Mutual Funds

 

Basics

Mutual funds are a way for many investors to pool their money and invest in a variety of stocks.  Mutual funds are operated by an investment company that raises funds from shareholders (thousands, even millions of people) to invest in stocks and bonds or other investments.  Funds are divided up into shares.  The price of each share is called NAV, Net Asset Value, also called Book Value (for calculation see below).

There are thousands of funds (actually more than 8,500) to choose from.  Each fund offers something different.  For example, some funds invest only in one sector; such as technology or retailing; some by market capitalization Market Capitalization; some international, others try to select the best stocks across all markets.  Index Funds Index Funds invest in a broad index.  Your choices are almost endless.

Before you invest in a mutual fund you need to do your research.  Read the fund's prospectus, which outline the investment objectives of the fund.  See if they meet your objectives.  Also look at financial websites, a few are listed below, that compare one mutual funds performance over another.  Always look at a fund's performance over time, not just one year.  When looking for a fund you need to decide what type of investor you are: long term, income oriented, or aggressive.  Also all mutual funds have costs associated with them, some more than others.  Make sure you understand all these costs because they will affect your bottom line.

All mutual funds are regulated by the Security and Exchange Commission (SEC) Stock Market & Security Exchanges.  The Investment Company Institute (ICI) is the national association most fund companies belong to
http://www.ici.org , which has additional information on mutual funds.
 


 

Benefits of Mutual Funds

For most people mutual funds are an excellent way to invest in the stock market.  Not only is there a wide variety of funds but mutual funds also offer many other benefits


  • Portfolio Management:  When you purchase a fund, you are also purchasing the expertise of an experienced portfolio manager.  You don't need to do research and continuously monitor your securities, they do it for you.  This does not mean that you should not periodically monitor your funds performance.  If they are not meeting your realistic expectations you might consider changing funds.  If you are new to investing or don't want to continually monitor your portfolio, mutual funds might be the right investment for you.
  • Diversification:  When you purchase a mutual fund you actually own a small portion of all the stocks, bonds or other investments in the fund.  Based on the type of fund this might be an investment in a single sector or across a broader market area.
  • Small Minimums:  The typical minimum investment is $2,500, although some funds will accept a minimum as low as $250 or $500.  You can also continually add to your investment using a plan called dollar-cost averaging Stocks: Buying, Selling & Researching for an even greater long term accumulation.
  • Ease of Purchasing and Selling Shares: You can purchase or sell mutual funds through a broker, bank, or online based on the net asset value, or NAV, (which is calculated at the end of each trading day), minus management expenses.


 

Open-Ended Fund (CEFS) vs Close-Ended Fund

Mutual Funds can either be open-ended or close-ended funds.  Most are open-ended funds. Here are the primary features of both:

 

Open-Ended Fund:

  • A fund that continually creates new shares on demand (although the manager can close it if they think the fund is getting too big).
  • You can purchase the shares at Net Asset Value (NAV) (see above).  You can redeem them (sell) at any time at the value of the NAV directly from the fund.
  • Usually trades at the end of the market day.
  • It may or may not have a sales commission attached to it.
Close-Ended Fund:
  • A fund that has a fixed number of shares.
  • Usually listed on the stock exchange.  You can actively buy or sell them.
  • Since its shares are traded on the market, they can be traded any time during the market day.
  • Since it is a stock, it always has a commission associated with it.


 

Mutual Fund Costs

When you invest in mutual funds you have to understand all the costs involved.  There are two major classifications: Load Funds and No Load Funds.  However, it is not that simple. You have to dig deeper to understand all the costs.  Here are some of the terms you may encounter.  You might be charged with only one, or a combination of fees. Again, check the prospectus.



