Mutual Fund Investing

Printable PDF Version (12 pages)

Contents

What Is a Mutual Fund?
Why Mutual Funds versus Individual Securities?
Mutual Funds: 10 Advantages
Mutual Fund Disadvantages
The Mutual Fund Marketplace
Worksheet 1: Mutual Funds with a Growth Objective
Worksheet 2: Mutual Funds with an Income Objective
Worksheet 3: Mutual Funds with Both Growth and Income Objectives
Worksheet 4: Mutual Funds with a Preservation of Capital Objective
Worksheet 5: Mutual Funds with All Four Objectives
What Mutual Funds Cost and Where To Buy Them
Putting It All Together: How To Find the Right Mutual Fund
Summary
Action List
Risk Return Chart

One of the most popular investment choices today is mutual funds. In 1979 mutual fund industry assets totaled $56 billion. By early 1999 they stood at $5.5 trillion! Almost 600 new mutual funds were created in 1998 alone, bringing the total to about 7,400 funds (more than 12,000 if you count different share classes) offered by about 500 different mutual fund groups.

According to the Securities and Exchange Commission (SEC), the number of American households that own mutual funds rose from one in 18 in 1980 to one in three by 1997. Yet, a survey conducted by the Investment Company Institute, the mutual fund industry’s trade group, shows that most investors do not understand what they own or how their funds work, although more than 77 million Americans own mutual funds.

Almost everyone has a need to learn the basics of mutual funds. Some might need to know how to choose investments for a 401(k) or other retirement plan; others, how to invest money received from an insurance or divorce settlement. Many people just want to know how to get started as investors. Still others own a hodge-podge of funds bought at various times without much thought as to how they complement each other. Getting a year-end bonus, a tax refund, or reading that a popular fund is about to close also prompts many would-be investors to buy funds.

An individual’s investment portfolio should be more than just a collection of mutual funds. Before you select funds to invest in, you will want to determine your investment goals, your time-frame for needing the money, and the amount of risk you are willing to take. This publication will help you learn how to invest in one of the best investment vehicles ever created. One of the top reasons for learning about mutual funds is that you can save money if you choose the funds and maintain your portfolio yourself.

What Is a Mutual Fund?

A mutual fund is a portfolio of stocks, bonds, or other securities. It is collectively owned by hundreds or thousands of investors and managed by a professional investment company. The shareholders are people who have similar investment goals. Each criterion is spelled out in a prospectus, the official booklet that describes a mutual fund. Investors then know what they are getting and can match their objectives to a fund. The pooled money has more buying power than one investor alone, so a fund can own hundreds of different securities. Thus, its success does not depend on how one or two companies perform.

A mutual fund makes money in two ways: by earning dividends or interest on the investments it owns and by selling securities that have appreciated in value. You, in turn, make money in the form of dividends and interest passed on to you and from the increase (or decrease) in the fund’s value. The mutual fund manager keeps constant watch on financial markets and adjusts the portfolio to achieve the strongest returns. Because you own part of a fund, the hard work of selecting and monitoring stocks and bonds is done for you.

The majority of mutual funds available are open-end funds. Open-end funds can have an unlimited number of investors or money in the fund. Managers of closed-end funds decide up front how many shares they will issue and when they will sell them. The only way to purchase shares in a closed-end fund, once the original shares have been sold, is to buy them from someone who currently owns shares in the fund. Occasionally open-end funds can and do close to new investors, often because of high cash inflows that cannot be invested in a timely manner. They do not become closed-end funds, however, because current shareholders can still buy additional shares from the fund company.

When investors purchase a mutual fund, they own a piece of an investment portfolio. They share in the gains, losses, and expenses in proportion to the amount they have invested in the fund. At the close of every trading day, a mutual fund company tallies the value of all the securities in its portfolio and deducts its expenses (such as management fees, administrative expenses, advertising costs). The balance is divided by the number of shares owned by shareholders to arrive at the dollar value of one share of the mutual fund. This value, the net asset value, or NAV, is the price your fund pays you per share when you sell.

Open-End Fund
An investment company that continually buys and sells shares to meet investor demand. It can have an unlimited number of investors or money in the fund.

Closed-End Fund
An investment company that issues only a certain number of shares that can be bought and sold on market exchanges.

Why Mutual Funds versus Individual Securities?

