Pyramid of Mutual Funds

PYRAMID OF MUTUAL FUNDS

25. Gold & Precious Metals

24. Sector

23. Single Country

22. Emerging Markets

21. International Stock

Mostly Growth

20. Global

19. Real Estate

18. Small Cap/Aggressive

17. Value

16. Zero Coupon

15. Medium Cap

14. Blue Chip/Large Cap

13. International Bonds

12. High Yield Bonds

Mixture Stocks/Bonds and some hybrids

11. S&P 500 Index

10. Convertible Securities

9. Utility Funds

8 Equity Income

7. Balanced (Growth & Income)

6. Asset Allocation

5. GNMA

4. Long Term Government, Municipal and Corporate Bonds (20+ Maturity)

3. Medium Term Government, Municipal and Corporate Bonds (10 year maturity)

2. Short Term Government, Municipal and Corporate Bonds (3 year maximum maturity)

Basic Bond Funds

1. Money Market Funds (No derivatives)

Money Market funds

FDIC Insured CD's and Savings Accounts

Individual Treasury Bills, Notes and Bonds

INSURED ISSUES

Note: This pyramid does not necessarily conform to returns over the past 15 or 20 years. It represents my review of such returns coupled with recent and expected economic conditions as well as an understanding by consumers as to how each grouping should work. For example, and as stated many times, very few people really understand how GNMA's work.

MUTUAL FUND PYRAMID OF INVESTING

THIS INFORMATION IS PROVIDED IN FAIRLY NON TECHNICAL TERMS. HOWEVER IT SHOULD BE SUFFICIENT TO GIVE YOU A GRASP OF CERTAIN DEFINITIONS AND CHARACTERISTICS OF INVESTING THAT YOU OR YOUR ADVISOR MUST KNOW AND REVIEW BEFORE INVESTING.

Overview- The intent of the following is to give you, the investor, a short and concise review of the risks and rewards of the certain investment(s) you may be considering based on my experience and interpretation of risk and may not conform to other risk profiles.

The pyramid is an attempt to classify each investment as to its overall risk BY ITSELF- meaning no other investments are offsetting. It is not intended to be 100% accurate per specific portfolio because there are innumerable factors that must be considered in each fund, with each manager, with each economic scenario etc. But it will provide you an acceptable gauge- with perhaps a 10% to 15% error for a given economic scenario- of where your initial risk will reside. After you review this, you must also review asset allocation- the use of non correlated investments. With these two elements, you can start towards making investment selections. BUT NOT BEFORE THEN.

Pyramid strategy- Almost all teaching in investments suggests that you "cover your bases first" before moving up the pyramid and taking on more risk. That's why treasury instruments and insured deposits are shown first. Bonds are included next since, historically, they are less volatile than stock- meaning their returns do not fluctuate as greatly.

Basic stock index funds are usually next in line followed by more aggressive positions until you reach the top and are involved in far more speculative investments. For example, just think about gold since the mid 80's. They have increased somewhat in the 2000+, but it reflects more the emotional backlash to the stock market than the higher value of gold in and of itself.

The general statement is if there are no dependents- just yourself - and you have discretionary money (money not needed for basic living expenses and that can be saved) you can take on more risk than a person with a spouse, family or other type of responsibilities. It's also generally agreed that if you are older you should reduce your risk exposure since there is a shorter time to potentially make up any losses. But few people fit into "slots", so you should carefully analyze your situation to determine what you should do based on your NEEDS- not necessarily what you would like or want to do. Hopefully the following descriptions and definitions will be helpful.

AS A GENERAL GUIDE, YOU SHOULD/MUST HAVE PART OF YOUR INVESTMENTS IN THE MORE SECURE AREAS FIRST BEFORE INVESTING IN THE MORE RISKY AREAS. THE YOUNGER YOU ARE, THE MORE MONEY YOU MAKE, THE FEWER DEPENDENTS AND DEBTS YOU HAVE, THE MORE RISK YOU CAN THEORETICALLY TAKE. BUT NEVER TAKE A LOT OF RISK UNLESS YOU OR A COMPETENT ADVISOR TRULY UNDERSTANDS THE MARKETPLACE AND HOW YOUR INVESTMENT WORKS.

