Mutual Funds

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In this section, we will cover the following:

• Types of Mutual Funds
• Mutual Fund Styles
• Types of Mutual Fund Fee Structures
• How to Select a Mutual Fund
• Calculating Mutual Funds Gains and Losses

A mutual fund company pools money from many investors and purchases different securities on their behalf. Proportionate to their investments, investors share in the investment gains and losses produced by the fund. Each mutual fund has an investment manager, or investment adviser, who manages the fund to meet its investment objectives as described in that particular fund's prospectus.

There are several key attributes that make mutual funds extremely popular among individual investors in the United States.

• Diversification: A single fund may hold securities from hundreds of different issuers -- something few investors could accomplish on their own. This broad diversification significantly reduces downside risk caused by problems with an individual stock or bond.
• Professional Management: A seasoned investment manager who has access to extensive research, market information, skilled analysts and traders, and technology makes investment decisions for the fund. Few individual investors have the time or dedication to select securities and closely track the portfolios.
• Liquidity: Shares in a mutual fund may be bought and sold on any business day in the United States. A fund is required to redeem shares for the market value of the securities within the fund.
• Convenience: Funds may be purchased or sold by mail, telephone, or the Internet and monies can be transferred from one fund to another to reflect an investor's changing views or needs.
• Small initial investment: Many funds offer minimum initial investments of less than $1000 and increments of $100 or less.

Types of Mutual Funds

There are three basic types of mutual funds:

• Open-End Funds
• Closed-End Funds
• Offshore Funds

Open-End Funds
Open-end mutual funds are investment funds that purchase a group of securities and then sell shares in the fund. They are called open-end funds, as there is no limit on the number of shares allowed to be issued. Open-end mutual fund shares trade at their Net Asset Value (NAV). This is the value securities held by the fund, minus any fees charged by the fund, divided by the number of shares in the fund.

For example, if the total value of all the securities held in the fund was $1 million, fees were $50,000, and there were 10,000 shares outstanding – NAV would be ninety-five dollars.

Closed-End Funds
Closed-end funds are similar to open-end funds, but they have a fixed number of shares issued, much like a corporation. Closed-end funds trade on a stock exchange at whatever price the market sets. The price does not necessarily always reflect the NAV of the component securities held by the fund.

Offshore Funds
Typically, offshore funds are managed by large institutions and are registered outside the US. To be sold in the US, offshore funds must abide by strict federal and state regulations.

Mutual Fund Styles

Each mutual fund has an investment objective or focus. Many funds have similar
objectives and can be placed in groups called "styles." These include:

• Stock Funds
• Money Market Funds
• Bond Funds
• Hybrid Funds
• International Funds
• Specialized Funds
• Index Funds

Stock Funds
There are three common types of stock funds:

• Aggressive Growth
• Equity Income
• Growth

Aggressive Growth
Aggressive growth funds are normally the riskiest type. They seek capital appreciation and often use investment techniques such as short selling, leveraging, frequent trading, and small cap equities. Because of their growth focus, they reinvest earning in the company and therefore do not produce significant interest income or dividends.

Equity-Income
Equity income funds are for investors who seek current interest income or dividends. To provide dividends, income fund managers invest at least fifty percent of their assets in stocks with above-average yields.

Growth
Growth funds invest primarily in stocks of companies with earnings that are expected to grow at an above industry average rate. They seek capital appreciation, but are not normally as risky as aggressive growth funds. Some do seek to offer current income as a secondary objective.

Money Market Funds
Money market funds invest in short term government, corporate or bank issued debt. The objective is preservation of capital while maintaining a stable price of one dollar a share.

Bond Funds
There are several basic kinds of bonds funds:

• Corporate – These generally invest in corporate bonds of investment grade quality. Because the bonds are investment grade, the corporate bond funds are considered a fairly safe investment.
• Junk/ high-yield – High-yield funds invests in corporate bonds of lower quality ratings, and can therefore provide higher returns.
• Government – Government funds invest in bonds issued by the US Treasury and Agencies. These funds are an extremely safe investment.
• Tax advantaged – These funds invest in securities issued by state and local government entities. The interest earned is generally exempt from federal income taxes and in some cases state and local taxes. They offer many of tax advantages that can offset the lower returns the bonds provide.

