Introduction   Advantages   Disadvantages   Classification

Fund Fees   Selecting Funds

Mutual funds have been around for a long time, dating back to the early 19th century. The first modern American mutual fund opened in 1924, yet it was only in the 1990’s that mutual funds became mainstream investments, as the number of households owning them nearly tripled during that decade. With recent surveys showing that over 88% of all investors participate in mutual funds, you're probably already familiar with these investments, or perhaps even own some. In any case, it's important that you know exactly how these investments work and how you can use them to your advantage.

Introduction to Mutual Funds

A mutual fund is a special type of company that pools together money from many investors and invests it on behalf of the group, in accordance with a stated set of objectives. Mutual funds raise the money by selling shares of the fund to the public, much like any other company can sell stock in itself to the public. Funds then take the money they receive from the sale of their shares (along with any money made from previous investments) and use it to purchase various investment vehicles, such as stocks, bonds and money market instruments. In return for the money they give to the fund when purchasing shares, shareholders receive an equity position in the fund and, in effect, in each of its underlying securities. For most mutual funds, shareholders are free to sell their shares at any time, although the price of a share in a mutual fund will fluctuate daily, depending upon the performance of the securities held by the fund.

Advantages of Mutual Funds

• Diversification. Buying a mutual fund provides instant holdings of several different companies.
• Choice. Mutual funds come in a wide variety of types. Some mutual funds invest exclusively in a particular sector (e.g. energy funds), while others might target growth opportunities in general. There are thousands of funds, and each has its own objectives and focus. The key is for you to find the mutual funds that most closely match your own particular investment objectives.
• Liquidity is the ease with which you can convert your assets--with relatively low depreciation in value--into cash. In the case of mutual funds, it’s as easy to sell a share of a mutual fund as it is to sell a share of stock (although some funds charge a fee for redemptions and others you can only redeem at the end of the trading day, after the current value of the fund's holdings has been calculated).
• Low Investment Minimums. Most mutual funds will allow you to buy into the fund with as little $1,000 or $2,000, and some funds even allow a "no minimum" initial investment, if you agree to make regular monthly contributions of $50 or $100. Whatever the case may be, you do not need to be exceptionally wealthy in order to invest in a mutual fund.
• Convenience. When you own a mutual fund, you don't need to worry about tracking the dozens of different securities in which the fund invests; rather, all you need to do is to keep track of the fund's performance. It's also quite easy to make monthly contributions to mutual funds and to buy and sell shares in them.
• Low Transaction Costs. Mutual funds are able to keep transaction costs -- that is, the costs associated with buying and selling securities -- at a minimum because they benefit from reduced brokerage commissions for buying and selling large quantities of investments at a single time. Of course, this benefit is reduced somewhat by the fact that they are buying and selling a large number of different stocks. Annual fees of 1.0% to 1.5% of the investment amount are typical.
• Regulation. Mutual funds are regulated by the government under the Investment Company Act of 1940. This act requires that mutual funds register their securities with the Securities and Exchange Commission. The act also regulates the way that mutual funds approach new investors and the way that they conduct their internal operations. This provides some level of safety to you, although you should be aware that the investments are not guaranteed by anyone and that they can (and often do) decline in value.
• Additional Services. Some mutual funds offer additional services to their shareholders, such as tax reports, reinvestment programs, and automatic withdrawal and contribution plans.
• Professional Management. Mutual funds are managed by a team of professionals, which usually includes one mutual fund manager and several analysts. Presumably, professionals have more experience, knowledge, and information than the average investor when it comes to deciding which securities to buy and sell. They also have the ability to focus on just a single area of expertise. (However, it should be noted that this apparent benefit has not always translated into superior performance, and in fact the majority of all mutual funds don't manage to keep up with the overall performance of the market.)

Disadvantages of Mutual Funds

• No Insurance. Mutual funds, although regulated by the government, are not insured against losses. The Federal Deposit Insurance Corporation (FDIC) only insures against certain losses at banks, credit unions, and savings and loans, not mutual funds. That means that despite the risk-reducing diversification benefits provided by mutual funds, losses can occur, and it is possible (although extremely unlikely) that you could even lose your entire investment.
• Dilution. Although diversification reduces the amount of risk involved in investing in mutual funds, it can also be a disadvantage due to dilution. For example, if a single security held by a mutual fund doubles in value, the mutual fund itself would not double in value because that security is only one small part of the fund's holdings. By holding a large number of different investments, mutual funds tend to do neither exceptionally well nor exceptionally poorly.
• Fees and Expenses. Most mutual funds charge management and operating fees that pay for the fund's management expenses (usually around 1.0% to 1.5% per year). In addition, some mutual funds charge high sales commissions, 12b-1 fees, and redemption fees. And some funds buy and trade shares so often that the transaction costs add up significantly. Some of these expenses are charged on an ongoing basis, unlike stock investments, for which a commission is paid only when you buy and sell.
• Poor Performance. Returns on a mutual fund are by no means guaranteed. In fact, on average, around 75% of all mutual funds fail to beat the major market indexes, like the S&P 500, and a growing number of critics now question whether or not professional money managers have better stock-picking capabilities than the average investor.
• Loss of Control. The managers of mutual funds make all of the decisions about which securities to buy and sell and when to do so. This can make it difficult for you when trying to manage your portfolio. For example, the tax consequences of a decision by the manager to buy or sell an asset at a certain time might not be optimal for you. You also should remember that you are trusting someone else with your money when you invest in a mutual fund.
• Trading Limitations. Although mutual funds are highly liquid in general, most mutual funds (called open-ended funds) cannot be bought or sold in the middle of the trading day. You can only buy and sell them at the end of the day, after they've calculated the current value of their holdings.
• Size. Some mutual funds are too big to find enough good investments. This is especially true of funds that focus on small companies, given that there are strict rules about how much of a single company a fund may own. If a mutual fund has $5 billion to invest and is only able to invest an average of $50 million in each, then it needs to find at least 100 such companies to invest in; as a result, the fund might be forced to lower its standards when selecting companies to invest in.
• Inefficiency of Cash Reserves. Mutual funds usually maintain large cash reserves as protection against a large number of simultaneous withdrawals. Although this provides investors with liquidity, it means that some of the fund's money is invested in cash instead of assets, which tends to lower the investor’s potential return.
• Different Types. The advantages and disadvantages listed above apply to mutual funds in general. However, there are over 10,000 mutual funds in operation, and these funds vary greatly according to investment objective, size, strategy, and style. Mutual funds are available for virtually every investment strategy (e.g. value, growth), every sector (e.g. biotech, Internet), and every country or region of the world. So even the process of selecting a fund can be tedious.