INDIVIDUAL ISSUES: Though we are addressing mutual funds, it is necessary to start with individual ownership of the least risky assets- normally cash and cash equivalents. Historically however, these returns are considerably less than bonds and stocks. Individual Treasury instruments are backed by the Federal Government. Treasury bills have maturities of 3, 6 and 12 months; notes up to 10 years and bonds up to 30 years (the Treasury has discontinued). The longer the maturity, the greater the yield- though yield historically tends to flatten out after five or seven years.

Your risk is primarily limited to inflation. For example if you had a 12 month T-bill earning 5% and inflation was 6%, you have a net loss at the end- even less when taxes are deducted from the return.

Longer term bonds may be greatly impacted by the movement in interest rates as identified later. But if held to maturity, the government will guarantee that your principal is returned. There is no such guarantee with mutual funds.

Also falling into the secure definition are FDIC insured Certificates of Deposit and savings accounts. The amount currently is $100,000 per ownership. These categories may also be impacted by inflation.

NON FDIC INSURED INVESTMENTS

All investments beyond Treasury instruments and FDIC covered accounts are in non insured and non guaranteed securities. If you invest in any investments besides these investments, you could lose money due to a number of different factors. Mutual Funds are NOT guaranteed by any federal or state agency against loss. Do not invest unless you understand and are willing to take additional risks.

1. Money market funds are not FDIC insured. They invest in short term government, municipal or corporate bonds with less than 12 months to maturity and try to maintain a $1.00 per share value. Some funds may use derivatives in an attempt to increase return and these are normally based on movements in interest rates. If they guess right, your fund may have higher returns than others. If they guess wrong, there may be substantial losses. Some of the losses in the past were paid back by the funds, but there is no guarantee or requirement by law to do so. You should read the prospectus carefully to determine what the fund managers can and have been doing.

Some money market funds in variable annuities have actually "broken the buck" in 2002- meaning that they have not retained the $1.00 per share value.

2. Short term government, municipal and corporate bonds. Theses bond funds may have maturities generally no longer than 3 years- though there is no specific requirement of the time frame. Normally, the longer the time frame, the greater the risk and the greater the opportunity for a higher yield. Within this category, ratings by the various services also come into play since the higher the services rating, the lower the risk, everything else being equal. Government and municipal securities generally have higher ratings OVERALL than corporate securities and usually yield less. Managers in almost all bond funds continually buy and sell bonds, so there is no actual maturity date for the fund. Check for derivative use.

YOUR INVESTMENT IN THESE SECURITIES COULD DROP IN VALUE IF INTEREST RATES WERE TO GO UP IN THE ECONOMY.

3. Medium term government, municipal and corporate securities might be limited to around 10 years to maturity- though there is no set time period. These are more volatile than the shorter term bonds and tend to yield more. That is not preordained since an inverted yield curve could cause short term rates to be higher than longer term rates.

4. Longer term bonds(average maturity around 20 years+) have the highest risk in the conventional bond arena, everything else being equal. They yield more and are more volatile than either short term or medium term bonds. They tend to go drop more in value when rates go up and go up more when interest rates go down.

NOTE: GNMA's are not included in the above definitions.