Hybrid Funds
For those looking to invest in both stocks and bonds, Hybrid funds may be the solution. Hybrid funds come in two main forms: balanced or income.

• Balanced – Balanced funds invest in a relatively fixed combination of both stocks and bonds. In general, these funds will hold a minimum of twenty five percent in stocks and twenty-five percent in bonds at any time.
• Income – Income funds invest in both stocks and bonds with the primary goal of realizing current income. These funds will generally not invest more than fifty percent of their assets in stocks.

International Funds
For those looking to invest beyond US borders,International funds can be a fantastic option. International funds are either stocks (equity) or bond funds.

• International Equity – These funds invest heavily in foreign stocks. Depending on the fund, US stocks may or may not be held.
• International Bond – International bond funds invest primarily in non-US currency denominated debt, which are frequently obligations of foreign governments or agencies.

Specialized Funds
Specialized funds allow investors to focus on a specific industry, or sector, including Finance, Health Care, Natural Resources, Precious Metals, Technology, and Utilities. Single Country Funds are funds that focus on one particular country. They are typically used for international diversification.

Index Funds
An index fund is a passively managed fund that matches the performance of a widely known index. This is accomplished by holding either all of the securities in an index in the appropriate proportions or by holding a statistically selected sample of securities that closely tracks the desired index.

Mutual Fund Fee Structures

As we've learned, Mutual funds are great ways to diversify risk and make money. However, the fees charged on mutual funds are often difficult to understand. The following information can help you sift through the jargon to determine how much you are truly giving up for fund management.

A fund's expense ratio is the total amount that a fund takes out to cover all expenses. This amount is expressed as a percentage of the value of the fund and does not include any sales charges.

Below are the basic components of mutual fund fee structures:

• Sales charges
• Redemption fees
• Management fees
• 12b-1 fees

Sales Charges
Sales charges are either classified as "load" or "no-load."

• LOAD funds charge a commission (load), typically between three percent and eight-and-a-half percent when new shares are purchased. These funds are usually purchased from stockbrokers, financial planners, investment advisors, and mutual fund companies.
• NO-LOAD funds have no sales charge. Investors purchase shares directly from the fund. Many investors prefer no-load funds because there is no commission. When choosing between two equally attractive funds, a no load fund is usually the way to go.

Redemption Fees
Redemption fees are also called "back-end load fees." Some funds charge a percentage fee when shares are sold. Often this fee is reduced or waived if shares are held for a minimum amount of time.

Management Fees
Most funds pay a management fee to the fund managers based on the total assets in the fund. This fee is extracted from the customers' accounts and covers all administrative costs associated with running the fund

12b-1 Fees
Although many funds choose to include all costs under the management fee, some funds set aside up to one-and-a-quarter percent of assets to cover marketing costs.

How to Select a Mutual Fund

Selecting a mutual fund can be tricky. Here's the paradox: the Securities and Exchange Commission (SEC) and the National Association of Securities Dealers (NASD) have imposed such stringent disclosure requirements that the information the funds are allowed to provide don't always help you make an informed decision. Have you ever read a prospectus? Many people outside of the investment community either have not, or have difficulty sifting though the terminology. Here are a few guidelines to help simplify the job.

What to look for
As you research, it is important to remember that although certainly an important consideration, performance isn't everything. It is long-term performance that is key. While no one can predict the future, past performance can provide some indication of how a fund might react to similar market conditions. Fund performance figures can be found in the fund's prospectus, as well as the quarterly (and annual) mutual fund issues of financial publications like the The Wall Street Journal, Forbes, Money Magazine, U.S. News and Consumer Reports.

