Mutual Funds: An Introduction

A mutual fund is a pool of money, supplied by investors like you, that is usually invested in stocks, bonds, and/or money market instruments. Each fund has a professional manager or a team of managers making day-to-day and minute-by-minute buy and sell decisions.

By pooling your resources with other investors in a mutual fund, you can reduce - but not totally eliminate - risk. If you further diversify by purchasing shares of more than one type of mutual fund, your risk is reduced even more. Also, since fund managers buy and sell large blocks of securities, the costs are often lower than what you would pay on your own.

Some fund companies will sell shares directly to investors. Others are sold through brokers, online brokerages, banks, financial planners, and insurance agents who are registered to sell mutual funds. In most cases, you can sell your mutual fund shares at any time, but certain withdrawal charges may apply. Generally, mutual funds are considered long-term investments (five or more years).

Good Reasons to Invest in Mutual Funds

• Professional managers have more experience than the average investor and managing the fund is their job.
• A variety of funds are available, including stock, bond, and money market mutual funds.
• Funds, while riskier, may provide more growth than fixed rate instruments. Mutual funds, however, are not federally insured and may lose value.
• You won't have all your eggs in one basket. Mutual funds are diversified (i.e., they represent a wide variety of investments) to help protect against the failure of one of the underlying securities. Keep in mind there is no guarantee that a diversified portfolio will outperform one that is not diversified.
• Most mutual funds are liquid, meaning they are easily turned into cash. You can arrange to sell your shares at the current Net Asset Value (NAV), which is the daily market value of the fund's total investment portfolio divided by the number of outstanding shares.

Drawbacks to Mutual Funds

• Funds are not risk-free. It is possible that you could lose money since mutual fund shares are usually shares in stock and/or bond portfolios and are not guaranteed.
• Distributions are taxable. You will owe taxes on any dividend or capital gain distributions from the fund portfolio in the year they are received - even if the distribution is reinvested.
• There are fees and expenses. Most fund companies impose sales charges, called "loads". Other charges, like redemption fees; advertising and distribution fees (see page 3); low-balance account fees; and custodial bank fees can also be imposed. Check with the fund company to find out what kinds of fees you can expect.

How Mutual Funds May Help You Make Money

Capital appreciation occurs when you sell shares for a price higher than you paid for them. The profit you realize is called capital appreciation.

Dividends are a payout of a portion of a company's earnings to stockholders. Mutual fund earnings come from dividend-paying stocks and income-producing bonds held in the fund's portfolio. As a shareholder, these dividends are passed on to you. You may reinvest dividends or receive them in cash.

Capital gain distributions. When stock in a fund portfolio is sold at a gain, the profit is passed on to fund shareholders as a capital gain distribution. As with dividends, you may either reinvest the distribution or receive it in cash.

Before deciding to invest in mutual funds, ask yourself:

Are you prepared to make a long-term investment? Allowing your money to work for five or more years takes patience and discipline, but historically, mutual funds have rewarded those who exercise both. If you think you'll need your money within a relatively short time, consider investing in a money market or other low-risk fund.

How much risk can you comfortably tolerate? Mutual funds have varying degrees of risk and fluctuate in value daily. Don't choose a fund if the manager's investment strategy will make you uncomfortable.

What are your investment goals? A comfortable retirement? A child's college education? Are you simply trying to build wealth? Mutual funds are excellent vehicles for all three, but you would probably choose different funds to accomplish each of those goals.

Are you willing to keep learning and give your portfolio a regular checkup? Even though a professional will be managing your money, you need to keep track of how the fund is performing. You can check a fund's net asset value (NAV) in the financial section of major newspapers or online. When you have questions about a fund, contact the fund company for answers.

Fund Categories

The vast majority of mutual funds are open-end funds, meaning there is no predetermined limit on the number of shares the fund can issue. The more money investors put into the fund, the larger it grows, and the more shares it issues. The price of each share is based on its net asset value (NAV). You can liquidate your shares at any time.

Closed-end funds offer a fixed number of shares. Once sold, these shares are usually publicly traded on the nation's stock exchanges and cannot usually be redeemed by the fund company. The value of shares is determined by supply-and-demand forces of the marketplace, as well as by the value of the fund portfolio.

There are thousands of funds in the marketplace today, so how do you narrow the choices? Start by identifying the type of fund you might need. Most funds fall into at least one of the following categories:

Money market funds are typically invested in short-term instruments, including CDs and treasury bills and bonds. They offer the lowest potential for return but they also offer the least risk.

Generally, money market funds are appropriate for investors who want to stay out of the market for a time or for individuals who might need the money in a short time and want to avoid greater risk. Money market funds are typically offered at $1.00 per share.

