Looking at options - Investment Strategy, part 2

Healthcare Financial Management, Nov, 1991 by William G. Kistner

In last month's "Personal Finance," which dealt with factors to consider in a personal investment strategy, investment options were broken into five categories: cash and equivalents, fixed income options, equities, non-liquid assets, and other assets.

In considering traditional investment options, Exhibit 1 provides a frame of reference for historical return on investment options--certificates of deposit, U.S. Treasury bills (T-bills), long-term bonds, and stocks.

Treasury bills. Often seen as a risk-free investment, T-bills are issued by the U.S. government and mature every 30 days. Purchasing T-bills eliminates interest rate and credit risk. If interest rates increase, a T-bill matures in time to invest funds at a higher rate.

As Exhibit 1 shows, T-bills have out-performed inflation during each time period studied, but the exhibit lists pre-tax rates of return on investment. If taxes are taken into account, a T-bill investor will either slightly beat, match, or underperform inflation, depending on the period.

This rate history suggests that, if one's goal is to beat inflation over the long term, one should not leave a substantial amount of funds invested in T-bills or cash equivalents for long periods of time.

Government bonds. With the exception of 20-year returns, government bonds have outperformed T-bills. Investing in long-term government bonds means accepting a risk not found with T-bills: interest rate risk. To assume that risk, an investor demands a higher rate of return than what is given on risk-free T-bills.

Standard & Poor's 500 index. The Standard & Poor's Corp. (S&P) index of 500 stocks shows that stocks have outperformed the other two categories. When investors buy stock in a company, they accept additional credit risk and demand a higher return. Because purchasing stock involves market and business risks, a premium is paid for assuming those risks.

A route for the average investor. The need for diversity and the amount available for investing may draw the "average" investor toward mutual funds. Professional investment management also may be attractive. Apart from commissions, mutual fund assets are subject to an investment advisory fee (ranging from .5 to 1.5 percent of assets managed).

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Transaction costs for investments that a manager buys for a mutual fund are lower than what an individual investor would pay. Diversification and professional management are principal advantages of mutual funds, particularly when an investor lacks substantial sums to invest.

Many of the newest common stock funds target a specific industry or sector of the economy, such as investing solely in healthcare firms. Investors wanting diversification within the stock market can choose a stock index fund, which attempts to mirror the S&P 500 index. Because of the range of funds available, an investor usually can find a fund offering the type of investment mix wanted for allocating assets.

Watch for fees. Along with offering different investment objectives, funds may differ in fee and commission structures. Some funds, for example, charge no "load" or commission, while others charge a small percentage of the amount invested. By the same token, some funds assess a sales charge when shares are redeemed, while others carry an annual fee or "trailing commission." Because these fees will reduce the return on investment, fee structures should be fully understood before a fund is chosen.

Open-end versus closed-end. Mutual funds also can be divided into two groups based on how they are capitalized and priced. In an "open-end" mutual fund, an investor purchases shares directly from the fund and sells them back. The price is set at the fund's net asset value, which is the value of fund assets divided by the number of outstanding shares. A "closed-end" fund has a fixed capital structure and a limited number of shares, just like a stock itself. Closed-end funds are publicly traded on the open market at above or below the net asset value of the portfolio of stocks.

When selecting mutual funds, investment advisers generally avoid last year's "high flyer." Select funds that have performed well over several years in good markets and in bad.

William G. Kistner, CPA, is a tax partner with Ernst & Young in Chicago, Ill. Reader's comments and questions are encouraged and can be addressed to: William G. Kistner, CPA, Ernst & Young, 150 S. Wacker Dr., Chicago, IL 60606.