Mutual funds are among the most popular investments on the market. There are over 8,000 of them holding over $4 trillion dollars. Many people buy them because of their competitive returns. Others like them because they are easy to buy and sell. Still others cite the fact that mutual funds, because they hold several investments, can spread risk.
This tutorial is written for the investor who wants basic knowledge of mutual funds. We will discuss the following topics:
WHAT IS A MUTUAL FUND AND HOW DOES IT WORK
A mutual fund raises money from investors to invest in stocks, bonds and other securities. It is a package made up of several individual investments. When those investments gain or lose value, you gain or lose as well. When they pay dividends, you get a share of them. Mutual funds also offer professional management and diversification. They do much of your investing work for you.
Mutual funds may be open-end or closed-end funds. The term "mutual funds" is used most often to mean open-end funds. Open-end funds issue new shares continuously as investors buy them. Investors redeem their shares directly to the fund, which in turn must buy them back. Closed-end funds issue a fixed number of shares that the fund may redeem only upon termination of the fund's trust. Shareholders in a close-end fund may, however, sell their shares through a broker on the secondary market to other investors but not back to the fund. This tutorial will focus on open-ended funds.
BUYING
AND REDEEMING MUTUAL FUNDS
You can buy mutual fund shares directly from the mutual fund company
or from a stock broker. Either way buying and redeeming is relatively
easy.
To buy shares directly from a mutual fund, you send money to the
fund. Redeeming shares works the same way. In all cases, the customer
(you) executes all transactions with the mutual fund company. Many
funds also allow you to redeem shares over the telephone. You can
also set up an automatic investment plan to do your work for you.
Under this plan, you can have a fixed amount of money withdrawn
monthly from your bank account and sent to the fund. Using this
option requires that you first authorize it on your application
form. Most mutual fund companies do allow this option. Many funds
require initial investments over $1,000. However, many of them waive
this requirement if you agree to an automatic investment plan that
withdraws from your bank account until you have reached the required
minimum.
MUTUAL
FUND EXPENSES
Mutual funds charge fees for the costs of running the fund. A
fund's prospectus will list all the fees charged by the fund.
Sales charges are the fees one may pay when purchasing or redeeming
shares of a mutual fund. By law, sales charges may not exceed 8.5
percent of the amount invested. Funds with sales charges are called
load funds. These may be front load or back-end load. Funds
with no sales charge are called no-load funds.
Redemption fees are charges that may also be imposed when
investors sell shares back to a fund.
Mutual funds may charge 12b-1 fees to cover expenses such as advertising,
brokers' costs and toll-free telephone lines.
They also may charge management fees, and exchange fees (if you
transfer money from one fund to another within the same fund family).
INCOME AND DISTRIBUTIONS
Mutual funds pay their holders dividends from the earnings of the stocks, bonds, etc. in the fund.
Dividends from a mutual fund are your percentage of earnings from the company who distributed the stock to shareholders. You can receive dividends as cash, or you can reinvest them into the fund. Many funds will automatically reinvest your dividends if you have given them authorization. Any dividends will be taxed as though they were ordinary income, unless they come from a return of capital, a tax-free municipal bond fund, or are part of a retirement account.
Another source of potential income in mutual funds is capital gains. When a security in a fund is sold, any gain (or loss) on it must be distributed to shareholders. You can receive your capital gains as cash, or you can have them reinvested. The taxation rules that apply to dividends also apply to capital gains.
Investors may also benefit from share price increases. This is the rise in value of a share of your fund. If the price of one share increases by one dollar, you have made a gain of one-dollar times the number of shares you own. This type of gain is called paper profit because you do not receive it until you sell shares.
All of these sources of gain make up the total return of a mutual fund.
Now we will look at some different types of funds.
STOCK AND GROWTH FUNDS
Stock funds invest primarily in common stocks of corporations to provide growth in value. They bring the stock market to the investor who does not have the time or ability to pick stocks or construct a portfolio. These funds are usually growth-oriented, since stocks provide growth.
Growth funds are a type of stock fund structured to grow over time. These funds invest primarily in stocks of corporations that show potential for growth. Growth funds may choose businesses or smaller companies that have the potential to grow quickly. Growth funds often forego paying dividends to their customers because growth companies reinvest their earnings instead of paying them to investors.
Read the tutorial on Types of Mutual Funds to learn more.
BOND FUNDS
Bond funds invest primarily in bonds to provide income with safety of principal. They bring the world of bond investing to the small investor. Most bond funds are conservative focusing on payment of dividends. Investors can choose among several types of bond funds. Below are some of the most popular.
Municipal bond funds invest in debts issued by state and local governments. Their dividends are free from federal taxes.
Government bond funds invest in debts of the U.S. Government and its agencies. These funds include mortgage-backed securities as well as bills, notes and bonds of the U.S. Treasury.
Corporate bond funds invest in debts issued by companies in the private sector.
MONEY MARKET FUNDS
Money market mutual funds invest in the short-term debt obligations of corporations, federal, and state governments and their subsidiaries. They bring these investments to the small investor for an initial investment as low as $500 (depending on the fund). Money market funds invest in Treasury bills, commercial paper, banker's acceptances, negotiable certificates of deposit, repurchase agreements and short-term debts of U.S. Government agencies. A fund's prospectus will list each investment and how much of it the fund has bought.
The returns on money market funds depend on the yields of their individual holdings. Money market instrument yields can fluctuate greatly. This causes the yields of money funds to fluctuate as well. Investors who hold money market funds can track the funds' yield changes in the financial pages of most major newspapers.
"HYBRID" FUNDS
There are mutual funds that do not specialize in a particular security. These funds are structured to meet an objective such as rapid growth, matching a market index, or investing in one area of the economy. They use combinations of securities to meet their goals. We will look at several of these "hybrid funds."
Income funds are structured to provide regular income dividends to their investors. These funds invest in "income securities" of corporations or governments (including preferred stock, bonds, and money market instruments). Such securities yield relatively stable current income. They focus on paying dividends as their top priority while de-emphasizing the growth in value of their portfolios. Preservation of capital is a concern. Income funds are popular with investors who want stable income from their mutual funds.
Index Funds are for the investor wishing to keep his or
her mutual fund's performance in line with "the market". These funds
are made up of the securities that comprise major market indexes.
The advantage of index funds is that they are always in line with
their market index. Their downside is that they cannot outperform
the market. Some funds divide their holdings evenly among the various
stocks. Some use dollar weighting so that bigger companies comprise
a larger share.
Balanced funds seek to balance growth and income in one portfolio. To do this, they invest in common stock, preferred stock, bonds and cash equivalents. Hypothetically, these funds have a "balanced" ratio of these asset types. Managers of balanced funds can, however, shift this ratio one way or the other to take advantages of high interest rates or stock market growth. Balanced funds generally have low volatility and are popular with investors seeking current income with growth potential.
Growth and income funds are similar to balanced funds. However, they rely more on growth stocks that pay dividends.
Sector funds (specialized funds) limit their holdings to one industry. They may choose industries such as health care, biotechnology or pharmaceuticals. To be classified as a sector fund, a fund must put at least 25 percent of its money into one industry. One advantage of sector funds is that certain industries will outperform the market as a whole. On the other hand, a downturn in an industry may affect all the companies in the portfolio.
"Socially responsible" mutual funds seek to combine social and ethical beliefs with investing. Many of them avoid investing in companies whose products and/or business practices they consider harmful. They may avoid investing in tobacco companies, the alcohol industry, weapons industries, companies that violate environmental protection laws, and companies with poor records of employee treatment.
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