Since the 1920s, mutual funds have helped Americans achieve their financial goals. Today they are one of the most popular investments. According to the Mutual Fund Education Alliance, more than 80 million investors in the United States own mutual funds.
But if you’re like most investors, you may have questions about different fund types, class shares, expenses and how to select the funds most suitable to your investment needs. You’ll find answers to these questions in this five-part series of articles about the world of mutual funds.
What is a mutual fund?
Mutual funds are often referred to as open-end funds. This means there is no limit to the number of shares investors can buy and sell. You might also hear about closed-end funds, which are investment companies that sell a fixed number of shares traded only on the stock market.
The money you invest in a mutual fund is pooled along with that of other shareholders with similar financial goals. Most mutual funds are part of a larger investment company or family of funds. Each fund is managed by a team of professional money managers who monitor the fund’s performance and, based on thorough research, choose investments they believe will help the fund reach the investment objectives stated in the prospectus (for example, current income or capital growth).
Because a mutual fund is essentially a collection of different investments, investors use them to reduce investment risk without having to purchase individual stocks and/or bonds. Diversification, while recommended, does not guarantee a profit or ensure against a market loss.
Another advantage of investing in mutual funds is liquidity. Generally, you can redeem or sell your shares any day the stock market is open. However, you should keep in mind that investment values will fluctuate and there is no assurance that the objective of any fund will be achieved. Mutual fund shares are redeemable at the current net asset value, which could be more or less than their original cost. Fund annual operating expenses apply as well as plan administration charges. These are described in the prospectus.
Stock mutual funds
If you’re considering investing in a mutual fund, you’ll need to know about the types of funds that are available. You can select a stock or equity fund, bond fund, balanced fund (a combination of stock and bond funds), lifestyle fund or money market fund. In Part Two of this series, we’ll take a look at stock funds.
Generally, stock or equity mutual funds are best suited for investors who:
o Seek capital growth over extended periods of time
o Are willing to tolerate share-price volatility
o Have an investment horizon of five or more years
Stock funds can have different investment objectives and target companies in various industry sectors and market capitalization (the gauge of a company’s size or value). Funds invest in companies within one of the three market capitalization categories: large-cap funds (more than $11.7 billion), mid-cap funds ($2.9 billion to $11.7 billion) and small-cap funds (up to $2.9 billion).
The following are the different types of stock funds, ranked in order of the highest to lowest investment risk:
Aggressive growth funds-Seek rapid growth of capital, often through investment in smaller companies and with investment techniques involving high-risk, short-selling, leveraging and frequent trading.
Growth funds-Seek capital appreciation by investing in equity securities of companies with earnings that are expected to grow at an above-average rate. Current income, if considered at all, is a secondary objective.
Growth and income funds-Seek capital appreciation and current income equally by investing in equity securities that have above-average yields and some potential for appreciation.
Income funds-Seek income rather than capital appreciation by investing primarily in equity securities of companies offering good dividends.
International stock funds-Invest at least two-thirds of their portfolios in equity securities of companies located outside the U.S. (global stocks). Domestic (U.S.) stocks may or may not be held.
Specialty funds-Seek capital appreciation by investing at least 65% of assets in equities of a single industry or sector, such as financial services, healthcare, natural resources, precious metals, real estate or utilities.
Lifestyle Funds-Invest in other funds and are optimized to reflect levels of risk and return suitable to specific times of an investor’s life.
Bond funds
As the name suggests, bond funds are mutual funds investing in various types of bonds. Bond funds may be appropriate for investors who:
o Value relatively steady income over growth
o Seek yields that are potentially higher than money market rates
o Want to diversify investments
o Can accept modest fluctuations in the share price
Bond funds aren’t the same as bonds. There’s no fixed yield nor contractual obligation to repay investors their principal at a future date, as is the case with bonds. Bond fund managers continually trade their positions, so the risk-return characteristics of a bond fund investment is always changing, just as with other mutual fund investments.
The main types of bond funds include:
Corporate bond funds-Seek a high level of income by investing two-thirds or more of their portfolios in corporate bonds.
Global bond funds-Invest in worldwide debt securities. Up to 25% of their portfolio’s securities (not including cash) may be invested in companies located in the United States.