For most people, mutual funds should be a major part of their investment portfolio–unless they have a lot of money and ample time to devote to investing in individual securities. While there are arguments for buying stocks and bonds directly, consider buying mutual funds first, or at least use them as a core holding, because of the following drawbacks to individual stock and bond picking and trading:

• First, a great deal of time and expertise is required to analyze a company–-its prospects for earnings growth, its performance over the short and long term in comparison to its competitors, its debt level and credit worthiness, its plan for new products, and technological changes looming that might harm or improve business.
• Second, purchasing individual securities involves higher transaction costs, though competition and online trading have significantly reduced the cost of buying and selling stocks.
• Third, owning individual stocks means you are less likely to have proper diversification. To diversify a stock portfolio, you need to own at least 10 different companies in different industries, which could cost thousands of dollars. For the same price you might pay for 100 shares of one security, you can buy shares in a fund that owns 100 securities. Diversification lowers your investment risk–if one or two stocks plunge, others may gain in value, offsetting the loss.

Nevertheless, there are several circumstances when you do not need mutual funds:

• If you are skilled at picking individual stocks
• If you have at least $20,000-50,000 to buy at least 10 to 20 stocks (depending on stock prices)
• If you plan to invest in Treasury bills, notes, or bonds.

In the last case, you would do better purchasing Treasury bills, notes, or bonds directly through the Federal Reserve’s Treasury Direct program (www. publicdebt.treas.gov).

Mutual Funds: 10 Advantages

1. You get full-time, professional money management. Most people do not have the time or skill to select and monitor individual stocks and bonds.
2. You reduce risk through diversification because a mutual fund owns many stocks or bonds. You can also pick your level of market risk by choosing particular types of funds (such as money market funds to ensure your principal will not drop in value, bond funds if you want current income and some stability in your portfolio, stock funds if you want your money to grow over the long term.)
   
3. You will earn competitive returns on your investment. Mutual funds can give the kinds of returns you need to reach your goals. In fact, by choosing an index fund (a fund that invests in securities of one of the broadly based market indexes such as Standard and Poor’s 500), you can expect to match the market’s performance, minus the expenses of running the fund. This is an assurance that no other investment can provide.
4. You don’t need a lot of money to get started. Many funds require only $1,000 to open an account, and some funds require minimum initial investments as low as $250 to $500. Later deposits can be as small as $25 to $100 if you use an automatic investment plan (AIP). AIP is an arrangement whereby you agree to have money automatically withdrawn from your bank account on a regular basis (such as once a month or every quarter) and used to purchase fund shares.
5. You retain ready access to your money. A mutual fund is required to buy back your shares, which makes withdrawals easy. Your check will be mailed within seven days of the request at the closing price (NAV) on the day it is received.
6. Mutual funds are a cheaper way to get the investing job done. The shareholders share research and operating costs. The most efficiently run funds have an expense ratio (the percentage of fund assets deducted for management and operating expenses) of less than 1% a year. Some well-established funds charge annual fees as low as 0.2% to 0.5%. Sales fees vary, but many funds are sold directly through their sponsors with no sales charge–-known as “no-load” funds. Funds that charge a sales commission are called “load” funds.
7. Mutual funds are convenient. You can buy (and sell) them directly from a mutual fund company by mail and by telephone and from full-service brokers, financial planners, banks, or insurance companies.
   

   Important note: When mutual funds are purchased from banks, they are not insured by the FDIC like other bank products.

   In addition, some discount brokers have established mutual fund “supermarkets” where investors can own funds from many different fund families in one consolidated account without any sales charges or transaction fees. You can also reinvest earnings from mutual funds in additional shares. Reinvesting and compounding are keys to building wealth.
8. Automatic withdrawal plans are available, making it possible to have a steady stream of income for retirement (for example, withdrawals of $250 per month).
9. Mutual funds have less risk of bankruptcy or fraud because they are highly regulated by the federal government through the Securities Exchange Commission (SEC), which is charged with assuring that mutual funds and investment advisors follow specific rules of disclosure.
10. Monitoring mutual funds is simple. Prices are reported daily in the financial section of many newspapers, and more in-depth information is available in the Sunday business sections.

Mutual Fund Disadvantages

1. If there is a broad market drop, your fund’s value will dip with it. The diversification of most mutual funds protects you when one or several securities fall but not when the whole market takes a downturn. The fact that funds can fluctuate up and down, sometimes wildly, is par for the course and should not deter you from investing or scare you out of the market.
2. There is no guaranteed rate of return with mutual funds as there is with CDs and Treasury securities. Since risk is higher, the likelihood of greater earnings is increased. You must also expect investment performance to fluctuate.
3. Unwanted taxable distributions can also be a disadvantage. Funds are required to pay out 98% of their dividends, interest, and capital gains annually. You must pay taxes on these distributions, even if you never received them but instead reinvested them in additional shares. Unfortunately, sometimes you can also owe taxes even if your fund lost money for the year.
4. Distributions are not currently taxable if the mutual fund is held in a tax-deferred account such as a 401(k) or IRA. Taxes are paid as distributions are made from the retirement account.
5. Record-keeping for tax purposes can be hard work. Investors who are not meticulous about keeping track of fund purchases and sales may end up paying higher taxes than they actually owe at the time of sale because of a miscalculation of their cost basis. This is the amount of your original deposit plus additional contributions and reinvested dividends and capital gains. The amount of taxes you pay will vary depending on how you calculate your gain or loss (for example: average price; first-in, first-out; or specific identification tax accounting methods). Thus, it is important to keep every annual statement for as long as you own the fund.

