Mutual Funds
While many people own individual stocks and bonds, most investors hold those securities through mutual funds. A mutual fund is a pool of money, collected from many investors, that is used to purchase particular assets, such as stocks, bonds, cash or some combination of the three.
There are thousands of mutual funds for investors to choose from, and each has a stated objective as to the type of investments it holds. The holdings are referred to as the mutual fund's portfolio, and its investors own a portion of the portfolio as shareholders. The mutual fund is run by a professional portfolio manager who decides which securities to buy and sell according to the fund's stated strategy.
Investors purchase shares from the fund itself and can sell their shares back to the fund when they want to cash out. Mutual funds report a daily net asset value (NAV) per share, which is the total value of all the fund's securities divided by the number shares owned by investors.
Why invest in a mutual fund?
Mutual funds are a relatively inexpensive way for average investors to buy professional management of their investments. Portfolio managers have investment expertise, as well as a team of research analysts supporting them, that average investors do not.
Mutual funds also provide diversification. If investors were to purchase all the securities owned in a fund portfolio on their own, the cost could be enormous. But by buying shares in a mutual fund, investors only need to put up a small amount of money to own a portion of all those holdings. Also, by owning a handful of mutual funds with different objectives, investors can further diversify their risk at low cost.
However, there are drawbacks to investing in mutual funds. For starters, you give up control of your investments to someone else when you buy a mutual fund. And professional management comes at a price. Also, managers can make mistakes, but you still have to pay them through fees. A fund's performance may lag the overall market.
CAUTION: Mutual funds are not insured by the FDIC. You can lose your investment in a mutual fund.
How do I make money from a mutual fund?
- Income payments: Funds generate income from the dividends and interest earned from the securities in the portfolio. The income is then distributed to shareholders. Investors can choose to receive payment for these distributions or reinvest them by buying more shares of the fund.
- Capital gains: When funds sell securities that have appreciated in value, the fund realizes capital gains, which are then distributed to shareholders at the end of the year. Investors can choose to receive payment for these distributions or reinvest them by buying more shares of the fund.
- Net asset value: When a fund's NAV increases, the value of investors' shares increases.
How do I figure out which funds are right for me?
You should always thoroughly investigate a mutual fund before investing in it. Do as much research as you can. Look for funds with strong track records and low volatility, but do not base your decision solely on past performance.
The first place to look for information is in the fund's prospectus, which can be requested from the fund company. The prospectus states the fund's objective, strategy, risks, fees and expenses, and financial performance.
TIP: If you have a problem with a mutual fund, you can contact the SEC at their online complaint center at www.sec.gov/complaint.shtml.
What are mutual fund "loads"?
A mutual fund load is a sales charge. You pay the broker a commission in the form of a load for recommending the fund to you. Loads typically range from three to five percent of the purchase.
There are three types of loads:
- Front-end loads are paid up front at the time you buy the mutual fund.
- Back-end loads, or contingent deferred sales charges, are paid when you sell the fund. This percentage usually declines over the course of 5 to 10 years. Over time, the load is eventually phased out.
- Level loads, the least common sales charge, are paid over time-typically one percent of your return every year for a set number of years.
No-load funds-and there are many-do not levy a sales charge at all.
Depending on your financial situation, one load structure may make more sense than another.
What are mutual fund "share classes"?
Many mutual funds offer several share classes to choose from. Each share class of the same fund has the same objective and invests in the same securities but charges a different load. Share classes are indicated by the letter-usually A, B, C or I-that comes after a mutual fund's name.
Different fund companies use different conventions when naming their funds' share classes, but in general, the A share class charges a front-end load, the B share class charges a back-end load, and the C share class charges a level load. I share classes usually require high minimum investments and are intended for institutional investors only. If a fund company uses letters other than those, you need to find out which load structure is matched up with which share class.
Besides the load, what other fees are associated with mutual funds?
Mutual funds charge various fees to pay for expenses such as the portfolio manager's services, transaction costs and marketing. Make sure you understand what fees you will be charged and how much they will reduce your overall return.
The annual expense ratio, listed in the fund prospectus as a percentage of assets, reflects most of the fund's costs, except loads. The fees included in the expense ratio are added up and divided by the assets in the fund to arrive at the annual expense ratio. These expenses are paid out of the fund's assets.
Annual expense ratios typically range from less than 1 percent to more than 2 percent. The expense ratio is partly determined by the costliness of the fund's investment objective. For example, index funds tend to be relatively cheap while foreign funds tend to be relatively expensive. Only compare the expense ratios of funds in the same category.
The primary fees included in the expense ratio are management fees and administrative fees. The "12b1" fee also makes up a significant portion of the annual expense ratio. This fee pays for marketing and advertising the fund and can reach nearly 1 percent of assets. Many funds charge no "12b1" fee. Transfer agent fees and custodian bank fees are also included in the expense ratio.
