Investing in Mutual Funds: Part Two

Important Factors to Consider Before Investing

Before investing in a suitable mutual fund, it is important that you determine your long-term investment strategies and tolerance for risk. The effects of tax consequences and fees on your returns should also be considered.

Degrees of Risk

Not one mutual fund is free of risk, which means you may lose some or all of the money your invested principal. If you are in need of liquidity when the value of your fund goes down, you will suffer a capital loss. Dividend or interest payments are also subject to change as market conditions fluctuate.

It is imperative that you read a fund’s prospectus and shareholder report to investigate the fund’s investment strategy and potential risks. Funds exhibiting higher rates of return may take risks that are beyond your tolerance and, therefore, inconsistent with your obejctives.

Fees and Expenses

Operating a mutual fund involves costs, as does any business. Some of the costs include transaction costs, advisory fees and advertising and distribution expenses. These costs are passed along to investors through fees and expenses. It is important that you understand that these charges can lower your returns.

Certain funds assess “shareholder fees” on investors whenever shares are bought and sold. However, every fund assesses regular, recurring “operating expenses.” Operating expenses are typically paid out of fund assets, which means that investors pay them.

In accordance with SEC rules, funds must disclose shareholder fees and operating expenses in a “fee table” located near the front of a fund’s prospectus. The following list will help you understand the various fees a fund may impose:

Shareholder Fees:

  • Sales Charge or Load on Purchases – a charged assessed when you buy mutual fund shares. Also known as a “front-end load,” the broker responsible for the purchase of the shares receives this fee. A front-end load reduces the amount of your initial investment. For example, assume you have $500 and want to invest it in a mutual fund with a 6% front-end load. The $30 sales load assessed is taken from the initial investment, and the remaining $470 will be invested in the fund. FINRA rules cap front-end loads at no more than 8.5% of your initial investment.

  • Purchase Fee – another charge assessed by some mutual funds when shareholders buy shares. The fund, not the broker, receives the purchase fee, which is typically imposed to cover some of the fund's costs associated with the purchase transaction.

  • Deferred Sales Charge or Load — a charged assessed when you sell mutual fund shares. Also known as a “back-end load” or “contingent deferred sales load,” the broker responsible for the sale of the shares receives this fee. The amount of the load depends on how long the investor has held his or her shares and typically decreases to zero if shares are held for long enough.

  • Redemption Fee — a fee assessed when shareholders sell or redeem shares. A redemption fee is paid to the fund and is typically used to cover costs associated with the sale of shares. Not all funds charge a redemption fee.

  • Exchange Fee — a fee assessed on shareholders if they exchange or transfer to another fund within the same “family of funds.” Not all funds an exchange fee.

  • Account Fee — a fee assessed on investors for the maintenance of their accounts. For example, an account whose value is less than a certain dollar amount may be charged an account fee. Not all funds separately impose an account fee.

  • Management Fees — fees assessed to pay the fund’s investment adviser for portfolio management and administration of the fund. Management fees are paid out of fund assets and are distinct from “Other Expenses.”

  • Distribution and/or Service Fees (“12b-1” Fees) — fees assessed to cover the marketing and selling of fund shares and the costs of providing shareholder services. Distribution fees are paid out of fund assets and include fees to compensate brokers and prepare sales literature and prospectuses for new investors. “Shareholder Service Fees” are assessed to provide responses to investor inquiries and to provide investors with information about their investments.

  • Other Expenses — expenses related to custodial, legal and accounting, transfer agent, and other administrative expenses that are not already included in management or 12b-1 fees.

  • Total Annual Fund Operating Expenses (“Expense Ratio”) — the total amount of a fund's annual fund operating expenses. The ratio is expressed as a percentage of the fund's average net assets and is used to compare funds.

“No-Load” Funds

Some funds coin themselves “no-load” and, therefore, do not charge any type of sales load. However, no-load funds may assess fees that are not sales loads, such as purchase, redemption, exchange or transfer, and account fees. In addition, no-load funds will have operating costs or expenses.

A fund’s fee table should be reviewed before investing in a fund, including no-load funds. Even the slightest difference in fees can cause substantial differences in returns over time. For instance, a $10,000 investment in a fund that returned 10% return per year before expenses and had annual operating expenses of 1.5% would amount to $49,725 after 20 years. If the fund’s expenses were 0.5%, the return would amount to $60,858 after 20 years – a difference of 18%!

Breakpoints

Mutual funds that charge front-end sales loads will offer a discount for larger investments. The sizes of the investments required to obtain a lower sales load are referred to as “breakpoints.”

Funds are not required to offer breakpoints, but, if breakpoints are offered, they must be disclosed. Beware of a recommendation to buy mutual funds shares for an amount that is “just below” the fund's sales load breakpoint. It is possible that your broker is simply trying to earn a higher commission.

Breakpoint formulas are created by each fund and calculate whether an investor is entitled to receive a breakpoint. Therefore, breakpoint information can be obtained from your financial advisor or directly from the fund. It is recommended that you look into how a particular fund establishes breakpoint discount eligibility, as well as the amount of breakpoints.

Classes of Funds

Mutual funds typically offer different classes of shares. For instance, a fund may offer "Class A" and "Class B" shares. Regardless of the class, the fund will hold the same investment portfolio of securities and implement the same investment objectives and policies. The difference in shares lies in the services, distribution arrangements and fees and expenses. As a result, each class will perform differently.

The key benefit of a multi-class share structure is the ability to choose a fee/expense arrangement that is most suitable for your investment goals. The following are the most common mutual fund share classes, as well as some of their characteristics:

  • Class A Shares — Class A shares usually assess a front-end or up-front load. Also, 12b-1 fees and annual expenses are lower than other mutual fund share classes. Some mutual funds offering Class A shares lower the front-end load as the amount purchased increases. Therefore, be sure to inquire about breakpoints.

  • Class B Shares — Class B shares usually do not assess a front-end load. Instead, they may charge a 12b-1 fee and a contingent deferred sales load, as well as other annual expenses. In addition, Class B shares can be converted to a class with a lower 12b-1 fee if the shares are held for a long enough period of time.

  • Class C Shares — Class C shares usually assess a 12b-1 fee and either a front- or back-end load, as well as other annual expenses. However, the load for Class C shares tends to be lower than Class A and Class B shares. Class C shares do not convert to another class, and they have higher annual expenses than Class A and Class B shares.

Tax Consequences

Dividends or interest payments received as a result of buying and holding an individual stock or bond are taxable at the end of each. However, you will not incur any capital gains tax until sell the stock or bond and realize a profit.

Mutual Funds function differently. Similar to dividends from a stock, dividend payments received as a result of buying and holding mutual fund shares will be taxed in the year you receive or reinvest them, and you will owe taxes on any capital gains when shares are sold. In addition to the above-described tax consequences, you may also have to pay capital gains taxes on the fund's capital gains. This tax consequence is automatically triggered because the law requires funds to distribute capital gains to shareholders if the fund sells securities for a net profit.

Capital gains distributions will almost certainly cause you to owe taxes, regardless of whether the fund performed negatively from the moment of purchase at some point during the year. Therefore, you should contact the fund to inquire about when the fund makes distributions in order to avoid paying more than your fair share of taxes. Sometimes, this information is posted on a fund’s website.

Pursuant to SEC rules, mutual funds are required to disclose their after-tax returns. When determining after-tax returns, mutual funds must use standardized formulas, much like the formula used to calculate before-tax returns. After-tax returns are located in the “Risk/Return Summary” section of the prospectus and can be used to compare taxes among funds.

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