5. GNMA- Government National Mortgage Association Modified Passthroughs funds, and the similar FNMA and Freddie MAC mortgage securities reflect a pool of residential mortgages (normally) where you, the investor, get most of the principal and interest payments as they are paid by the homeowner each month. GNMA's have direct backing by the U.S. government and are the least risky of the three types of mortgage pools. They therefore may yield slightly less than funds using mostly FNMA'S or other mortgage instruments. However, the GNMA guarantee (and the similar FNMA and Freddie MAC warranties) is limited to only a mortgage default (non payment of monthly premium) and has nothing to do with the possibility that the principal may go up or down as interest rates in the economy change. However, and the reason GNMA's are highlighted separately, is that they do not necessarily move in the same direction as "regular" government, municipal or corporate bonds- in some cases moving exactly the opposite. This happens because as economic interest rates go down, more people that have mortgages tend to want to refinance at the lower rates. Therefore, as these people refinance, you get more money back and now must take a higher risk to attain the higher previous yield (risk of reinvestment). Historically therefore, as interest rates drop, so may the GNMA value- opposite to almost all regular bond funds. By the same token, when economic rates rise, the value of principal may drop since you hold a portfolio of lower yielding mortgages. GNMA funds are not well understood by most investors so caution is advised before you invest. They do best in a low interest rate volatility climate.

In essence, if economic rates stay relatively flat, GNMA funds will tend to earn more than comparable rated and term to maturity bond funds. But if rates move up or down very much, you may find that the total return on GNMA funds may be less than other bond funds.

6. Asset allocation funds tend to temper risk by using stocks, bonds and cash. The use of three (supposedly) non correlated (non corresponding) securities is an attempt to reduce risk since cash and bonds have, historically, lower volatility than stocks. The idea is to use more bonds when stocks are not doing well and more stocks when the market is growing well. Larger cash positions are used when neither type of security is supposedly going to do well. Different mutual funds use dramatically different ratios even given the same economic conditions, so it is prudent to review the past fund mixture ratios to see if they are acceptable to you.

Asset allocation funds may be generally used if you do not want to take an excessive risk in the market and if you do not want to continually monitor your fund since the fund managers will vary the mix as they see fit. However, there is still no guarantee that they will make a profit in any given year or even over time.

Additionally, the historic trend of stocks and bonds being non correlated is not an absolute. This is most apparent with the lowering of rates starting in 2000 and the subsequent substantial decline of the market as well. Asset allocation funds have lost money on al counts.

7. Balanced funds are similar to asset allocation in that they use two different investments- stocks and bonds. But, historically, they tend to have 60% in stocks and 40% in bonds and may not vary that much even when the economics change. Stocks and bonds together tend to lower volatility (risk). They also tend to have lower returns than pure stock funds.

Balanced funds also represent moderate risk and may also be acceptable for those not desiring to monitor their fund constantly. However, there is still no guarantee that they will make a profit in any given year or even over time- though most have.

Once again, consider 2000- 2003 and the element that stocks and bonds do NOT necessarily move counter to each other and that both may lose in the same economic environment.

8. Equity Income funds normally use stocks that generate (hopefully) consistent income through dividends. In addition , if the stock market appreciates, the investor may also participate in the increased value of the shares. By the same token, if the market declines overall, total returns could be negative.

Note that during the 90's, many firms lowered dividend payments in lieu of growth. Subsequent to the fall of Exxon, Worldcom, etc. some companies have attempted to move back to the offering of dividends. However, there exists substantial difficulties regarding the accounting use of stock options and pension underfunding that has yet to resolve the valid use of dividends.

9. Utility funds are similar to equity income funds due to their income payouts. Generally considered to be "relatively safe and consistent" income funds, economic conditions may impact the returns as is evidenced in 1994 when the utility stock index dropped over 25% at one point.

10. Convertible securities are bonds that have the capability, under certain conditions, to convert to stock in the company. The bonds normally have a yield less than standard bonds due to the convertible opportunity. Their value also hinges, at least in part, on the movement of the underlying stock.

11. S&P 500 index funds. Most funds buy just a basket of some of the S&P 500 stocks-those that supposedly are an excellent reflection of the entire 500 stocks. Many analysts and investors believe that managed funds do not- at least over the long term- provide a consistent return higher- or even as great- as an index. It is true that many pension funds use a lot of index funds simply for this reason. Returns, as compared to the S&P 500 in total- will be less due to expenses of running the fund and how well the individual stocks selected mirror all 500 stocks. There are many types of index funds- small cap, international, etc. and may be used in conjunction with other funds to build your own asset allocation portfolio.

