Investing in Mutual Funds: Part One
Over the past decade, American investors have increasingly preferred mutual funds to accumulate savings for retirement. Many mutual funds offer diversification and professional management. However, as with other investment choices, investing in mutual funds does not go without risk. It pays to understand both the pros and cons of mutual fund investing and how to go about choosing a fund that meets your goals and tolerance for risk, as well as fees and tax implications that may diminish your returns.
What Are Mutual Funds?
A mutual fund company pools money from a number of investors and invests in stocks, bonds, short-term cash instruments, or a combination of these investments. The “portfolio” represents the combined holdings of the mutual fund, and each mutual fund share represents a portion of an investor's ownership of the holdings in the portfolio.
Mutual fund characteristics include:
- Mutual fund shares are purchased from the fund itself (or from the fund through a broker) instead of from the secondary market, such as the NYSE or Nasdaq.
- The net asset value or “NAV” is the price investors pay for each share plus any applicable fees or “sales loads” at the time of purchase.
- Investors can sell their shares back to the mutual fund or to a broker acting for the fund.
- Mutual funds are created and sold to new investors on a continuing basis. However, some funds will stop selling shares, for instance, when the fund has grown too big.
- “Investment advisers” registered with the SEC manage the funds’ portfolios
Advantages and Disadvantages
Mutual funds have their advantages and disadvantages. Investors should consider their unique circumstances before deciding whether mutual fund investing would be advantageous. Some of the reasons mutual funds are advantageous and attractive include:
- Qualified Management – Skilled money managers research, analyze, select, and actively follow the performance of the fund’s holdings.
- Diversification – Diversification, or “don't put all your eggs in one basket, is the crux of investing. An investment portfolio should consist of a wide range of industry sectors and companies to help lower your risk. Mutual funds facilitate diversification through ownership of mutual fund shares, which represent ownership in individual stocks, bonds, or other holdings.
- Affordability – Mutual funds provide access to markets to investors who do not have the financial ability to purchase a wide range of securities.
- Liquidity – Mutual fund shares can be redeemed at the current NAV at any time. Investors should consider the potential impact of any fees and charges prior to redemption.
- A few possible disadvantages include:
- Costs Regardless of Poor Performance – Sales charges, annual fees, and other expenses, regardless of how the fund performs, are always assessed. Taxes on any capital gains may also be assessed depending on the timing of the investment.
- Control – Investors can rarely determine the exact holdings of a fund’s portfolio at any given time. In addition, they cannot control the fund manager’s purchase or sale transactions or the timing of those trades.
- Price Ambiguity – Individual stock price information can be obtained by simply looking up quotes online or by calling your financial advisor. By contrast, mutual fund prices will depend on the fund’s NAV, which might not calculated until many hours after an order has been placed. Mutual fund NAVs are calculated at least once every business day, usually after the market close.
Different Types of Funds
Investors interested in mutual funds have a plethora of choices. Before investing in a fund, it is important that you investigate the investment strategy and risks of the fund and determine whether it fits your investment profile. Developing an investment profile, or determining your goals and risk tolerances, is the first step of sound investing and is typically prepared with the assistance of an experienced financial professional. Mutual fund choice are more easily narrowed after the investment profile is completed.
There are three main categories of mutual funds: “equity” or stock funds, “fixed income” or bond funds, and “money market” or short-term debt instrument funds. Each fund type will have its own risk/reward tradeoff; i.e., the higher the potential return, the higher the risk of loss.
Money Market Funds
Money market funds are less risky than other mutual funds because they can only invest in high-quality, short-term investments issued by the U.S., state, and local governments, as well as corporations. Money market funds try to maintain their NAVs $1.00 per share, but the NAV may fall below $1.00 if the fund performs poorly. Therefore, it is possible to lose money.
Money market funds are also subject to “inflation risk.” Since money market funds pay dividends linked to short-term interest rates, their returns have been historically lower than both bond and stock funds. If inflation outpaces the dividend rate, investment returns will be eroded over time.
Bond funds are generally riskier than money market funds because they aim to producing higher yields or returns. Unlike money market funds, the SEC does not restrict bond funds to high quality, short-term investments. Bond funds can vary dramatically in their risks and rewards because each fund holds different types of bond issuances. Some of the risks associated with bond funds include:
Credit Risk — the possibility that a bond issuer will fail to pay their debt obligations to bondholders. Bond funds that invest primarily in U.S. government or insured bonds have less credit risk than high yield bond funds that invest in companies with poor credit ratings.
Interest Rate Risk — the risk that an increase interest rates will cause the market value of bonds to go down. Even bond funds that invest only in U.S. government and insured bonds are subject to interest rate risk. Funds that focus on longer-term bonds tend to have greater interest rate risk than funds that invest in bonds with shorter durations.
Prepayment Risk — the risk that a bond will be paid off before it matures. For example, if interest rates decrease, a government entity or company may decide to pay off (or “retire”) its outstanding bonds and issue new bonds at a lower rate. Prepayment risk extends to the fund not being able to reinvest the proceeds from early retirement into bonds with similar yields.
Historically, stock funds have performed better than bond and real estate funds. However, a mutual fund that invests exclusively in stocks can dramatically increase and decrease in value over the short term. There are many reasons for stock price fluctuations, such as the overall strength of the economy or demand for a company’s products or services.
Not all stock funds have the same investment objectives. For example:
- Growth funds buy stocks that have the potential to return large capital gains.
- Income funds buy stocks that pay regular dividends.
- Index funds aim to mimic a particular market index’s returns, such as the S&P 500, by investing in nearly all, or a representative sample, of the stocks that make up the index.
- Sector funds buy stocks in a particular industry, such as technology or financial stocks.
How to Buy and Sell Shares
Some mutual fund shares can be purchased directly from the fund. Other mutual fund shares are marketed and sold through brokers, financial advisors, registered representatives, or insurance agents. All mutual funds will buy back shares on any business day and must send the proceeds from the sale within seven days.
Fund shares are purchased at the current NAV per share plus any fee the fund assesses at the time of purchase. The value of your shares can be determined by calling the fund's toll-free number, contacting your broker or visiting the funds website. Also, popular newspapers sometimes print the NAVs for various mutual funds in their business and investment section. When shares are sold, the net amount received will be the NAV minus any fees the fund assesses at the time of redemption, such as a back-end load or redemption fee.
An exchange occurs when shareholders transfer their holdings from one fund to another fund within the same family and is ideal when an investor’s investment goals or tolerance for risk change. Not all funds offer exchange privileges. A “family of funds” shares common administrative and distribution systems, but each fund may have different investment objectives and strategies. In most cases, fund exchanges do not incur fees.
Be sure to consider the possible tax consequences of a fund exchange. Investors may be liable for any capital gains on the sale of the original shares or, depending on the circumstances, subject to a capital loss.
How Funds Can Earn Money for You
You investment can generate money in three ways:
- Dividend Payments — If the fund earns income in the form of dividends and interest payments from securities in its portfolio, the fund will pay its shareholders nearly all of the income (after deducting disclosed expenses) in the form of dividends.
- Capital Gains Distributions — If a fund sells its stocks for more than what it paid for them, the fund has a capital gain. At the end of the year, these capital gains (minus any capital losses) will be distributed to investors.
- Increased NAV — The NAV of a fund will increase if the market value of a fund's portfolio increases after expenses. A higher NAV reflects an increase in the value of your investment.
Funds usually give investors a choice as to whether they prefer dividend payments and capital gains distributions. Dividends or distributions can be reinvested in more shares, or the fund can send payment directly to the investor.