Mutual Funds

Mutual fund share are purchased directly from the fund or a broker instead of from other investors on a secondary market, such as the NYSE or Nasdaq Stock Market.

What are mutual funds?

A mutual fund is a company that pools money from many investors and invests the money in stocks, bonds, short-term money-market instruments, other securities or assets, or some combination of the investments. The combined holdings of the mutual fund are known as its portfolio. Each mutual fund share represents an investor’s proportionate ownership of the fund’s holdings and the income those holdings generate.

Here are a fund’s distinguished characteristics:

  • Mutual fund shares are purchased directly from the fund or a broker instead of from other investors on a secondary market, such as the NYSE or Nasdaq Stock Market.
  • The price that investors pay for mutual fund shares is the fund’s net asset value or NAV plus any fees that the fund imposes at the time of purchase (sales load).
  • Mutual fund shares are “redeemable”, meaning investors can sell their shares back to the fund or broker acting for the fund.
  • Mutual funds generally create and sell new shares to accommodate new investors. In other words, they sell their shares on a continual basis, although some funds stop selling when, for example, they become too large.

 

Advantages and Disadvantages

Every investment has advantages and disadvantages. But it’s important to remember that features that matter to one investor may not be important to you. Mutual funds can offer an attractive investment choice because they generally offer the following features:

  • Professional Management – Professional money managers research, select, and monitor the performance of the securities the fund purchases.
  • Diversification – is an investing strategy that can be neatly summed up as “Don’t put all your eggs in one basket.” Spreading your investment across a wide range of companies and industry sectors can help lower risk if a company or sector fails.
  • Affordability – Some mutual funds accommodate investors who don’t have a lot of money to invest by setting low dollar amounts for initial purchases, subsequent monthly purchases, or both.
  • Liquidity – mutual fund investors can readily return their shares at the current NAV- plus any fees and charges assessed on redemption – at any time.

But mutual funds also have features that investors might view as disadvantages, such as:

  • Lack of Control – Investors typically cannot ascertain the exact make-up of a fund’s portfolio at any given time, nor can they directly influence which securities the fund manager buy and sells or the timing of those trades.
  • Price Uncertainty – With an individual stock or ETF, you can obtain real time pricing information with relative ease by checking financial websites or calling your broker. By contrast, with a mutual fund, the price at which you redeem or purchase will typically depend on the fund’s NAV, which the fund might not calculate until many hours after you have place your order. In general, most funds calculate their NAV at least once every business day, usually after the close of the markets.

Different Types of Funds

Most mutual funds fall into one of the three main categories – money market funds, bond funds (also called “fixed income” funds) and stock funds (also called “equity” funds). Each type has a different features and different risks and rewards. Generally, the higher the potential return, the higher the risk of loss.

Money Market Funds

Money market funds have relatively low risks, compared to other mutual funds and most other investments. By law, they can invest in only certain high-quality, short-term investments issued by the US government. Money market funds try to keep their net asset value (NAV) – which represents the value of one share in a fund – at a stable $1.00 per share. But the NAV may fall below $1.00 if the fund’s investment performs poorly. Investor losses have been rare, but they are possible.

Money market funds pay dividends that generally reflect short-term interest rates, and historically the returns for money market funds have been lower than either bond or stock funds. That’s why “inflation risk”- the risk that inflation will outpace and erode investment returns over time – can be a potential concern for investors in money market funds.

Don’t confuse a “money market fund” with a “money market deposit account.” The names are similar, but they are completely different:

A money market fund is a type of mutual fund. It is not guaranteed or FDIC insured. When you buy shares in a money market fund, you should receive a prospectus.

A money market deposit account is a bank deposit. It is guaranteed and FDIC insured. When you deposit money in a money market deposit account, you should receive a Truth in Savings Form.