There are a number of funds that mirror other indexes. They may include Mid cap, small cap and international indexed funds and belong in the first risk category where the type of fund is identified.

12. High Yield Bond Funds. Bonds are rated AAA down to D. Bonds rated BBB and above are called "investment grade". Bonds rated below BBB are usually called "junk bonds" and tend to pay, because of that lower rating, a higher yield. Investors should look at the average rating of the fund. An average weighted rating of BB may indicate a "low risk" fund in the entire junk bond/high yield risk area of the pyramid. An average C rated high yield bond fund indicates one of the highest levels of risk in this area.

As regards the rating, the lower than investment grade rating does not mean the bonds are in eminent timing for default since historical analysis shows that it is not that significant over time. However, during the last 10 years, there have been a least two major problem periods where high yield bond funds lost value. Most of the lower value was due to the fact that fund managers had to sell bonds in a short period of time in a thinly traded market- that is where there are not many buyers and sellers. If you need to sell in a hurry, you tend to get a very low price.

If the economy is strong, lower rated high yield funds tend to do better than the better rated high yield fund since, as the economy improves, a C rated company may do better and be "unrated" to, say, B. The market will then, normally, see an increase in value/price. Of course a recessionary climate could drive the prices and ratings lower still. The lower the ratings, the higher the risk,, the higher the yield.

Also look at the average maturity. Everything else being equal, a high yield fund will act the same as a regular bond fund. The longer the maturity, the higher the risk. Also, If economic interest rates go down, the principal will go up and vice versa.

13. International Bonds may earn higher returns than U.S. bonds. However, they take a significant added level of risk due to currency fluctuations. If the dollar appreciates against your foreign bond, your returns can drop appreciably and may be negative regardless of what else may be happening to economic rates.

14. Blue Chip and large capitalization stocks represent the bigger and more historically successful companies. You look to these for continued growth based on past performance. Many have also shown a history of paying dividends as well. The risk is identified as higher than the 500 index overall since you are selecting just one section of the marketplace- not a broad coverage.

15. Medium capitalization stocks are not quite as large as that listed above and may provide some greater element for growth. That stems from the fact that small capitalization stocks (#20) have historically shown greater growth than large capitalization stock (though also with greater volatility). The point being that perhaps being in the middle provides a little of both- reasonable growth with acceptable risk. As with all investments, you should review the past history of the fund in question both in terms of appreciation, dividend payout and volatility and then make a determination if it might do the same in the future. Past history is a guide, but it in no way represents

what the future may return.

16. Zero Coupon bonds can be government, corporate or municipal bonds. These are unique bonds in that you do not receive any cash flow. You buy the bonds at a discount and receive face value when they mature. For example, you might buy a bond for $600.00 with 10 years to maturity. When the 10 years are up, you'll get the $1,000 promised (assuming no default, etc.). Your yield is determined by the amount of the discount and the time until maturity. Since there are NO payments till the end, zero coupons are VERY volatile securities and will have far more extreme movements in price than regular bonds. Your principal will go up more if economic rates decline but will go down far more if interest rates were to increase. If you need to sell prior to maturity, the value could be substantially different from the $1,000 you could get when the bond matures.

You must also be aware of taxes. Even though you do not get any money, there is an interest amount that is being earned internally by the bond. You will be taxed each year on the interest as though you had received it- except for bonds that are normally exempt from tax. If you are sure to hold a bond to maturity and it is guaranteed against default, it could drop down to around to risk level 8.

17. Value stocks represents companies that may have had recent poor histories but which now may be on the brink of recovery. Since their statistical ratios are less than other companies that are currently doing well, they are considered under valued. Obviously if the growth does not happen, they might drop even more.

18. Small capitalization/aggressive growth stock funds represent smaller companies that historically have been shown to grow faster and have higher appreciation than larger companies- though also with greater volatility. They tend to pay little, if any, dividends since they put earnings back into the business.

