Some nut has targeted Janus Capital in a letter bomb attack:

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We sure hope it had nothing to do with Janus' appearance in our Six Annual Mutual Fund Turkey Awards this year:

Heck, they were only an honorable mention.

Slate's Daniel Gross lists five reasons why he thinks there’s a hedge fund bubble, and that bubble is close to bursting. It's required reading for anyone who is thinking about choosing a hedge fund over a well-diversified mutual fund portfolio.

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Welcome to Part III of MAXuniversity!

One of the things we hoped to achieve when we started MAXfunds.com was to help investors to make better-informed mutual fund investing decisions – to give them a better way to look at mutual funds. Part III of MAXuniversity shows you how, by revealing our seven golden rules of mutual fund investing.

Rule #1: No Loads!

Like we said in MAXuniversity part II, you should never, ever buy a fund that comes with a front end or back end load. To repeat, you start 5% or more behind a no-load fund. Also, it does not matter whether the load is up front, back end, or one of them newfangled level loads.

Rule # 2: Don't overestimate Past Performance figures

At MAXfunds.com, every employee is required to get the phrase "Past Performance Is No Indication of Future Returns" tattooed somewhere on their body. Preferably their foreheads. They must be able to recite it in some twelve languages. We make them post it over their beds, so it is the first thing they see when they wake up in the morning, the last thing they see before falling asleep at night.

We know, you've heard it a million times before. But despite this phrase's presence in practically every mutual fund ad ever created, not enough investors pay attention to it.

According to a report by the investment company institute, 88% of fund buyers cite past performance as the primary reason they select one fund over another. And really, it's hard to blame them. It seems perfectly reasonable to think that if a fund has posted 25%+ returns for 3 years in a row it's got a pretty good shot of doing it again next year too. And why shouldn't it? The fund manager must be doing something right. Three years in a row, that's no fluke.

No, it's not a fluke, but chances are performance like that isn't sustainable either. As crazy as it sounds, often the better a mutual fund has performed in the past, the more difficult it becomes for the fund to perform well in the future. According to a study by The Financial Research Corporation, over the ten-year period of 1988-1998, funds whose performance placed them in the top 10% (10th percentile or higher) of all mutual funds one year fell, on average, to the 51st percentile (woefully average) the next year.

When a fund posts good returns for a few years in a row, a lot of people want to invest in it. The more people that want to invest in it, the more money the fund has to invest. The more money the fund has to invest, the more difficult it is to continue posting good returns. Why? Read on!

Rule # 3: No Fat Funds

Did you know mutual funds can get fat? They can. A fat fund is one that has so much money the manager literally has trouble investing it all.

Mutual funds exist to make money for the people who put them together. The way they make it is by charging a management fee to shareholders that is a percentage of each shareholder's investment. If a fund charges shareholders a fee of 1.5%, and the fund has assets of $1 million dollars, the fund management company will make $15,000. With assets of $10 million dollars, they will make $150,000. Assets of $100 million dollars produces fees of $1.5 million dollars. The more money the mutual fund takes in from shareholders, the higher their fee works out to be. It's only natural that a fund will try to pull in as much money from as many people as it can.

The problem is that very often the more money a fund manager has to invest, the worse the fund performs. Why? Because finding good investments is not that easy, even for professional money managers.

Here's an example: Let's say a fund manager, we'll call her Marge, runs 'The Marge in Charge Fund' a small-cap fund with modest assets of $30 million dollars. She and her research team find 30 small cap stocks to invest in - and they put a million dollars into each company.

Now Marge and her team pick well. Her fund goes up 30% the first year, 40% the next year, and 40% the year after that. In fact the fund's performance is so good, it shows up on the cover of Money Magazine as one of the "Top 5 Funds Every Investor Must Buy Immediately or Life Just Isn't Worth Living." Investors see the article and figure Money Magazine knows what it's talking about. They start writing checks. In a few months, Marge's fund has $500 million dollars of new investor money (not an unreasonable scenario, we assure you).

Marge's small-cap fund just got fat.

Marge now has two options: she can invest the $500 million in the same thirty stocks the fund's portfolio already owns, she can look around for a bunch of new stocks to buy.

The problem with investing the $500 million into the 30 stocks she already owns (and each of which she's already invested a million dollars) is that for a mutual fund, it's bad to have too large of a position in any single stock. If a fund owns much more than 1% of any company and decides to sell those shares, it will negatively affect the price of the shares it sells. Fund managers want to get in and out of stocks quickly and efficiently without moving the price a lot. If they own too much of one stock, this becomes extremely difficult.