The Mutual Fund Marketplace

Mutual funds fall into three main categories:

• Stock (investing primarily in stocks)
• Bond (investing in debt issues)
• Money market (investing in short-term cash assets)

All are established to achieve one of the following investment objectives:

• Growth
• Income
• Growth and Income
• Preservation of Capital

A mutual fund’s stated objective might read something like, “This fund seeks capital appreciation,” meaning it is appropriate for investors who want to grow their money over the long term. Or it could state, “This fund seeks current income,” indicating that the fund should be considered by investors who need a regular stream of income from their investments. The way these objectives are to be accomplished is outlined in the fund’s prospectus and is the responsibility of the professional money manager hired by the mutual fund company.

To be a successful investor, you must match your objectives to that of the fund (such as long-term growth for retirement in 15 years). Equally important is matching the fund’s risk level to your own risk tolerance. Use the worksheets on the next pages to find the appropriate funds for your goals and objectives. Then match your risk preferences to the risk scale. The worksheets break down mutual fund types by their basic investment objectives. Use them to help you match your goals with the appropriate funds. Examples for each category are provided. Any of the sample objectives could be met by any of the mutual fund types in each category. Write in your goals in the space provided on the right under “Match Your Objectives” in each chart.

What Mutual Funds Cost and Where To Buy Them

What you pay to purchase or sell a fund, as well as the on-going fund operating expenses, affects the rate of return on your investments. Generally, there are four categories of expenses–direct sales commissions, management fees, marketing costs, and overhead expenses.

Mutual funds come in two types: load and no-load. Load funds carry an up-front sales charge of 4% to 8.5% of the amount invested for “Class A” shares and are bought from a stockbroker, commission-based financial planner, and others who earn their livings on sales commissions. A mutual fund is considered low load if it carries a smaller up-front sales charge of 1% to 3%. Some funds charge a back-end load, also known as a “contingent deferred sales charge” (CDSC). You don’t pay a sales fee to get into the fund, but you will have a sales charge on the way out if you sell early. These funds, commonly called “Class B” shares, were created to combat the negative image of up-front loads. Typically, the charge declines 1% each year until it disappears after the fifth or sixth year. However, management and marketing fees are usually higher on this version of a load fund. Try to avoid this arrangement if you don’t know how long you will hold the fund.

No-load funds, on the other hand, require no up-front fees to purchase shares. Investors deal directly with the fund company, a mutual fund supermarket (such as Charles Schwab, Waterhouse), or a fee-only financial planner, rather than with a broker.

Some load and no-load funds also have redemption fees to discourage investors from moving in and out of certain funds too frequently. Both no-load and load funds charge annual money management and administrative fees expressed as a percentage of the assets in the portfolio. These costs, in addition to the marketing/advertising fees, called a 12b(1) fee, make up a fund’s expense ratio. The 12b(1) fee pays for advertising and distribution costs, as well as broker compensation. Deducted from shareholder assets, 12b(1)fees can range from 0.1 to 1.00%, and every shareholder pays a prorated share. Typical expense ratios, which can include a 12b(1) fee, range from 0.5% to 2% of fund portfolio assets.

Generally, no-load funds have lower fees than load funds, resulting in lower expense ratios. However, there is an exception–”Class C” shares–another version sold by a broker that has no sales charge but has a higher 12b(1) and management fee than either Class A or B shares. All things being equal, low cost funds will net you higher returns than high cost funds. Costs matter!

Putting It All Together:
How To Find the Right Mutual Fund

Now that you are familiar with the various types of mutual funds, here are some specific guidelines for picking them.

Step 1. Identify the types of funds you need (for example, growth) to reach your goals.

Focus your search on a specific type of fund with a specific investing objective first. Eventually your goal should be to build a portfolio that includes both stock and bond funds with various investment objectives and investment styles for greatest diversity. This process involves assigning appropriate percentages of your total investment portfolio, no matter the size, to interest-earning (income) and stock (growth) investments. You can purchase them gradually, perhaps starting out with a balanced fund, an asset allocation fund, a lifestyle fund, or a broad-based index fund such as a “total stock market” fund. The latter tracks 7,000+ large, medium, and small U.S. companies and is offered by fund families like T. Rowe Price, Vanguard, Fidelity, Charles Schwab, and others.

Step 2. Read and learn.

