A mutual fund enables investors to pool
their money and place it under professional investment management. The portfolio
manager trades the fund's underlying securities, realizing a gain or loss, and
collects the dividend or interest income. The investment proceeds are then
passed along to the individual investors. There are more mutual funds than there
are individual stocks.
Glossary
"Open" or "closed"
Most mutual funds are open-end funds. This means that at the end of every day,
the investment management company sponsoring the fund issues new shares to
investors and buys back shares from investors wishing to leave the fund. A
mutual fund can also be a closed-end fund. The sponsor of a closed-end fund
registers and issues a fixed number of shares at the initial offering, similar
to a common stock. Investors then can buy or sell these shares through a stock
exchange. The sponsor does not redeem or issue shares after a closed-end fund is
launched, so the investor must trade them through a broker.
Exchange-traded fund
A new innovation, the exchange traded fund (ETF) combines characteristics of
both open and closed end mutual funds. An ETF usually tracks a stock index, like
an index fund, but can be redeemed on demand for its underlying holdings,
eliminating the discounts and premiums that are common with closed-end funds and
forcing prices to remain very close to the net asset value (NAV). ETFs are
traded throughout the day on a stock exchange, just like closed-end funds.
Net asset value
Main article: net asset value
The net asset value, or NAV, is a fund's value of its holdings, usually
expressed as a per-share amount. For most funds, the NAV is determined daily,
after the close of trading on some specified financial exchange, but some funds
update their NAV multiple times during the trading day. Open-end funds sell and
redeem their shares at the NAV, and so only process orders after the NAV is
determined. Closed-end funds may trade at a higher or lower price than their NAV;
this is known as a premium or discount, respectively. If a fund is divided into
multiple classes of shares, each class will typically have its own NAV,
reflecting differences in fees and expenses paid by the different classes.
Some mutual funds own securities which are not regularly traded on any formal
exchange. These may be shares in very small or bankrupt companies; they may be
derivatives; or they may be private investments in unregistered financial
instruments (such as stock in a non-public company). In the absence of a public
market for these securities, it is the responsibility of the fund manager to
form an estimate their value when computing the NAV. How much of a fund's assets
may be invested in such securities is stated in the fund's prospectus.
Share class
Many mutual funds divide their assets up among multiple classes of shares. All
of the assets of each class are effectively pooled for the purposes of
investment management, but classes typically differ in the fees and expenses
paid out of the fund's assets. These differences are supposed to reflect
different costs involved in servicing investors in various classes; for example,
one class may be sold through brokers with a front-end load, and another class
may be sold direct to the public with no load but a "12b-1 fee" included in the
class's expenses. Still a third class might have a minimum investment of
$10,000,000 and only be open to financial institutions (a so-called
"institutional" class). In some cases, by aggregating regular investments by
many individuals, a retirement plan (such as a 401(k) plan) may qualify to
purchase "institutional" shares (and gain the benefit of their typically-lower
expense ratios) even though no members of the plan would qualify individually.
Turnover
Turnover is a measure of the amount of securities that are bought and sold,
usually in a year, and usually expressed as a percentage of net asset value. It
shows how actively managed the fund is.
A caveat is that this value is sometimes calculated as the value of all
transactions (buying, selling) divided by 2; i.e., the fund counts one security
sold and another one bought as one "transaction". This makes the turnover look
half as high as would be according to the standard measure.
Turnover generally has tax consequences for a fund, which are passed through to
investors. In particular, when selling an investment from its portfolio, a fund
may realize a capital gain, which will ultimately be distributed to investors as
taxable income. The very process of buying and selling securities also has its
own costs, such as brokerage commissions, which are borne by the fund's
shareholders.
The Dalbar Inc. consultancy studied mutual fund stock returns over the period
from 1984 to 2000. Dalbar found that the average stock fund returned 14 percent;
during that same period, the typical mutual fund investor had a 5.3 percent
return ([1]). This finding has made both "personal turnover" (buying and selling
mutual funds) and "professional turnover" (buying mutual funds with a turnover
above perhaps 5%) unattractive to some people.
Load
A front-end load or sales charge is a commission paid to a broker by a mutual
fund when shares are purchased, taken as a percentage of funds invested. The
value of the investment is reduced by the amount of the load. Some funds have a
deferred sales charge or back-end load which is paid to the broker out of the
proceeds when shares are redeemed. (This is distinct from a redemption fee,
which is also paid out of proceeds, but is kept by the fund. Many funds charge
redemption fees when shares are sold a short time after they are purchased, to
discourage investors from market timing.) Load funds are sold through financial
intermediaries such as brokers, financial planners, and other types of
registered representatives who charge a commission for their services.
It is possible to buy many mutual funds directly from the fund sponsor, without
paying a sales charge. These are called no-load funds. Some discount brokers
will sell no-load funds, sometimes for a flat transaction fee or even no fee at
all. (This does not necessarily mean that the broker is not compensated for the
transaction; in such cases, the fund may pay brokers' commissions out of
"distribution and marketing" expenses rather than a specific sales charge.)