Option two isn't much better. Even for professional money managers, it's not that easy researching and finding good stocks – you have to really analyze each company and its competition. The average small company stock has a market cap of about $500 million dollars. For Marge's fund to try and invest the $500 million dollars in her fund and not exceed a 1% stake in each company, she'd have to find another 100 good small cap stocks to invest in. That's a lot of different stocks, and Marge had a hard enough time finding 30 good ones. What's likely is that she'll find a few good companies to invest in, and a few that aren't so good. With each not so good stock she adds to her portfolio, the more mediocre her returns in the future.

Marge does have a third option. She can stop accepting new money once the fund reaches a certain asset level, say $250 or $300 million, and not have to make as many sacrifices in her portfolio management. From a shareholder standpoint, this is what Marge should do. From Marge's perspective, this option is not very attractive. Marge's fund charges a 1% management fee. For every $100 a shareholder invests in the fund, Marge makes $1 each year. With assets of 30 million dollars, Marge and her team make $300,000. Not bad. But Marge lives in New York City, and nowadays in the Big Apple 300 large doesn't get you very far. But with assets of $500 million dollars, the management fee would be $5 million per year. Those are 5 million very good reasons for Marge not to close the fund to new investors. Hello Tavern on the Green, goodbye Benny's Burritos. Hello Tribeca loft, goodbye 4th floor 500 square foot walk up. Hello... you get the picture.

How do you know if a fund is too fat? Look at its Fat Fund Index, found on each fund's MAXinsights page. We've figured out what each fund's maximum asset size should be and compared it with the fund's actual assets. A Fat Fund Index of 1 or 2 is ideal. It means that fund is slimmer than Kate Moss and isn't in danger of getting fat anytime soon. A Fat Fund Index of 3 is still acceptable, but is developing some love handles and should watch it's new shareholder money intake (and so should you). A 4 means a fund is too fat - it's exceeded its maximum recommended asset size and will probably start producing less than stellar returns in the very near future. A fund with a Fat Fund Index of 5 is a real glutton - bloated, slow, and unhealthy. A fund with a Fat Fund Index of 5 should be avoided at all costs.

Rule # 4: The Younger the Better

Does the age of a mutual fund have anything to do with the kind of returns it produces? Very often, the answer is yes.

Younger mutual funds will tend to have lower asset levels than older funds. As we talked about above, funds with lower asset levels generally produce better returns than fatter funds. But that's not the only reason younger funds do well.

Mutual fund companies know that many investors use past performance as the primary factor in deciding whether to buy a fund or not, and a fund that produces exceptional returns for its first several years can continue to attract investor money long after its glory days are behind it. Fund companies often pull out every stop to make sure their newest funds produce the best returns they possibly can. They do this in several different ways.

Large fund companies will seed their younger funds with hot initial public offerings. An I.P.O. is when a company first offers shares of itself for sale to the public. Big investors like mutual funds can get in on I.P.O.'s at the offering price, not the first traded price like your average investor. When the public starts buying, the shares owned by the fund are almost guaranteed to go sky-high. A few good I.P.O.'s in a new fund's portfolio can do wonders for a fund's performance figures.

Another way fund companies boost the performance of their younger funds is by front-running - purchasing shares of a company for the younger fund's portfolio just before they make a big purchase for one of their larger funds (or talk the stock up on CNBC). Some mutual funds are so big and make such large stock purchases that they actually cause the shares of the company they are buying to go up. If their little brother already owns shares of that stock, it's going to help the younger fund's returns.

You can tell how old a fund is by finding its F.P.O. (first public offering) on the top of it's MAXinsights page. While you're at it, check out the funds Family Advantage Index - a statistic that reveals to what degree a fund is helped by belonging to a large fund family. A fund with a Family Advantage Rating of 1 belongs to a large and wealthy fund family which will almost certainly help its early performance. A fund with a Family Advantage Rating of 5 is an only child, so it's not going to benefit as much from I.P.O. seedings, or front-running.

Rule # 5: Watch Expenses

The expense ratio is the percentage of investor money the fund uses each year to run the fund and pay the manager. An expense ratio of 2% means that 2% of your money last year went to things such as administrative costs, management fees, research trips, legal counsel, accounting, printing statements and literature, advertising fees, investment conference junkets to Bermuda, fancy promotional materials and other stuff.

The most important thing to remember about expense ratios is that they vary widely, and differences from fund to fund really do matter. Some mutual funds charge only one-half of one percent to manage investors' money. Others have sky-high expense ratios of nearly five percent. In our opinion, there is very little reason to invest in a fund with an expense ratio of more than 2.0% (and even that's only for the rarest gems in the fund world).