Visit the library or buy some books on mutual fund investing that will build on what you have learned from this publication. Some useful references are Mutual Funds magazine, Mutual Funds For Dummies by Eric Tyson (IDG Books, 1995), Guide to Successful No-load Fund Investing by Sheldon Jacob (Irwin, 1995), and The Right Way to Invest in Mutual Funds by Walter Updegrave (Warner Books, 1996). More advanced books are John Bogle’s Bogle on Mutual Funds (Irwin, 1994) and Common Sense on Mutual Funds (John Wiley and Sons, 1999).

Step 3. Do some research on specific funds.

There are excellent tools to help narrow the list. Personal finance magazines (such as Money, Kiplinger’s Personal Finance Magazine, Business Week and Forbes) publish their “best buy” lists generally twice a year in February and August. Barron’s and The Wall Street Journal publish a quarterly Mutual Fund Review that reports on all funds’ categories and objectives, current and past performances, as well as fee structures. Also, the Investment Company Institute (www.ici.org) has excellent, free publications on mutual funds.

Once you spot several funds that have consistently performed well and are aligned with your goals, go to your library’s reference section to complete your research. Rating services such as Morningstar Mutual Funds or Value Line Mutual Fund Survey provide current data on nearly 1,700 mutual funds with a one-page report on each. This makes it easy to review and compare funds you are considering. Look at 3-, 5-, and 10-year periods. Last year’s high flyer could be this year’s dud. Morningstar Mutual Funds is also available in a monthly version, covering 700 no-load and low-load funds. In addition, check out these worthwhile Web sites: www.morningstar.net, www.networth.galt.com, www.brill.com, and Mutual Fund Magazine Online at www.mfmag.com. Some sites charge a fee for online fund reports.

Step 4. Systematically narrow your choices.

You can quickly whittle down the 12,000+ fund list by using a few criteria. For example, suppose you are looking for a stock fund to invest for retirement. Right there, you have cut the number to a little over 5,000 funds by eliminating all the bond and money market funds. Perhaps you will toss out all funds that have a sales commission, all stock funds with an expense ratio over 1.4%, funds that have an investment minimum over $3,000, any fund where the manager’s tenure is less than 5 years, and all funds that have not out performed 60% of comparable funds over the last 3 and 5 five years. Pay most attention to performance, cost to invest, and risk, as you research various funds.

Step 5. Call or write for a prospectus.

A prospectus for a mutual fund is the selling document legally required to be distributed to mutual fund investors. It describes the fund’s investment strategy as well as the risks and costs of an investment.

Step 6. Make your purchase.

While you can always do business by mail, and in some cases, at a local investment center, most mutual fund groups offer a toll-free number for telephone assistance. Of course, if you are buying a fund with a sales commission, the broker or financial planner handles your order.

Step 7. Continually buy more shares.

One of the best ways to grow your investments is to use a dollar-cost averaging strategy. This means buying a set dollar amount of an investment at periodic intervals, usually monthly or quarterly. For instance, $50 per month would be invested in your mutual fund. When the price of the fund is low, your dollars buy more shares. When the fund’s NAV moves higher, you will buy fewer shares. Although dollar-cost averaging does not guarantee you a profit, in most cases your average cost per share will be less than the current price.

Summary

Successful mutual fund investing requires a plan and the discipline to stick to your plan. Mutual funds are a proven winner and one of the best ways for the small investor to build wealth while managing risk. You have what you need to get going. As the NIKE® advertising slogan says, “Just do it.” Start with the action steps on the next page.

Action List

1. List long- and short-term financial goals on the worksheet on pages 4-6 so you can match them with an appropriate mutual fund.
2. Learn about mutual fund investment choices (such as stock funds) available through your employer’s retirement plan (for example, 401(k), 403(b)).
3. Attend an investment seminar sponsored by the Mississippi State University Extension Service or financial services firms.
4. Call the Extension Service for additional personal finance information/fact sheets, etc.
5. Decide on your selection criteria (such as minimum deposit, low expense ratio).
6. Identify specific mutual funds that match your investment goals.
7. Call at least three mutual fund organizations for a prospectus.
8. Read about these mutual funds and mutual funds in general (such as prospectuses, annual reports, books).
9. Use Morningstar or Value Line and compare at least three mutual funds of the same type for performance, cost, and risk.
10. Complete a mutual fund application and make an investment.
11. Track the progress of your fund(s) at least quarterly.

Revised by Jan Lukens, MBA, CFP, AFC, from Mutual Fund Investing by Patricia Brennan, CFP, AFC, CHC of Rutgers Cooperative Extension.

(500-11-00)

Copyright 2001 by Mississippi State University. All rights reserved.

This document may be copied and distributed for nonprofit educational purposes provided that credit is given to the Mississippi State University Extension Service.

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