19. Real estate funds invest in the stock of companies primarily devoted to real estate activity either through building, financing and other real estate related services. It is one of the few ways of investing in real estate while allowing almost complete liquidity since, in almost all cases, a mutual fund is required to send you your money within seven days of a receipt of a sell order. One reason an investor might include this area is that this industry's movements are not directly correlated (move the same) with the movements of the stock or bond market. It might therefore be possible to have growth independent of this market and the various combinations may even possibly reduce the overall risk of the portfolio.

20. Global funds may purchase the stocks of foreign countries as well as the United States. Therefore the risks and returns are based on the proportion invested in the various countries- but are not solely tied to non U.S. stocks. Investors need to recognize that foreign stock is subject to an additional risk- that of currency devaluation. If a foreign county's money appreciates more in value as compared to the U.S. dollar, then every dollar of stock that was purchased overseas becomes worth less than before, everything else being equal. That may mean that even though the foreign stock went up, you could still show a loss.

Some funds may hedge currency fluctuation by purchasing various types of derivatives- but this is a standard way of REDUCING risk with some funds. However, there is a cost associated with buying these different derivatives, so the fund's overall return will be reduced accordingly.

Investors using some foreign stock in their portfolios are following a form of asset allocation and diversification by adding non correlated securities in an attempt to reduce risk while attempting to increase or maintain the returns expected.

21. International or foreign funds buy only non U.S. stocks so they are solely dependent on the countries they invest in. Some funds will pick stocks of any country- some will focus on the Pacific Basin, Latin America, Europe, etc. You should feel comfortable that the area the manager has and will invest in reflects your own desires. You must also be aware that problem that happen in one country may effect many others. The problems in Mexico in 1994 dropped the value of many funds that carried only a small amount- even none- of Mexico securities.

22. Emerging Foreign Markets- the stock markets in foreign countries are not required to adhere to the same reporting standards as required under the Securities Exchange Commission. Therefore managers buying stocks in these countries must do extra work in analyzing the companies they will buy. Even more difficult is to review new and smaller countries that may have recently opened up their markets to foreign investment- or that may have had a political change that might offer opportunities (South Africa). Many of these countries also have special buy and sell laws for foreigners and may decrease the liquidity of redemptions. The risks are at least as great as that of single country funds.

23. Single country funds invest in one country only and your risks are tied to only their performance. If it does poorly- as Japan did for several years- your return could be negative for some time. There are not many mutual funds that invest in just one country- the major country is Japan.

24. Sector funds focus the majority of its investments in only one area- health, technology, computers- and like single country funds are almost solely dependent on the movement of that one area. Sector funds must have at least 25% of their portfolios in the area selected, but that leaves a great latitude for the rest of the money. One technology fund could have 75% invested in these stocks while another only 30%- yet both call themselves a Technology fund. Investors need to research historically how the fund had invested its money. But as with single country and emerging markets, if you "guess" right, there can be substantial rewards.

25. Gold and precious metals funds are always at the top of a pyramid and should only be used when you can afford a high risk. Some teachings in asset allocation suggest a maximum of 5% to 10% of your portfolio may be invested in this area as an offset to inflation, but be sure to review past history of your fund and type of metal before investing. There is a lot of volatility in this area.

IF YOU PURCHASE AN INVESTMENT (FUND) THAT IS WELL OUTSIDE OR YOUR RISK LEVEL AND/OR WHERE LESS CONSERVATIVE VEHICLES HAVE NOT BEEN PURCHASED, YOU HAVE VIOLATED THE BASIC TENETS OF INVESTING AND ARE QUITE PROBABLY PURCHASING AN UNSUITABLE INVESTMENT FOR YOUR SITUATION.

Yes, it is possible to skip some bond assets as an investment due to their relatively low returns over time. However, those needing income cannot, for example, eliminate medium and (some) long term bonds by moving unilaterally to high yield funds.

One cannot eliminate the use of balanced funds or the S&P 500 by unilaterally investing in options, international funds or golf.

Anyone doing so is probably limited in the fundamentals of risk and reward and is buying the wrong thing at the wrong time and at the wrong risk level.

YOU MUST DO YOUR HOMEWORK!