Here is a checklist of additional factors to look at:

• Objective – Be sure to understand what types of securities a fund manager buys. Are they stocks, bonds, or a combination of the two? They may be companies of varying market capitalization, or size, with different missions altogether. You can only evaluate whether or not a fund is suitable for you until you can answer questions of this nature.
• Investing style -- Look for consistency when it comes to investments. A fund that delivers good returns year after year could offer a more stable and more rewarding ride than a new high flier.
• Costs – What does the fund cost? The cost of professional money management provided by the mutual fund manager is built into the cost of the fund. Mutual fund fees are unavoidable, but do vary from fund to fund.
• Risk level -- Some funds are more volatile than others. Be sure that the risk level at which the fund operates is in synch with your own risk tolerance.

Where to look
There are a few places you can look to for help with the process. These include:

• Online Brokers
• Professional advisors
• Fund Web sites
• Print and online business press
• Morningstar

Let's take a closer look at each.

1. Online brokers.Some online brokers provide extensive information about mutual funds. SiebertNet, for example, offers a product called Fund Exchange that provides all the resources you need to support your fund investment decisions.
2. Learn from professional advisors When investment professionals evaluate mutual funds, they look underneath the performance figures, fee tables, and canned objective statements to see how the fund is really being managed. What stocks does the fund own now? What stocks is it likely to buy in the future? Does the fund manager have a system for choosing stocks? What is the manager's investing philosophy and approach? Is the manager likely to stay with this fund? The whole approach is future-oriented, unlike the prospectus information, which is allowed to tell only about the past. Financial advisors can call the funds and get answers to these questions. Individual investors cannot. That's why it's sometimes worth it to pay a sales charge so you can get the necessary information from a professional advisor—as well as help matching funds to your individual needs. (The SEC and NASD disclosure requirements do not apply to brokers and financial advisors; this is why they can often get more information than you could get on your own.)
3. Fund Web sites.Some mutual fund Web sites offer lots of information, including their top ten holdings and manager commentaries that tell which stocks the manager likes now. Other funds aren't so generous with the information, figuring you might steal their stock ideas. When choosing a fund family, look for breadth of information. For a list of mutual fund Web sites, go to the Mutual Fund Education Alliance.
4. Print and online business press.Interviews with fund managers can tell you a lot about how a fund is being managed. Typical questions managers are asked include "How would you sum up your investing style?" and "What are your criteria for picking stocks?" Two good sources of fund manager interviews in the press are Barron's, either print or online versions, and Brill's Mutual Funds Interactive. You might also catch "Wall Street Week" on PBS on Friday evenings, where Louis Rukeyser frequently interviews mutual fund managers.
5. Morningstar is the definitive mutual fund resource, offering tons of statistics as well as analysis and commentary. Try to resist blindly going with the five star funds and understand why Morningstar came up with the ratings it did.

HerTip: Online investment clubs can also be a valuable source of information when selecting a mutual fund or other investment product. Here you will also get feedback from investors with similar investment strategies and goals as you.

Calculating Mutual Funds Gains and Losses

Equity investors have it easy when it comes to calculating investment gains or losses. They simply calculate the difference between the buying and selling price.

Mutual fund shareholders who reinvest fund dividends at varying prices face a more complicated task. The IRS has devised four very different ways to determine mutual fund gains and losses. Each method can result in decidedly different results, so you'll want to pick the approach most favorable to your own situation.

First in, first out. Unless you specify otherwise, the IRS assumes the shares you sell are the first ones you purchased. Because they've had the longest time to appreciate in value, these shares typically have the highest gains—and the biggest tax burden.

Specific shares method. You could also decide to specify exactly which shares you sold. This approach allows you the most control over your tax situation.

You'll need to show the number of shares you've sold, the purchase date, and the purchase price. Your fund company may be able to help you assemble the necessary documentation if your own records are incomplete.

Average cost/single category. The single-category method considers all your shares as one purchase, no matter how long you've owned the investment. To determine an average cost per share, you simply divide the total paid for all your shares by the number of shares owned. This is one of the easiest methods available.

Average cost/double category. This approach allows you to calculate average costs for both short-term and long-term shares. You can then decide which group you wish to sell. Whichever average cost method you choose must be used for all future sales or exchanges of that security. However, if you own more than one fund, you can use a different approach for each.