Some mutual funds charge shareholders an account maintenance fee that is not included in the expense ratio.
TIP: Use the SEC's mutual fund cost calculator at www.sec.gov/investor/tools.shtml before buying a mutual fund.
What are "sector funds"?
Sector funds are mutual funds that invest in one particular industry. There are more than 1,000 funds that focus exclusively on sectors such as technology, financials, health care, real estate and utilities. Because sector funds are concentrated on one area of the economy, their returns can be highly volatile.
But sector funds are useful for providing exposure to specific groups. They can fill gaps in your portfolio or play a speculative role for aggressive investors. However, most people get adequate exposure to most sectors from diversified mutual funds. Only a small portion of a portfolio, if any at all, should be allocated to sector funds.
What are "index funds"?
One of the advantages of investing in mutual funds is professional management. But you run the risk of the manager drifting away from the fund's stated strategy, making decisions that are not tax-efficient for shareholders or simply underperforming the market. The expenses of actively managed funds can also eat into returns.
Index funds are a low-cost option for investing in a diversified array of securities-without the help of a portfolio manager. And with index funds, you always know exactly what you are getting. Index funds cannot really underperform the market because they represent the market.
Index funds are not actively managed by an investment professional. Rather, they are portfolios of the same securities that make up a particular index, such as the S&P 500. The performance of an index fund matches that of the index it follows. Index funds charge lower expenses because they do not have to pay management fees, trigger fewer taxes because they rarely buy or sell securities and as a result, provide higher returns than many actively managed funds.
Indexes represent different slices of the market. Some of the best-known indexes include:
- Dow Jones Industrial Average is made up of 30 blue chip stocks with each stock having the same weighting.
- S&P 500, the most widely used benchmark for the market, is weighted according to the market cap of the stocks it includes.
- Nasdaq Composite includes more than 5,000 companies listed on the Nasdaq stock exchange.
- Russell 2000 tracks U.S. small cap stocks.
- Wilshire 5000 comprises almost all publicly traded U.S. stocks.
Index funds have dramatically increased in popularity in the last decade, and there are now so many index funds representing so many segments of the market that an investor could construct a well-diversified portfolio with nothing but index funds.
What are "exchange-traded funds"?
Exchange-traded funds, or ETFs, are index mutual funds that trade like stocks on an exchange. ETFs offer the liquidity of a stock and the diversification of a mutual fund. Unlike mutual funds that are priced only once at the end of every trading day, ETFs experience price movements throughout the day, just like a stock, which some investors like to take advantage of.
As with index funds, you know exactly what you are investing in when you buy an ETF because they are pegged to a specific index and ETFs offer the same tax-efficiency. But in many cases, ETFs are even cheaper than their corresponding index funds.
However, unlike mutual funds, investors cannot buy ETFs directly from fund companies. ETFs must be purchased through brokers, and investors must pay commissions on them as if they were stocks. For that reason, ETFs are unsuitable for investors who want to dollar-cost average. ETFs are best for investors who want to make a large, one-time lump sum investment.
Most ETFs are listed on the American Stock Exchange. Some of the best-known ETFs include:
- SPDRs, called Spiders, track the S&P 500.
- Diamonds follow the 30 stocks in the Dow Jones Industrial Average.
- QQQs comprise the Nasdaq 100.
What are "variable annuities"?
A variable annuity is an investment product that comes with insurance benefits. You pay regular premiums, a portion of which are invested in various securities, often mutual funds, and a portion of which go toward a life insurance policy. At retirement, you receive income from the annuity. At death, your beneficiaries receive a death benefit. Both the retirement income and the death benefit are usually determined by the value of the investments in the account.
The investments in an annuity grow tax-deferred-that is, you only pay taxes once you withdraw the money. Investors who already contribute the maximum amount to their employer-sponsored retirement programs as well as other tax-advantaged investment plans but want to save additional amounts on a tax-deferred basis often buy variable annuities.
When evaluating a variable annuity, carefully consider the overall cost. The charges you can expect to pay with an annuity include:
- Mortality and expense charge (M&E): This covers the basic insurance benefit.
- Administrative fee: This fixed dollar amount is usually waived if your account value reaches a certain threshold.
- Underlying fund expenses: The annual expense ratio of the mutual funds in the account.
- Charges for various features and benefits: Insurance companies will charge you different fees for different riders to the contract, which can vary significantly.
- Surrender charges: The surrender charge period is stated in the prospectus. The surrender period can range from 3 to 10 years, during which the charge usually declines. Some annuities have no surrender periods.
Make sure the investment options meet your needs in terms of risk and diversification. Look for an insurance company that has a high rating for financial strength.