Seek out funds with expense ratios of 1.25% or less. Anything higher and it's just too hard for the fund manager to produce returns that are worth the risk of investing. You can find the expense ratio for each fund at the very top of its MAXinsights page. You may need to cut a small or new fund a little slack on this rule because it is difficult to keep costs down as low as the big funds. Very often, the advantages offered by small fund offset the handicap of a slightly higher expense ratio.

Rule # 6: Check Performance Relative To Class

We know, we told you not to look at past performance when deciding to invest in a fund. But there is real value in knowing how well a fund has done against other funds of the same type. If you're in a Latin America fund that was up 20% last year you're probably pretty happy. But if all the other Latin American funds are up 50% in the same time period, all of a sudden your fund isn't looking so good. Performance Relative to Class is one of the most effective indicators a mutual fund shopper can use to weed out under-performing managers.

Rule #7: Know The Fund's Risk Level

One of the trickiest things about picking funds is figuring out how risky the fund is that's being considered. Potential investors often just see the performance, the rankings, or the slick advertisements and buy, buy, buy. Usually the funds that end on top of "The Best Performing Fund of the Year" list took some big risks to get there.

It's not that risk is necessarily bad, but investors should always find out how risky the fund they're considering investing in is. If you can afford to lose a whole lot of a particular mutual fund investment, go ahead and take a risk. If you can't, you had better find a safer fund.

On the data page you will find every funds risk level expressed as a number from 1 through 5. A fund with a 1 rating is about as safe as equity investing gets, with the likelihood of losing more than 15-20% being pretty remote. A fund with a 5 rating is very risky, with loses of over 40% being relatively common. Of course, funds with risk levels of 5 can go up more in the right market than a 1 fund. (Keep in mind these rankings were developed for equity funds. Most bond funds are safer than even a 1 ranked equity fund – there is a certain, unavoidable degree of risk in investing in equities.)

We're glad you're here. Consider this first part an investing primer. In it, we'll talk about what investing is, cover some important investing concepts, and discuss some popular investment options. We're not going to tell you about how you should pay off your credit cards before you start investing (you should), or suggest ways to save money like cutting your own hair (you shouldn't). We are going to assume you're reading this because you have some extra cash lying around (either a lot or a little) and would like to figure out how best to invest it.

First, you shouldn't start investing with the intention of getting rich overnight. In the investment game, no adage is more appropriate than "Slow and Steady Wins the Race." Your objective should be a 10-12% return per annum for most of your pre-retirement years. Spectacular? Not like the recent market performance. But even a 10% return per year for twenty-five years increases the value of an investment tenfold, and that ain't bad.

That said, let's get to the good stuff.

What is investing?

To oversimplify a bit (we're pretty simple people), investing is using the money you have to try to make more money. It's the exact opposite of consumption, more commonly referred to as buying stuff. When you plunk down money for a new television, you do so because you want to watch Oprah or Monday Night Football. You have no illusions that you will get any value from the purchase besides the ability to watch TV. You certainly don't expect to resell the television for a higher price sometime down the road, or to be able to rent it to some guy who can't afford to buy a television of his own. That's consumption.

You invest, on the other hand, because you think you can sell your investment for a future profit (like a stock), or because you think your investment will produce some kind of income (like a house you can rent), or a little of both.

Risk vs. Reward

To a certain extent, investing is trying to predict the future. A safe investment is one in which the future outcome is more certain. A riskier investment is one in which the future is less so. When you put money in a bank CD (certificate of deposit), you're literally guaranteed to get your money back, plus a little interest. Because they're so safe, you're not going to make a heck of a lot of money investing in a CD. What comes with a CD's low risk is a low return.

Other investments aren't so safe. If you invest in, say, a llama farm, there are a whole host of things that could cause the farm to fail and you to lose some or all of your investment. Nobody likes the taste of llama-burgers, your herd is stolen by llama rustlers, there's a llama wool glut on the market, whatever. Because of the higher risk associated with this kind of investment, you'd expect a higher rate of return than from a CD. One of the keys to successful investing is putting your money in investments where the risk level is appropriate for the potential return.

Investment Options

We've divided the investment options listed below into two categories. "The Bad Ones" are investment vehicles we think the average person would be wise to stay away from. "The Good Ones," - real estate, stocks, bonds, and mutual funds - are the investments we think offer the greatest chance for success.