  • No Load Funds:  Funds sold directly to the public.  They do not charge a sales commission.  This however, does not mean there are no fees attached to the fund. Just like load funds they too will have management and possibly other fees (see below).
  • Load Funds:  Sold through brokers which charge a commission.
  • Front-End Loads:  Commission is paid when you purchase a share.  These fees vary based on the fund.  The fee can also be on a sliding scale, decreasing for larger investments.  The load is calculated on the gross amount of the investment (commission is taken out first).  This means that if you are investing $1,000, and the load is 3% ($30.00), this would be deducted first, therefore your investment in the fund would actually only be $970.00.
  • Back- End Loads (aka: Redemption Fees or Deferred Sales Fee:  These are charges that can be deducted from your original investment if you redeem the shares (sell them) within a specified time (described in the prospectus).  Generally the fee declines over time and sometimes is cancelled altogether if you hold the fund for a specific period of time.  For example the fee may be 4% if you sell within the first year and go down to 3% if you sell after 2 years.  This is done to discourage people from frequently changing funds.
  • Management Fees:  All mutual funds charge management fees.  It can either be a flat fee or a sliding fee based on the value of the fund's portfolio.  However some management fees actually rise if the manager beats a pre-determined benchmark or falls if they trail a certain benchmark.  Remember, management fees are separate from “sales” fees.
  • Marketing Fees:  Many funds deduct the cost of advertising and marketing from the fund's assets rather than absorbing them in the management fees.  Regardless of where they put the charges, you end up paying for them.  These charges are called 12-b-1 fees.  These fees can vary however, if the 12-b-1 fee is great than 0.25% per year, it may not be called a “no-load” fund.
  • Administration Fees:  Fees for all the paperwork involved in managing a fund, legal fees, accounting fees, sending out statements etc.
One way to find out about the expenses/fees charged by a fund is called the Expense Ratio.  This is shown as a percentage of the fund's assets. It includes all fees, except sales loads (deferred or front-end).  The higher the ratio the less paid out to shareholders. In general try to avoid paying a sales load and look for a fund with a low expense ratio.


 

How To Calculate Net Asset Value (NAV) Or Book Value Of A Mutual Fund

The NAV (this is also called Book Value) is the value of the mutual fund's assets (market value of all the securities held by the fund plus cash and equivalent holdings), minus the funds expenses/liabilities, divided by the total number of outstanding shares.  The NAV is the price, per share, that you can buy or sell the mutual fund.  The NAV is calculated daily at the close of the markets (except Exchange Trade Funds which are calculated like stocks and can be purchased at any time during the trading day Exchange Traded Funds.

For example:  Here is how you would find the ($20.00 NAV) on a per share basis of Imaginary High Five Mutual Fund:


Assets
(underlying securities, things of commercial
or exchange Value
$52million
Cash and Equivalent Holding $10million
Expenses & Liabilities $2 million
VALUE $52 Mil (Assets)
+ $10 Mil (Cash/Equiv Holdings)
Sub Total $62 Mil
  $2 Mil (Expense/Liabilities)
Value $60 Mil
VALUE PER SHARE $60 Mil (Value)
/ 3 Mil (# of Shares)
NAV/Book Value $20 Per Share


 

Types of Mutual Funds

As mentioned above there are numerous types of mutual funds you can invest in.  Here is a brief description of just some of them.  When in the fund the word "bond" is mentioned, check out our sections on Bonds.




 

