negative return for that year. But that advice certainly doesn't apply to funds sporting the triple-digit returns that seem to frighten the SEC.

Instead, you should know that a distribution that's more than 15% of a fund's net asset value is considered excessive.

You should also be aware of a fund's turnover ratio. That's the amount of a fund's portfolio that is sold off during the year. Selling stocks can generate taxable gains and transaction costs. The capital gains will be passed on to you, and the transaction costs will be deducted from the fund's assets, reducing your return.

Even though high turnover can be a sign that a fund is not the most tax-efficient, it doesn't necessarily mean high capital gains. But you should keep an eye on it.

Frankly, it's incredibly difficult for a fund to be specific about its tax impact on you. Every individual's tax situation is different. If taxes truly take precedence over returns for you, you can use

Morningstar's

Web site to compare the tax-adjusted returns of funds.

Consider the age and size of the fund.

"You can get a better picture of a fund's performance by looking at how the fund has performed over longer periods and how it has weathered the ups and downs of the market," says the SEC.

However, if investors buy only those funds with long-term track records, they couldn't buy an Internet fund at all.

The oldest Internet funds, like

(MNNAX) - Get Report

Munder NetNet and

(WWIFX)

WWW Internet, aren't even four years old.

Rather, investors should look at a manager's experience in running funds. Some Internet fund managers, like David Alger of the

(EIFAX) - Get Report

Enterprise Internet fund, have a long history of buying aggressive growth and technology stocks.

Think about the volatility of a fund.

You'll have to do more than just think about it.

The SEC suggests that investors, "Read the fund's prospectus and annual report, and compare its year-to-year performance figures."

You can do better than that.

Standard deviation is a measure of a fund's own volatility or its range of performance. However, this number won't tell you much on its own. You can compare one fund's standard deviation with that of another, say a benchmark like an S&P 500 index fund. The higher the standard deviation, the more volatile the fund.

Morningstar's Web site carries standard deviation figures for every fund.

For more evidence of volatility, you can examine a fund's performance quarter over quarter, rather than year over year. That should give you a feel for how much a fund's return will swing. For example, the

(TVFQX)

Firsthand Technology Value fund fell 29.7% during the third quarter of 1998 and then rocketed 60.6% during the fourth quarter. By comparison, the

(VFINX) - Get Report

Vanguard 500 Index fund fell 10% and rose 21.4% in the same periods.

You'll need to decide whether you (and your portfolio) can stomach those kinds of swings.

The remainder of the SEC's helpful hints are even more prosaic.

The SEC says, "Ask about recent changes in the fund's operations." That just means you should make sure the fund's manager or investment style hasn't changed recently. A fund company's customer service rep can tell you whether a manager has changed. Knowing whether a manager stays true to his or her investment style is harder to pin down. It requires keeping close tabs on the fund's holdings and deciding whether they're the kinds of stocks you expect it to own.

If the SEC really wants to drive its points home with investors, it should throw in some real-life examples.

If you invested, say, $10,000 in the

(LETRX) - Get Report

Lexington Troika Russia fund at the end of 1997 after it produced a 67.4% return that year, you would have been left with $1,700 at the end of 1998.

Better yet, the SEC could continue to clear away the legalese still found in too many fund documents so that they're understandable to even investing neophytes.

Send your questions and comments to

deardagen@thestreet.com, and please include your full name.

Dear Dagen aims to provide general fund information. Under no circumstances does the information in this column represent a recommendation to buy or sell funds or other securities.