The Bad Ones

Precious metals, heating oil, frozen concentrated orange juice concentrate, pork bellies, any other kind of bellies – The rules of the commodities game seem pretty simple: You think the price of something like gold, heating oil or pork bellies is going to go up. Some other guy thinks the price is going to go down. You make a contract with the other guy (through a broker who makes a commission no matter what happens). If you're right, you get his money; if you're wrong, he gets your money. O.K., you may be thinking, odds are 50/50 (less the broker commission, of course). Could be worse, right? Not really. Chances are the other guy does commodities trading for a living, and knows something about the commodities market that you don't. In fact, this guy probably knows a bunch of things about the commodities market you don't. Do yourself a favor. If you're considering investing in commodity futures, think again. You'll be much better off going to Las Vegas. You'll still lose a bunch of money, but at least you'll get to see Wayne Newton.

Beanie babies, baseball cards, superman comics, etc. - Collectibles. We're all for buying 'em… if you want to put them on your mantle piece and show them off to your friends when they come over. But as investments, collectibles aren't so hot. They have no potential for earnings or income. They offer the buyer only one way to make money - the hope that in the future someone will pay more for it then the buyer did. Don't get us wrong, this does happen. But for every $20,000 stamp or $10,000 comic book you hear about, there are piles and piles of tag sale junk that aren't worth much of anything. If you have fun with collectibles, go ahead an buy them. Just don't expect them to make you rich - you'll probably end up disappointed.

Schemes hatched by your hare-brained brother-in-law - Never invest in any scheme in which your hare-brained brother-in-law is involved. You will lose every cent of your money, guaranteed. And while we're at it, include schemes of your hare-brained father-in-law, hare-brained cousins, hare-brained friends, hare-brained cousin's hare-brained friends, and anyone else, hare-brained or not, you know, meet on the street, talk to on the phone, or come in contact with in any way. The point is that you should stick to mainstream investments like stocks, bonds, and mutual funds. It's just too hard for regular people to judge the value of obscure investment opportunities (heck, most of the time it's too hard for professional investors to do it).

The Good Ones:

Real Estate - Purchasing a home should be most people's main investment goal. Over the long haul the value of real estate almost always goes up. It rarely drops 50% in price a few months after you buy it like individual stocks can. There are also many tax advantages to owning your own home. Besides, you can live in a house. No matter how much Microsoft stock you own, you can't raise a family in their offices in Seattle (actually, if you owned a lot of the stock, you could vote yourself in to run the place, and then do whatever you want, including changing the slogan for Windows Vista to "Hold the pickles hold the lettuce, Janet Reno - you can't get us"… but I digress).

Bonds - Bonds are a tradable form of debt, or money that a company or a government owes. Let's say your city decides to build a new dog racing track. The going rate for new dog tracks in your neck of the woods is $1 million dollars, and your city just doesn't have that kind of cash lying around. So they do what a lot of people do when they want to buy something they can't afford: they borrow. And the way they borrow is by selling bonds.

When an investor buys one of these dog track bonds, they are buying a promise made by your city to repay the borrowed money in a certain time period and at a certain rate of interest. Buying these bonds is considered a very low risk investment. Your city isn't going anywhere (unless it is hit with one hell of a tornado), and chances are it's going to have enough money from taxes, parking tickets, and dog race gambling proceeds to pay any money it owes.

Most large corporations also issue debt in the forms of bonds. Corporate bonds are a bit riskier than state, local, or federal government debt because companies may not earn enough to pay the money back. Different corporations have different risk levels. Those whose perceived ability to pay back loans is less than other bond-issuing companies will issue bonds with a higher yield. The riskiest of all are called junk bonds: bonds issued by not so creditworthy companies that pay higher interest rates because of the greater risk of these companies defaulting on their loan payments. The risk/reward tradeoff is very obvious in bonds: The higher the chance that the debtor may not be able to make payments, the higher the bond's yield to maturity.

Here are the good points about bonds:

1. Low risk - United States Government Bonds are extremely low-risk investments. Barring the collapse of the government, you're guaranteed to get paid exactly what the bond promises, when it promises. Bonds from big established companies like General Motors and IBM are just slightly less safe than government bonds (slightly less safe works out to about a 1% higher interest rate). If you invest in U.S. Government or any highly-rated corporate bonds (bonds are rated for safety by bond rating companies), there is very little chance you will lose even a little bit of your money over the life of the bond.
2. Income you can count on - Most types of bonds pay what's called a coupon - the interest on the money you've lent, usually every six months. You can bank on this bond income arriving in your mailbox when it's supposed to for the duration of the bond's term.