Government bond funds-Invest at least two-thirds of their portfolios in U.S. government securities and have no stated average maturity. Bonds issued by Uncle Sam are backed by the full faith and credit of the U.S. government.
High-yield bond funds-Seek a high level of current income by investing at least two-thirds of their portfolios in lower-rated corporate bonds (Baa or lower by Moody’s and BBB or lower by Standard and Poor’s rating services).
Mortgage-backed funds-Invest at least two-thirds of their portfolios in pooled mortgage-backed securities.
National municipal bond funds-Invest predominantly in municipal bonds. The funds’ bonds are usually exempt from federal income tax but may be taxed under state and local laws.
Other world bond funds-Invest at least two-thirds of their portfolios in a combination of foreign government and corporate debt. Some funds in this category invest primarily in debt securities of emerging markets.
State municipal bond funds-Invest primarily in municipal bonds of a single state. The funds’ bonds are exempt from federal and state income taxes for residents of that state.
Strategic income funds-Invest in a combination of domestic fixed-income securities to provide high current income.
Other mutual fund investments
In addition to the stock and bond funds described in previous articles, mutual fund investing offers other choices that might be appropriate to your circumstances and goals. These choices include:
Balanced funds
These funds, also known as hybrid funds, are a combination of stock and bond funds. Balanced funds seek high total return by investing in a mix of equities, fixed-income securities and money market instruments. Unlike flexible portfolio funds, these funds are required to strictly maintain a precise weighting in asset classes.
Money market funds
Money market funds typically invest in short-term government and company loans, which, while lower-yielding, are generally less risky than many other types of funds. Money market funds can be appropriate for investors who:
o Need access to their money in the near future
o Are looking for a current short-term rate of interest
o Are very conservative in their investment approach
An investment in a money market fund is not insured or guaranteed by the Federal Deposit Insurance Corporation (FDIC) or any other government agency. Therefore, while the fund seeks to preserve the value of your investment at $1 per share, it is possible to lose money while investing in the fund.
Classification of class shares
When you invest in a mutual fund, you purchase a share of that fund. There are different share classes in which you can invest, the most common of which are class A, B and C shares. Share classes vary mainly in the type of sales charge and expenses you incur. The best share class for you depends on a number of factors, including the amount you plan to invest and how long you plan to hold the shares.
Share types
o Class A shares have a front-end sales charge you pay at the time of purchase and is deducted from your investment amount.
o Class B shares typically do not have an up-front sales charge. Instead, a class B share has a contingent deferred sales charge (CDSC) that declines each year until it eventually expires. Once their CDSC expires, Class B shares convert to Class A shares.
o Class C shares do not have an initial sales charge. Rather, they also have a contingent deferred sales charge-typically 1% if shares are sold within the first year. They do not convert to Class A shares and have an ongoing, higher management fee.
Operating expenses
All mutual funds have operating expenses that may include management fees, distribution fees or 12b-1 fees and shareholder mailings, among other expenses. You do not pay for these directly. Instead, they are deducted from the fund’s net assets-or the overall return of the fund. For more information on a fund’s fees and expenses, refer to the fund prospectus.
A fund’s total expense ratio is the combination of the different operating expenses, such as advisory fees, distribution fees and ongoing fees. The fund’s expense ratio is a means to compare its cost to that of other funds and to learn about the fund’s fees and expenses.
Shareholder fees include any commissions paid to brokers when shares are bought or sold. These commissions are often described as “front-end loads” (sales charges when you buy) or “back-end loads” (sales charges when you sell). No-load funds, as the name implies, do not have front-end or back-end sales charges, but generally do have operating expenses and shareholder fees.
Taxes
Each year, mutual funds outside of an employer tax-qualified plan must distribute substantially all of their income and capital gains to shareholders. As a result, shareholders of a mutual fund generally must pay income taxes on dividends and capital gains, if any. Each fund provides an IRS Form 1099 to shareholders annually to summarize the fund’s dividends and capital distributions. Then, when a shareholder sells shares of a fund, the shareholder will realize either a taxable gain or a loss.
Determine your financial objectives
Choosing the type of investment that is right for you depends on your financial goals. Are you saving for college or your retirement? Do you need stable income or can you afford a longer-term investment with greater historical risk, but potentially higher returns? Before investing in a fund, carefully review the fund’s investment style, performance history and expense ratio, and consider your time horizon and level of risk tolerance.