United States
Mutual funds can invest in many different kinds of securities. The most common
are cash, stock, and bonds, but there are hundreds of sub-categories. Stock
funds, for instance, can invest primarily in the shares of a particular
industry, such as high technology or utilities. These are known as sector funds.
Bond funds can vary according to risk (high yield or junk bonds,
investment-grade corporate bonds), type of issuers (government agencies,
corporations, or municipalities), or maturity of the bonds (short or long term).
Both stock and bond funds can invest in primarily US securities (domestic
funds), both US and foreign securities (global funds), or primarily foreign
securities (international funds). By law, mutual funds cannot invest in
commodities and their derivatives or in real estate. (However, there do exist
real estate investment trusts, or REITs, which invest solely in real estate or
mortgages, and mutual funds are allowed to hold shares in REITs.) A mutual fund
may restrict itself in other ways. These restrictions, permissions, and policies
are found in the prospectus, which every open-end mutual fund must make
available to a potential investor before accepting his or her money.
Most mutual funds' investment portfolios are continually adjusted under the
supervision of a professional manager, who forecasts the future performance of
investments appropriate for the fund and chooses the ones which he or she
believes will most closely match the fund's stated investment objective. This is
called active management, in contrast to indexing, in which a fund's assets are
managed to closely approximate the performance of a particular published index.
Because the composition of an index changes less frequently than the condition
of the market, an index fund manager makes fewer trades, on average, than does
an active fund manager. For this reason, index funds generally have lower
expenses than actively-managed funds, and typically incur fewer capital gains
which must be passed on to shareholders. The majority of actively managed funds
usually only match the performance of the index fund, but since they have higher
costs they then underperform the index funds. Three fourths of all mutual funds
underperform the S and P 500 index. This means the majority of the professional
managers can't execute a better stock picking strategy than simply buying the
500 S&P companies equally. For this reason, many advisors strongly suggest
avoiding mutual funds.
Mutual funds are corporations under US law, but they are subject to a special
set of regulatory, accounting, and tax rules. Unlike most other types of
corporations, they are not taxed on their income as long as they distribute
substantially all of it to their shareholders. Also, the type of income they
earn is often unchanged as it passes through to the shareholders. Mutual fund
distributions of tax-free municipal bond income are also tax-free to the
shareholder. Taxable distributions can either be ordinary income or capital
gains, depending on how the fund earned it.
Picking a mutual fund from among the thousands offered is not easy. The
following is just a rough guide, with some common pitfalls.
Unless you are in the highest tax bracket, you probably don't need a tax-exempt
fund.
Match the term of the investment to the time you expect to keep it invested.
Money you may need right away should be in a money market account. Money you
will not need until you retire in 30 years should be in longer-term investments,
such as stock or bond funds.
There are some funds that invest in both stocks and bonds called "balanced
funds." These are not generally as good an idea as a do-it-yourself balance of a
stock fund and a bond fund, simply because you get to control the mix yourself.
More stock is more aggressive, more bond is more conservative.
Expenses matter over the long term, and of course, cheaper is usually better.
You can find the expense ratio in the prospectus. Expense ratios are critical in
index funds, which seek to match the market. Actively managed funds need to pay
the manager, so they usually have a higher expense ratio.
Sector funds often make the "best fund" lists you see every year. The problem is
that it is usually a different sector each year (internet funds, anyone?). Avoid
making these a large part of your portfolio.
Closed-end bond funds often sell at a discount to the value of their holdings.
You can sometimes get extra income by buying these in the market. Hedge fund
managers love this trick. This also implies that buying them at the original
issue is usually a bad idea, since the price will often drop immediately.
Mutual funds often make their distributions near the end of the year. If you get
the money, you will have to pay taxes on it. Check the fund company's website to
see when they plan to pay the dividend, and wait until afterwards if it is
coming up soon.
Do your homework. Read the prospectus, or as much of it as you can stand. It
should tell you what these strangers can do with your money, among other vital
topics. Check the performance of a fund against its peers with similar
investment objectives, and against the index most closely associated with it. Be
sure to pay attention to performance over both the long-term and the short-term.
A fund that gained 53% over a 1-yr. period (which is impressive), but only 11%
over a 5-yr. period should raise some suspicion, as that would imply that the
returns on four out of those five years were actually very low (if not straight
losses).
Diversification is the best way to reduce risk. Most people should own some
stocks, some bonds, and some cash. Some of the stocks, at least, should be
foreign. You might not get as much diversification as you think if all your
stock funds are with the same management company, since there is often a common
source of research and recommendations. Too many funds, on the other hand, will
give you about the same effect as an index fund, except your expenses will be
higher.
The compounding effect is your best friend. A little money invested for a long
time equals a lot of money later.
[edit]
Scandals
In September 2003, the US mutual fund industry was beset by a scandal in which
major fund companies permitted and facilitated "late trading" and "market
timing".
The source of this article is
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