 

Bond Funds

Bond funds generally have higher risks than money market funds, largely because they typically pursue strategies aimed at producing higher yields. Unlike money market funds, the SEC’s rules do not restrict bond funds to high-quality or short-term investments. Because there are many different types of bonds, bond funds can vary dramatically in their risks and rewards. Some of the risks associated with bond funds include:

  • Credit Risk – the possibility that companies or other issuers whose bonds are owned by the fund may fail to pay their debts (including debt owed to holders of their bonds. Credit risk is less a factor for bond funds that invest in insured bonds or U.S. Treasury bonds. By contrast, those that invest in the bonds of companies with poor credit ratings generally will be subject to higher risk.
  • Interest Rate Risk – the risk that the market value of the bonds will go down when interest rates go up. Because of this, you can lose money in any bond fund, including those that invest only in insured bonds or Treasury bonds. Funds that invest in longer-term bonds tend to have higher interest rate risk.
  • Prepayment Risk – the chance that a bond will be paid off early. For example, if interest rates fall, a bond issuer may decide to pay off (or “retire”) its debts and issue new bonds that pay a lower rate. When this happens, the fund may not be able to reinvest the proceeds of an investment with as high a return or yield.

 

Stock Funds

Stock funds values can rise and fall more quickly (and dramatically) over the short term than other types of investment – including corporate bonds, government bonds, and Treasury securities.

Overall “market risk” poses the greatest potential danger for investors in stock funds. Stock prices can fluctuate for a broad range of reasons – such as the overall strength of the economy or demand for particular products or services.

Not all stock funds are the same. For example:

Growth funds focus on stocks that may not pay regular dividends but have the potential for large capital gains.

Income funds invest in stocks that pay regular dividends.

Index funds aim to achieve the same return as a particular market index, such as the S&P 500 Composite Stock Price Index, by investing in all – or perhaps a representative sample – of the companies included in an index.

Sector funds may specialize in a particular industry segment, such as technology or consumer products stocks.

All funds carry some level of risk. You may lose some or all of the money you invest – your principal – because the securities held by a fund go up and down in value. Dividend or interest payments may also fluctuate as market conditions change.

Before you invest, be sure you read a fund’s prospectus or seek the help of a financial advisor. Funds with higher rates of return may take risks that are beyond your comfort level and are inconsistent with your financial goals.

How Funds Can Earn Money for You

You can earn money from your investment in three ways:

  1. Dividend Payments – A fund may earn income in the form of dividends and interest on the securities in its portfolio. The fund then pays its shareholders nearly all of the income (minus disclosed expenses) it had earned in the form of dividends.
  2. Capital Gains Distributions – The price of the securities a fund owns may increase. When a fund sells a security that has increased in value, the fund has a capital gain. At the end of the year, most funds distribute these capital gains (minus any capital losses) to investors.
  3. Increased NAV – If the market value of a fund’s portfolio increases after deduction of expenses and liabilities, the value (NAV) of the fund and its shares increases. The higher the NAV reflects the higher value of our investments.

Fees and Expenses

Running a mutual find involves costs – including shareholder transaction costs, investment advisory fees, and marketing and distribution expenses. Funds pass along these costs to investors by imposing fees and expenses. It is important that you understand these charges because they lower your returns.

Some funds impose “shareholder fees” directly on investors whenever they buy or sell share. In addition, every fund has regular, recurring, fund-wide “operating expenses.” Funds typically pay their operating expenses out of fund assets – which mean that investors indirectly pay these costs.

SEC (Securities and Exchange Commission) rules require disclosing both shareholder fees and operating expenses in a “fee table” near the front of a fund’s prospectus. The lists below will help you decode the fee table and understand the various fees a fund may impose:

Shareholder Fees

Sales Charge (Load) on Purchases – the amount you pay when you buy shares in a mutual fund. Also know as a “front-end load,” this fee typically goes to the brokers that sell the fund’s shares. Front-end loads reduce the amount of your investment. For example, let’s say that you have $1000 and want to invest in a mutual fund with a 5% front-end load. The $50 sales load you must pay comes off the top, and the remaining $950 will be invested in the Fund. According to FINRA rules, a front-end load cannot be higher than 8.5% of your investment.

Deferred Sales Charge (Load) – a fee you pay when you sell your shares. Also know as a “back-end load,” this fee typically goes to the brokers that sell the fund’s shares. The most common type of back-end sales load is the “contingent deferred sales load’ (also known as a “CDSC or CDSL”). The amount of this type of load will depend on how long the investor holds his or her shares and typically decreases to zero if the investor holds his or her share long enough.