But investing in bonds does have some drawbacks:

1. Low risk - "Hey, you listed 'low risk' under both 'good points' and 'bad points'!" Right you are. The safety of bonds is both a good thing and a bad thing. Remember what we said earlier about risk vs. reward? Well, buying bonds is about as low-risk as investing gets - with the less-than-stellar returns to prove it. Currently, (currently being late 2007,) U.S. Government 30-year bonds are yielding an annual rate of about 5%. For every $1,000 worth of bonds you buy, you'll make $50 per year. That's not too bad, and for some of your money bonds are probably a great choice. But there are investments out there, like certain stocks and stock mutual funds, that are just a little bit riskier than bonds but with far better potential returns.
2. Interest rate fluctuations - When interest rates fall, people who lent money (bought bonds) at a higher rate are very happy because this increases the value of their bonds. The opposite happens when rates go up. Wouldn't you rather own a bond paying interest of 6% per year than 5%? So would everyone, making the market price of the 5% bond lower than the 6% bond. This effect is worse the longer the life of the bond, because while losing that 1% deference for a year is not that bad, losing it for 30 years is a very unpleasant thing. This is why owning long term bonds is great when rates fall, but awful when rates rise.

Individual stocks - While bonds are tradable debt, stocks are tradable ownership (a.k.a. equity). Stocks represent shares of ownership in a company that can be bought and sold. When you own a stock, you own a piece of the company which issued it. If that company does well, your stock will probably go up in value. If the company performs poorly, the stock can go down. If the company goes bankrupt, you'll probably lose the whole enchilada - the whole enchilada in this case representing all the money you've invested.

Here are the good points about stocks:

1. You own a piece of the action - Stocks represent ownership, bonds represent money you've lent. Owning a piece of a company that grows fast can be very rewarding. Would you rather have had Microsoft owe you 8% a year in interest over the last 10 years, or owned its stock that's gone up in value 20-fold?
2. Time is on your side (yes it is) - If you have a long-term investment strategy, a diversified portfolio of stocks almost always beats out a portfolio of bonds. The long-term return (over the last 70 or so years) on stocks is around 11%. Bonds have returned about half that. As long-term investments, stocks have historically been pretty tough to beat.

OK, you ask, what are the bad points about stocks? There are a few:

1. Time. Specifically Your Lack of It. Picking good stocks is not that easy. To invest properly you should research and analyze a wide range of factors, including the potential company's price-to-earnings ratio, its management team, its growth and earnings projections, market share, etc. Then do just as much work on its current and potential competition. And this isn't a one-time event. To manage a portfolio of individual stocks correctly, you should be constantly updating your research on the companies whose stocks you hold. It's not that picking good individual stock is impossible; in fact, knowing how to research companies is a great skill to have. But if you are going to invest in individual stocks, you should be prepared to spend a lot of time sitting at your computer, reading financial publications and financial statements, etc., - time we hope you can think of about seven thousand better ways to spend. (If you can't, drop us a line. We'd be glad to suggest just a few.)
2. Difficulty with diversification - Diversification is the investment equivalent of not putting all your eggs in one basket. It's one of the things that makes mutual funds such an appealing investment (more on that later). By spreading your money among many different investments, the chances of them all going south at once is pretty remote. If one goes down, chances are another will go up. It is difficult for an individual investor to build and maintain an adequately diversified stock portfolio. It means having money in a wide range of domestic and foreign stocks, as well as bonds and money markets. This level of diversification allows you to invest at a fairly high-risk level and get a relatively stable return. Assuming you could actually do enough research to pick all these stocks and bonds - and assuming you could actually buy most of these securities domestically - it would be almost impossible for an investor with a moderate amount of money to purchase them in lots that were efficient from a trading perspective. To own a small piece of hundreds of different securities worldwide would require a portfolio of several hundred thousand dollars at the very minimum.
3. Transaction costs - When you buy or sell a stock, you have to go through a broker, the intermediary between you and the security you want to buy. Buying and selling stocks can produce very high transaction costs (read: brokerage commissions and market maker profits) for the relatively small trades the individual investor would have to do to maintain a diversified portfolio.
4. Long, protracted bear markets - For all the hoopla about long-term performance, stocks can be bad investments. Real bear markets (the likes of which we haven't seen since the '70s) can take years to shake out. There have been 10-25 year stretches where people have made nothing in the market. The Japanese market, even counting recent gains, is still down over 50% from the highs it hit over 10 years ago. Bottom line, if you overpay for a stock, it may take a long time for the fundamentals to catch up with the hype you bought. Fortunately for all of us, really bad bear markets are a rare event (knock on wood).

Mutual Funds - Mutual funds are one of America's most popular investment vehicles, and with good reason. They solve many of the problems inherent in other investment vehicles by offering individual investors inexpensive access to expert management and easy diversification. Part II of MAXuniversity focuses solely on mutual funds: what they are, how they work, and why they may just be the best choice for you. Read on!