^{An investment in a Money Market Portfolio is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although a money market fund seeks to preserve the value of your investment at $1.00 per share, it is possible to lose money by investing in a Money Market Portfolio.}

Bond funds are also called fixed-income funds . These funds are typically invested in government and/or corporate bonds. Funds that are invested in state or local government bonds may offer some income that is exempt from income tax. Corporate bond funds may be invested in bonds from companies across the country or around the world. In general, funds holding bonds with longer average maturity periods have both higher yield and higher risk than funds with a shorter average maturity. Bonds, and therefore bond funds, are highly sensitive to interest rate fluctuations. Typically, bond funds are considered low-to moderate-risk investments, with a few in the high-risk category.

Independent agencies such as Standard & Poor's and Moody's rate bonds in the marketplace according to default risk. While scales differ, ratings generally run from AAA (high quality) down to C (lowest quality) or D (in default). Examine the ratings of the bonds in any fund you are considering for investment.

Stock funds, also called equity funds , are usually invested in various publicly traded stocks. Risk levels vary. Some of the more common stock funds include:

• Index funds : These funds attempt to mirror the performance of stock market indexes, such as the Dow Jones Industrial Average or the Standard & Poor's 500 Composite Stock Price Index (S&P 500). The S&P 500 is comprised of 500 blue chip stocks and is widely considered the benchmark against which stock mutual fund portfolio managers compare their performance. The Dow tracks the movement of 30 of the largest blue chip stocks traded on the New York Stock Exchange. Although you can't invest directly in an index, these funds generally invest in the same stocks tracked by one of these indexes and, consequently, closely match the performance of that index. Investing in an index fund reduces the risk that a portfolio manager will make poor investment decisions. Also, since these funds require little management and a lower turnover rate, both fees and capital gains distributions are lower. The downside to these funds is that they're managed for average performance, so they rarely perform significantly better than the market in general.
• Growth and income funds are generally comprised of investments in companies with a solid dividend payment record (to provide income) that are believed to have growth potential. The earnings of these companies, and therefore their values, are expected to increase. Growth and income fund investments span a broad range of industries. These funds are designed to help you hedge your bets - even if the share price falls, your loss may be offset by dividends. Growth and income funds fall in the middle of the risk spectrum for stock funds.
• Growth funds usually invest in companies believed to have better than average growth potential. The earnings of these companies, and therefore the values of their stocks, are expected to increase. These funds are invested in a broad range of industries. Growth funds are considered higher risk than growth and income funds. Expect significant fluctuation in share price.
• Value funds are funds that invest in undervalued stocks and wait for the market to recognize their value. Fund managers generally select undervalued stocks from several market sectors. These funds are for long-term investment; it may take years for value funds to realize their worth. Value funds have both high-risk and high-return potential.
• Balanced funds are invested in both stocks and bonds. Compared to stock-only funds, these funds provide diversification with potentially lower risk as well as potentially lower returns.
• International funds are invested in stocks or bonds of non-U.S. companies. Included in this group are global funds, which invest in both domestic and international markets, in one or more sectors. Investors in these funds are taking on a high degree of risk, since funds' holdings can be affected by political unrest or currency devaluation in a foreign country. Often, international funds are invested in companies from countries that are considered emerging markets, where business is rapidly developing (e.g., Latin America). The potential risks are very high, as are the potential rewards.
• Specialty or sector funds are invested in a specific market sector such as utilities or health care stocks, or in specific commodities such as gold or natural gas. Because they are so limited in scope, the risks can be very high.

All charges, fees and expenses are outlined in a fund's prospectus - a legal document that provides detailed information about the fund's investment strategy, fee structure, and operations. Mutual fund companies are required by law to provide you with a prospectus before you invest. Read it carefully before investing.

• Load vs. no-load funds. The price of most mutual funds includes a sales charge, known as a load, which is used to pay a commission to the broker/dealer or registered representative selling the fund.
• No-load funds are sold without a sales charge. In general, the mutual fund company, without a broker or salesperson as intermediary, sells them directly to you. These funds may, however, charge fees for marketing and administrative costs. Additionally, no-load funds may be subject to online transaction fees/commissions.
• A front-end load is an initial sales charge, usually a percentage of your investment, which is assessed when you purchase shares of the fund. Front-end loads generally range from two percent to eight percent of the amount invested.
•  A back-end load is one charged when you redeem shares. This deferred sales charge decreases each year you hold your shares, typically from five percent in year one to zero percent in year seven or eight and thereafter. The intent is to encourage you to hold your shares longer. Note that while most mutual funds either charge front-end load or a back-end load, some funds charge both, although they tend to be smaller fees.

