Money Management Q&As

August 3, 2007

Scholarship and taxes; bank-loan funds

Does a scholarship trigger income tax?

My son will start college in the fall and has been awarded a $3,500 merit scholarship. Will that money be taxable?

Not as long as he enrolls in a degree program and uses the cash for tuition; course fees; or required books, equipment, or supplies. But if he just takes classes randomly or the scholarship specifies that he must use the money for room and board, he'll owe tax on it.

I've heard that adding bank-loan funds to my portfolio could help diversify it, since they're not apt to move in step with either the stock or bond market. But what are these funds, and how risky are they?

Bank-loan funds, also known as floating-rate bond funds, mostly hold below-investment-grade commercial loans. Since banks adjust the interest rates on these loans periodically, the yields paid by mutual funds that invest in them also rise and fall in step. Bank-loan funds tend to yield more than investment-grade corporate bond funds but less than junk bond funds.

When interest rates rise, the increased income means bank-loan investments are less vulnerable to price drops, which can make bank-loan funds more stable than corporate bond funds. Moreover, bank loans are typically senior to a corporation's other debts and backed, at least in part, by collateral, reducing credit risk somewhat. But as the economy deteriorates and troubled companies begin defaulting on loans, the risk that bank-loan funds will lose value increases. So if you decide to add them to your portfolio, favor funds that hold a broad selection of loans to minimize the impact of defaults.

Judging a manager's role in performance

I find it hard to tell how much credit or blame for a mutual fund's performance belongs to the manager. Do any of Morningstar's statistical measures evaluate this?

You can check a fund's alpha measure at to get a sense of the manager's contribution. Alpha expresses the difference between the returns a fund actually posts and those projected for it based on the fund's beta (a measure of market risk). If the alpha figure is positive, the fund has delivered a higher-than-expected return given its market risk; if the alpha is negative, the fund underperformed based on that risk. An alpha of 5.0, for example, suggests that a fund's return is 5 percent higher than expected (e.g., 21 percent vs 20 percent). That additional performance can be attributed to the manager's skill in picking securities and timing sales or purchases. But look at the fund's R-squared as well before you put too much stock in the alpha's accuracy. R-squared measures how closely a fund's performance mirrors its benchmark index. The higher the R-squared, the more the alpha is apt to reflect the fund manager's contribution.

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