  • Stock Funds:  Invest in stocks.  They can be in the U.S., foreign stock or a combination.  They can have a conservative approach, investing in old established firms; or aggressive which take on a high risk/reward approach.
  • Bond Funds:  Funds that invest in a mix of government and corporate bonds Bonds.  Some are very conservative only investing in high quality, low risk, and lower profit bonds.  Others in low quality, high risk bonds.
  • Municipal Bond Funds:  These invest in tax-free bonds issued by local and state government.
  • High Quality Corporate Bonds:  Investing only in bonds from top rated corporations with the best chance of paying interest and principal on time.  High-Yield Bond Funds:  Investing in companies with low ratings, high yield, very risky.  These bonds are also referred to as Junk Bonds.
  • Balanced Funds:  Funds investing in both stocks (preferred and common) and bonds.  The prop ortion will be spelled out in the prospectus.  Most own more stocks than bonds.
  • Growth Funds:  Take a slow but steady approach over the long run.  They invest in large stable companies.
  • Aggressive Growth Funds:  These look to optimize capital gains.  They invest in new companies, often with great potential but often unproven, such as an IPO company (Initial Public Offering).  They may also invest in troubled companies that are trying to turn around their fortunes.  Higher risk, but they hope for a greater reward.
  • Income Funds (Equity Income Funds):  A fund designed to produce current income for its shareholders vs. growth of principal.  This is achieved by investing in companies that pay dividends and may also invest in convertible securities Bonds and other types of bonds.
  • Growth & Income Funds:  Combines the benefits of growth funds and income funds.  They seek to invest in well established companies and those that provide dividend income.
  • Index Funds:  Funds that invest in a broad selection of stocks that try to equal not beat the market Index Funds.
  • Flexible Portfolio Funds (Asset Allocation Funds):  Funds left to the discretion of the fund manager.  The amount of stocks, bonds, cash or other investments continues to fluctuate based on where or what the manager thinks can bring the highest return.
  • Global Funds:  Invests in both domestic (U.S.) and international stocks.  In the case of global funds and international funds an additional factor is the movement of currency values (which can either help funds increase in value or decrease in value).
  • Global Bonds Funds:  Funds that purchase bonds issued by U.S. companies and foreign companies.  As with global funds, these funds are also affected by the currency exchange rate.
  • International Funds:  A fund that invests all its assets and whose headquarter is outside of the United States.
  • International Bond Funds:  Funds invested in companies whose headquarters are outside of the U.S.  Sometimes these funds are specialized in an area such as emerging markets like Turkey and Brazil.
  • Single Industry (Sector) Funds:  These funds invest in only a single sector.  They are betting this one sector will outperform the other sectors.
  • Socially Screened Funds:  Funds with a social conscience.  Investing in environmentally friendly companies to ones that will not include a defense contractor.  There are also political screens to avoid investing in companies that have operations in countries that violate human rights.
  • Real Estate Investment Trust Funds (REIT):  These funds invest in real estate companies which own real estate, be it stores, offices, factories or apartments.
  • Money Market Funds:  These funds by law must invest in low-risk securities.  They invest only in short term (one day to one year) debt obligations such as:  Treasury Bills (see U.S. Treasury Offerings), Certificate of Deposit (CD) and commercial paper of financial company (short term promissory note issued by a large financial company, minimum $25,000, ranging from 30-270 days).  The NAV factor remains a constant $1 per share, but the interest rates fluctuate.  They are not FDIC insured, but the risk is low.  Money Market Funds are one of the safest types of mutual funds.  Its goal is to preserve principal modest dividends.
  • U.S. Government Bonds Funds:  Funds invested in both the U.S. Treasury issued securities and those of federal agencies (which are not fully backed by the government, but never-the-less are considered safe).  See U.S. Treasury Offerings.


 

Selecting A Fund

As you can see there are lots of options.   Here are a few things to look at when selecting a mutual fund. Keep in mind most funds in their prospectus, will not tell you which securities they actually own.  To find out, you have to ask for their latest quarterly or annual report.  Remember it may have changed from the time it was printed to the time you receive it.
  • Investment Objective:   Long range, short range, aggressive, conservative, corporate bonds, mutual funds are just some of the descriptions of funds to be found in the prospectus.
  • Investment Style:   Do they invest in large companies or small; domestic or international, or both; single sector or multiple sectors; bonds or stocks.  This information can be found in the prospectus.
  • Performance Record:   You need to know how the fund performance compare to: 1.  The Market as a wholes, and; 2.  its performance against comparable funds.  Look at the total return (price changes plus reinvested earnings) over many years. 
     
  • Fees & Expenses:   Before you buy make sure you are aware of all the fees involved in the mutual funds such as sales and management fees, marketing and administration fees (see above).
  • Services:   How easy is it to go in and out of a fund, or switch from one fund to another within the same company?   Are they helpful when you call?   Are their records easy to read?


 

Online Resources for Information on Mutual Funds