All mutual funds charge management and administrative fees that are used to pay the salaries of the fund managers and staff; expenses such as telephone and postage costs; and legal costs. More aggressive and actively managed funds carry higher fees than do minimally managed funds such as index funds. International funds typically have higher expenses as a result of the increased cost of doing business in foreign countries. These fees vary. They can be significant; it is wise to consider them when choosing a fund.

Each year your mutual fund company will send you a summary, detailing any dividend and/or capital gain distributions you have received. Bear in mind that taxes on all fund earnings must be paid in the year in which they are earned, whether they are credited to your account or paid to you in cash. Taxes assessed on earnings or gains from mutual fund investments can be complicated. You would be wise to consult with a tax advisor for information regarding your personal tax situation.

Some possible federal tax implications are outlined below.

• Short-term capital gains distributions occur when the fund manager sells securities held in the portfolio for one year or less. These distributions are taxed as ordinary income in the year they are received, regardless of whether the distributions are reinvested in your account or are paid to you in cash.
• Dividend (qualifying) distributions are taxed as long-term capital gains as of January 1, 2003 through December 31, 2008. Long-term capital gains are gains realized when securities are sold after being held in the fund for longer than twelve months. The tax rates for these gains will vary depending upon your tax bracket.

Bear in mind that you can minimize taxable capital gains distributions by investing in funds with low turnover - ones where the manager does not actively buy and sell stocks on a regular basis, but instead uses a buy-and-hold strategy (e.g., index funds).

Profits from selling your mutual fund shares will be taxed at the applicable capital gains tax rate (i.e., long term or short term). Note that transfers of shares between funds in the same family - for instance, from a growth fund to an income fund - are considered a sale of one fund and a purchase of another for tax purposes. Accordingly, you are liable for taxes on gains from the sale of both the first and the second fund.

How much you owe in taxes after you sell shares will be determined, in part, by the difference between what you paid including all fees and what you sold your shares for. This is called the cost basis. Often, the company will provide you with a year-end cost-basis statement. Because there are different ways to determine cost basis, it is wise to consult an accountant or tax advisor when considering the sale of mutual fund shares. Your personal tax circumstances and other factors may dictate a specific manner of cost basis calculation.

The following questions will help you make an intelligent choice.

How long has the fund's management team been in place? How much experience do they have? This information is in the fund’s prospectus and sales literature. If you don't see it, call the company or sales representative and ask. Look for teams with long and successful track records.

Have I read the prospectus thoroughly? Although the language may be dry and technical, don't get discouraged. You need to know the minimum investment, fees and expenses, and investment strategies and risks. When you invest, the fund company will assume you have read and understood the prospectus, so the time to ask questions is before you invest.

Do the brokers or customer service representatives answer my questions clearly? Are they easy to work with? Does the fund company make educational resources available to me? Is the company's service helpful and courteous? A good working relationship will help you feel comfortable with your investments.

Are the expenses reasonable? Cheaper isn't always better, but high management fees or loads can erode your profits.

What is the past performance of this fund? Don't be swayed by last month's hot fund. Check on how the fund has fared in both up and down markets. Look for funds that have performed well over a long period of time - a minimum of three to five years - bearing in mind that past performance is not a guarantee of future performance.

Does the company offer financial-planning services? Some companies offer one-on-one advice from a financial planner or registered representative. If you don't need assistance, consider no-load funds that you buy directly from the fund company.

Don't Forget...
There are no guarantees when investing in mutual funds. Shop wisely and use careful judgment. Get professional advice if you feel you need it. Become an educated consumer. You can learn a great deal from reading investment books, investment magazines, and newspapers. Annual and semi-annual fund reports are available online, at the library, or directly from the company. And, of course, before you invest in any mutual fund you need to read the fund's prospectus and ask the company for a Statement of Additional Information (SAI or Part B of the prospectus) if you want more in-depth information.

Reference

Common Sense on Mutual Funds
by John C. Bogle & Peter L. Bernstein
Published by John Wiley & Sons

Free Publications

The quarterly Consumer Information Center Catalog lists more than 200 helpful federal government publications. Obtain a free copy by calling 888-8-PUEBLO; on the Internet at www.pueblo.gsa.gov, or by writing:
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Websites

Mutual Fund Education Alliance
www.mfea.com
This site offers information and strategies for investing in mutual funds.

Investment Company Institute
www.ici.org
Find investing news, statistics and research on this website.

U.S Securites and Exchange Commision
www.sec.gov/investor/pubs/inwsmf.htm
This SEC brochure, An Introduction to Mutual Funds, explains the basics of mutual fund investing.