Redemption Fee – another type of fee that some funds charge their shareholders when they sell or redeem shares. Unlike a deferred sales load, a redemption fees is paid to the fund (not to the broker) and is typically used to defray fund costs associated with a shareholder’s redemption.

Exchange Fee – a fee that some funds impose on shareholders if they exchange (transfer) to another fund within the same fund group or “family of funds.”

 

Annual Fund Operating Fees

Management Fees – fees that are paid out of the fund’s assets to the fund’s manager for investment portfolio management, any other management fees payable to the fund’s investment manger or its affiliates, and administrative fees payable to the investment manager that are not included in the “Other Expenses” category. The funds can range from 0.40% to as high as 2.00%.

Distribution [and/or Services] Fees (“12b-1” Fees) – fees paid by the fund out of fund assets to cover the cost of marketing and selling fund shares and sometimes to cover the cost of providing shareholder services. “Distribution fees” include fees to compensate brokers and others who sell fund shares and to pay for advertising, the printing and labeling of prospectuses to new investors, and the printing and mailing of sales literature. “Shareholder Service Fees” are fees paid to persons to respond to investors’ inquiries and provide investors with information about their investments.

Other Expenses – expenses not included under “Management Fees” or “Distribution or Services (12b-1) Fees,” such as any shareholder service expenses, legal and accounting expenses, transfer agent expenses and other administrative expenses.

Total Annual Fund Operating Expenses (“Expense Ratio”) – the line of the fee table that represents the total of all of a fund’s annual fund operating expenses, expressed as a percentage of the fund’s average net assets. Looking at the expense ratio can help you make comparisons among funds.

Classes of Funds

Many mutual funds offer more than one class of shares. For example, you may have seen a fund that offers “Class A” and Class B” shares. Each class will invest in the same “pool” (or investment portfolio) of securities and will have the same investment objectives and policies. But each class will have different shareholders services and/or distribution arrangements with different fees and expenses. As a result, each class will likely have different performance results.

Here are some key characteristics of the most common mutual fund share classes offered to individual investors:

Class A Shares – Class A shares typically impose a front-end sales load. They also tend to have a lower 12b-1 fee and lower annual expenses than other mutual fund share classes. Be aware that some mutual funds reduce the front-end load as the size of your investment increases. If you’re considering Class A shares, be sure to inquire about breakpoints.

Class B Shares – Class B shares typically do not have a front-end sales load. Instead, they may impose a contingent deferred sales load and a 12b-1 fee (along with other annual expenses). Class B shares also might convert automatically to a class with a lower 12b-1 fee if the investor holds the shares long enough.

Class C Shares – Class C shares might have a 12b-1 fee, other annual expenses, and either a front – or back-end sales load. But the front- or back-end load for Class C shares tends to be lower than for Class A or Class B shares, respectively. Unlike Class B shares, Class C shares generally do not convert to another class. Class C shares tend to have higher annual expenses than either Class A or class B shares.

Other Classes – Other classes may also exist for some funds.

Past Performance

A fund’s past performance is not as important as you may think. Advertisements, rankings and ratings often emphasize how well a fund has performed in the past. But studies show that the future is often different. This year’s “number one” fund can easily become next year’s below average fund.

Be sure to find out how long the fund has been in existence. Newly created or small funds sometimes have excellent short-term performance records. Because these funds may invest in only a small number of stocks, a few successful stocks can have a large impact on their performance. But as these funds grow larger and increase the number of stocks they own, each stock has less impact on performance. This will make it more difficult to sustain initial results.

While past performance does not necessarily predict future returns, it can tell you how volatile (or stable) a fund has been over a period of time. Generally, the more volatile a fund, the higher the investment risk. If you’ll need your money to meet a financial goal in the near-term, you probably can’t afford the risk of investing in a fund with a volatile history because you will not have enough time to ride out any declines in the stock market.

Source: Russell Investments and SEC
http://www.sec.gov/investor/pubs/inwsmf.htm

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