Fund Classification

Mutual funds now come in every possible size, shape, and color, and if you're in your company's 401(k) or 403(b) plan, you've probably noticed that already. Here are some of the general categories of mutual funds.

Bond Funds
Bond mutual funds are pooled amounts of money invested in bonds. A purchaser of a bond is lending money to the issuer, and will usually collect some regular interest payments until the money is returned. Usually the amount of interest paid (the coupon) is fixed at a setage of the amount invested, thus, bonds are called "fixed-income" investments.

Balanced Funds
Balanced funds mix some stocks and some bonds. A typical balanced fund might contain about 50-65% stocks and hold the rest of shareholder's money in bonds. It is important to know the distribution of stocks to bonds in a specific balanced fund to understand the risks and rewards inherent in that fund.

General Equity (Stock) Funds: Styles and Sizes
Stock or equity mutual funds are pooled amounts of money that are invested in stocks. Stocks represent part ownership, or equity, in corporations, and the goal of stock ownership is to see the value of the companies increase over time. Stocks are often categorized by their market capitalization (or caps), and can be classified in three basic sizes: small, medium, and large. Many mutual funds invest primarily in companies of one of these sizes and are thus classified as large-cap, mid-cap or small-cap funds.

International/Global Funds
International funds invest in companies located in other countries. Global funds invest in both U.S. and international-based companies. In general, international and global funds are more volatile than domestic funds.

Sector Funds
Sector funds invest in one particular sector of the economy: technology; financial, computers, the Internet. Sector funds can be extremely volatile, since the broad market will find certain sectors very attractive and very unattractive - often in rapid succession.

Index Funds
Stock index funds seek to match the returns of a specified stock benchmark or index. An index fund simply seeks to match "the market" by buying representative amounts of each stock in the index. Index funds do not attempt to beat the equities market, they simply seek to come as close as possible to equaling it.

Fund Fees

A mutual fund's expense ratio is the most important fee to understand.
The expense ratio is made up of the following:

• The investment advisory fee or management fee is the money used to pay the manager(s) of the mutual fund. On average, this fee is about 0.5% to 1.0% annually of the fund's assets.
• Administrative costs are the costs of recordkeeping, mailings, maintaining a customer service line, etc. They vary in size from fund to fund, between 0.2% and 0.4% of fund assets.
• The 12b-1 distribution fee ranges from 0.25% of a fund's assets all the way up to 1.0% of the fund's assets. This fee is spent on marketing, advertising and distribution services.

You don't really need to concern yourself with how these components of the expense ratio are divided. You just need to know the bottom line.
For actively managed funds, the average number is between 1% - 1.5%.
For index funds, the expense ratio is typically around 0.20% - 0.25%.

Loads
"Load" refers to the sales charge many funds use to compensate the broker for his or her "services" in selling the fund to an investor, and this is in addition to the annual expenses discussed above. "No-load" funds simply are those funds that are sold directly to the investor, rather than through a middleman.

• Front-End Load. A front-end load (or sales load) is a fee that a broker charges when you purchase shares in the fund. Front-end loads may be as low as 1% of the amount you're investing, or as high as 8%.
• Deferred Load. Deferred load or contingent deferred sale load (CDSL) funds (sometimes called back-end loads), often labeled "B" class shares, defer the sales fee until you leave the fund.
• Level Loads. Level load funds, or "C" shares, charge small front loads, and level loads every year thereafter.

Turnover Rate and Taxes. A fund's turnover rate basically represents the percentage of a fund's holdings that it changes every year. A managed mutual fund has an average turnover rate of approximately 85%, meaning that funds are selling most of their holdings every year. Because buying and selling stocks costs money through commissions and spreads, a high turnover indicates higher costs (and lower shareholder returns) for the fund. Also, funds that have large turnover ratios will end up distributing yearly capital gains to their shareholders. Shareholders will have to pay taxes on these gains. Keep an eye on the turnover rate of any fund you own, and look to own funds with low (preferably no higher than 25%) turnover rates. (Index fund turnover is around 5% or lower.)

Selecting Funds

Before buying a fund, please make sure that you understand all the costs and fees associated with buying, and with owning, that fund.

Review the Prospectus
A mutual fund prospectus will provide most, if not all of the information that you need to determine, "What's up with this fund?"

• Fees can be found in the Fees Table.
• Objectives and Policies tell you more or less how the fund plans to invest your money.
• Risk tells you the risk involved in owning the fund.

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