Volume 62: To submit a question to MFI's panel of experts, please write to us.

This week's panel:

Ron Rutherford Ronald K. Rutherford, MS, MBA, CFP, CIMA, is Chairman & CEO of Rutherford Asset Planning, Inc. and is a New York City-based fee-only financial advisor. He is registered as an Investment Adviser with the SEC and a member of NAPFA, ICFP, and IMCA. Ron is the author of The Complete Guide to Managing a Portfolio of Mutual Funds and has consistently appeared on Worth magazine's Top U. S. Financial Advisor list. Ron is widely quoted in the financial press and has appeared on national television to discuss a variety of financial topics. For more information, visit Ron's website or call (212) 829-5580

Frank Armstrong Frank Armstrong is author of Investment Strategies for the 21st Century, published here, and president of Managed Account Services, Inc., a fee-only advisor specializing in global asset allocation strategies utilizing no-load mutual funds. Frank is a Certified Financial Planner (CFP) with 24 years' experience helping investors build wealth. The firm, an SEC Registered Investment Advisor currently manages in excess of $60 million for over 140 clients worldwide. Visit Frank's Managed Account Services, Inc. for more information about the Alternative to Business as Usual on Wall Street or call 1-800-508-8500.

Questions and Responses

• Why don't I always get a share-for-share exchange when converting to a Roth IRA?
• Am I better off sticking with an index fund?
• How do S&P 500 index funds differ?
• What's the difference between price/earnings ratios and price/book ratios?
• Why's my Giftrust fund underperforming?

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Why don't I always get a share-for-share exchange when converting to Roth IRA?

from Greg

Q: Why is it with some fund companies I get a share-for-share exchange when converting my regular IRAs to Roths (Janus, Safeco), whereas others only give me the current dollar value (Vanguard), ending up with less shares? Is there a "correct" way this should be carried out, or is it based on the individual company?

A (Ron): Greg, it should be the same number of shares. I checked with Vanguard. They told me that you should have gotten the same number of shares after the conversion. There might be some confusion if you got a paid out distribution just before the conversion. Call their customer service and have them take you through the details of the conversion.

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Am I better off sticking with an index fund?

from Bruce

Q: I invest monthly in two mutual funds aside from my 401K plan at work. However, I continually am somewhat disappointed by the returns, but soon remember that I am in for the long term and must be patient. It seems that everybody is trying to compete with the S & P 500 and usually falling somewhat behind. My question is, "Am I better off by just putting my money into an index fund and letting it ride, or are there actually funds out there that continually beat the S & P, and how do I find them?" The ones that I thought would prevail are not.

A (Frank): The S&P 500 Index is a group of 500 Representative Very Large Domestic Stocks. It's a useful measure of how large domestic stocks are doing, and often used by investors as a proxy of that asset class. Your question actually raises two very different issues:

1. Recently, The S&P 500 has performed better than almost any other asset class in the world. So, we might expect that funds that invest in small companies, for instance, would have a very hard time beating the S&P 500 index. But, that trend won't go on forever, and it's easy to imagine long periods of time when small companies will perform better than large companies. Then small company funds should have little trouble beating the S&P 500. So, to compare the recent performance of a fund not investing in Very Large Domestic Stocks with the S&P 500 is not an apples to apples comparison, and not useful. In a real sense, the issue is not to index or not, but asset class selection over the short run.

2. When we do make a fair comparison of funds within a well defined asset class, then we see that there is only a very small chance (about one in five) that an "actively managed" fund can beat its index. The average cost of trying to "enhance" the performance of an asset class by active management is a reduction in performance of about 2%. While a few managers will succeed in beating the index during any period, there is no evidence that anything other than random drift or dumb luck are responsible. As a predictive tool, past performance is a dismal failure. Managers with good past track records fail generate excess returns any more reliably than managers with terrible records. From where I sit, giving up two percent of my returns in an asset class for a one in five chance of beating the index is a suckers bet. Said another way, management selection presents an additional investment risk with an unacceptable negative payoff. Active managers love to confuse the issue of asset class performance with whether or not managers can reliably beat an appropriate index. That way they can whine that their style or asset class is out of favor without facing the uncomfortable reality that they don't add any value to the process, and that they usually trail the appropriate index. Even better for the active managers, when their asset class comes in favor (and they all do from time to time) then the managers can claim brilliance. They won't tell you that by comparing their "superior" performance to the S&P 500 they used the wrong benchmark.

Over very long periods of time, beating the S&P 500 is a do-able goal. However, you must be prepared to accept additional risk by investing in smaller companies, or distressed companies (value style) around the globe. Your best hope of actually capturing this additional performance lies in purchasing a diversified portfolio of index funds in these asset classes. This approach will require that you endure occasional long periods of under-performance relative to a large domestic only investment policy. You certainly wouldn't have enjoyed it for the last three years as the S&P 500 dominated every other asset class! Nothing consistently wins in the investment game. There is no magic bullet, and there are no shortcuts to security or profit. So, it will take discipline and patience. I hope that helps to resolve the issues for you.

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How do S&P 500 Index funds differ?

from Bret

Q: I see that there are many S&P 500 Index Mutual Funds. Can you tell me
how they differ?

A (Ron): Bret, there are 227 index funds out there as of November 1998. Of these, 104 attempt to track the S&P 500 Index. The following criteria are worth considering in fine-tuning your selection from here. The criteria are expense ratio, turnover, capital gains exposure, front or deferred load, and purchase constraints. Look at the table below. It includes the high, low, average, values; and a comparison with the Vanguard Index 500.

Criteria	High	Low	Average	VFINX
Expense Ratio	1.75%	0.03%	0.53%	0.19%
Turnover	73%	1%	9%	5%
Capital Gains Exposure	69%	7%	33%	44%
Load, Front	5.75%	0	1.34%	0
Load, deferred	5.00%	0	1.02%	0

Expense ratio is important since it is a direct reduction from shareholder return. A high turnover suggests that the fund is not a true index fund. Of the 104 funds, 38 are available only through investment advisors. The funds with loads are available primarily through brokers.

The capital gains exposure can be significant in a bear market. An index fund manager might liquidate shares at unfavorable prices to service shareholder redemptions. If you view this as an issue, consider Spiders. They are a creation of the American Stock Exchange and trade on that exchange like a stock (symbol SPY.) They track the S&P 500 Index. The format is an open-end unit investment trust. There are no embedded capital gains to worry about since there is no portfolio turnover. Check the AMEX web site at www.amex.com. You can download a prospectus from there. With online trading at less than $10 per trade, this is a worthy competitor to open-end index mutual funds.

Source: All data is from Morningstar Principia.

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What's the difference between price/earnings ratios and price/book ratios?

from Stacy

Q: Please explain the difference between price/earnings ratios and price/book ratios ... and what a "good" or "target" ratio is for the small investor.

A (Frank): Let's say you had a firm with a trading PRICE of $100.00 a share. The firm has EARNINGS of $5.00 , and the BOOK VALUE is $50.00.  Then PRICE/EARNINGS (P/E) = 100/5, or 20 to 1, or as usually quoted 20. PRICE/BOOK (P/B) is $100/$50 or 2 to 1

Many economists use BOOK/MARKET (BTM) instead of PRICE/BOOK which is just the P/B turned upside down. They like to use it because it avoids a division by zero problem that makes computers  crazy. BOOK/MARKET is $50/$100 or .5.

A high P/E, High P/B, or Low BTM relative to other stocks is an indication that the firm is experiencing rapid growth, and that investors expect that growth to continue. Low P/E's, P/B's or High BTM are associated with firms that have stagnated or are in actual decline. These distressed firms are often referred to as value investments.

In the old days we used to think that P/E's should range between 8 and 18. Things were getting a little pricey when we got to the 18 range. Today the stock market is trading far beyond that range. The S&P 500 is at 31 and the Dow is about 24. However, many firms are trading far ahead of the averages. AOL was recently trading at 550, while MCI was at 1750!!!

Then there are firms with no earnings at all like Amazon.com and Yahoo. So, their P/E's are infinite. Amazon.com now has a higher total stock capitalization than Sears!! Investors have convinced themselves that future profits will justify the current high prices of the stocks.

In these uncharted waters, you may decide that the market is a bubble in search of a pin, or you may decide that this is a new millennium where the old rules don't count. I tend to side with the bubble guys.

Long past history would show that investors consistently pay far too much for projected earnings, and that earnings are very difficult to project in any event. An earnings disappointment can be especially cruel with a high multiple stock. Paying too much for stocks leads to average lower expected returns.

Investors also seem to consistently value current assets below future earnings, so the price of distressed stocks gets pushed down. If you are willing to buy these dogs, you should expect higher future price appreciation on average than the growth investors.

Hope that sheds a little light on the subject.

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Why's my Giftrust fund underperforming?

from Wayne

Q: I like the irrevocable trust feature that Giftrust offers and have established a few funds for my grandchildren for twenty years out (college). When I began some of the funds, The average annual yield was 21%. It has slipped, they have changed management but it continues to be a non-performer. Is this recent low performance a function of the market or are the old-timers who made the fund work leaving? Should I continue to use this fund as our new grandchildren come along or is there another that I should be looking at?

A (Ron): Wayne, You are correct in saying that the returns of American Century- 20^th Century Giftrust have been a little sleepy lately. In fairness, part of that is due to the small cap growth style of the management team. However, I would have to lay the blame for the bulk of the underperformance on the management. That may also explain why there has been turnover of the management over the last few years. Let us hope that they can recover. Another fund now offers competition using this gift trust format. It is the Royce GiftShares Inv (symbol RGFAX.) Chuck Royce is the manger. The management style is small cap value. The minimum initial purchase amount is $5,000.

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Important Disclaimer

Investing in equities involves a serious principal risk, and no assurance can be given that the techniques described here will be successful. Returns vary and you may have a gain or loss when you sell your shares. Past performance is no guarantee of future results. Index returns shown are historical and include the change in share price, reinvestment of dividends, and capital gains. Indexes are unmanaged and do not reflect the impact of transaction costs. Transaction costs would have reduced the total returns.

International investments, especially those in emerging markets, entail greater risks (as well as greater potential rewards) than U.S. investing. These risks include political and economic uncertainties of foreign countries, as well as the risk of currency fluctuations. These risks are magnified in countries with emerging markets, since these countries may have relatively unstable governments and less-established markets and economies.

Lastly, the questions and responses set forth here are for general informational purposes only and are not intended to substitute for performing your own independent research or contacting your financial or legal professional before making any investment decisions. We make no guarantees as to the performance of any investment strategy you choose and are not responsible for any losses you might incur.

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