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Basic Finance Bootcamp Lesson 8: Introduction to Mutual Funds

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There is more to mutual funds than meets the eye. I think you’ll enjoy this session of the basic finance bootcamp as I give you an introduction to mutual funds. You will want to use this post next time you’re thinking about investing in them. It will serve as a nice checklist for things you should be looking at.

Investors can also choose to invest their monies through mutual funds.  A mutual fund is an investment company that pools the money of all of its investors and invests in a variety of securities in accordance with a stated investment objective.  When you buy shares of a mutual fund, you are a proportionate owner of the securities in which the fund invests.  If the companies in which the fund invests perform well, the value of the debt and equity securities issued by the companies will increase, which, in turn, will increase the value of the shares you own in the fund.

Types of funds

Bond funds invest in a variety of corporate and government bonds, while U.S. government bond funds invest only in Treasury securities and bonds issued by federal government agencies. Municipal bond funds invest in bonds of state and local governments—and the federal tax-exempt status of the interest income is passed through to fund investors.  You can even find a municipal bond fund that invests only in municipal bonds issued by the state in which you reside, which means you will be exempt from paying both federal and state income tax on the interest income generated by that fund.  Money market mutual funds invest only in short-term debt instruments—i.e., debt that matures 12 months or less from original issue, such as Treasury bills and commercial paper, which is short-term debt issued by large, credit-worthy corporations.

Growth funds invest most heavily in common stock of U.S. companies. Aggressive growth funds seek to invest primarily in domestic stocks with extreme growth potential, which are generally small stocks. Global and International stock funds invest a large percentage of their funds in non-U.S. stocks.  Some funds target the stocks of a single country, like the Japan Fund offered by the Fidelity family of funds.

Income funds seek to maximize current income (i.e., dividends and interest) and, therefore, divide a large percentage of their funds in bonds and preferred stocks. Balanced funds strive for what their name implies—a balance between income, capital preservation, and growth.  These funds invest in bonds and preferred stock, too, but also invest in common stocks of companies that the fund manager(s) believe will grow and produce large capital gains via price appreciation.

You can find a statement of the investment objective of a fund in the fund’s prospectus, which is a document that is required to be supplied to all prospective fund investors.  In fact, you’ll find this statement on the first page of the prospectus, along with summary tables of the fees and expenses associated with investing in the fund.

Fees and expenses

There are two types of mutual funds:  load funds and no load funds.  Load funds either charge a fee when you purchase the shares (a front-end load) or when you redeem them (a back-end load or deferred sales charge fee).  This money is used to pay a commission to the representative who sells you shares of the fund and will reduce your return on investment.  For example, if you write a check for $5,000 to a fund that charges a 5% front-end load, $250 of that will go to pay the commission; thus, you will actually be investing only $4,750.  If you invest $5,000 in a no load fund, the full $5,000 is invested.

The maximum load that can be levied is 8.5%, and some rear-end loads are “contingent,” meaning that the percentage charged depends on how long the investor has held the shares.  The longer the holding period, the lower the deferred sales charge.  All this is spelled out in the prospectus.

Some no load funds might charge a redemption fee to cover bookkeeping costs when shares are sold.  This is not defined as a “load,” however, and the maximum redemption fee allowed is 2%.  Another fee you might see listed is an exchange fee.  This is a fee charged if you exchange some or all of your shares in one fund for another fund offered by that family of funds.  For example, if you own shares in the International Stock Fund of a fund family (e.g., Fidelity, Vanguard, Dodge and Cox, etc.) and want to sell some of those shares and invest in the Balanced Fund of that same fund family, you might have to pay an exchange fee to do so.  This being said, most companies allow a certain number of free exchanges per year.

As with any company, mutual funds have annual operating expenses. These are expressed as a percentage of the average net assets of the fund and will appear in a table directly below the fees table.  They may include management fees, 12b-1 fees–which are used to cover marketing and advertising expenses incurred by a no load fund–and that age-old catch-all category, “other expenses,” which includes such items as legal fees and custodial fees paid by the fund.

The operating expense ratio of the fund is the sum of these annual operating expense percentages.  Obviously, the higher the operating expense ratio, the lower the profit for the shareholders of the fund, all else equal.

Buying shares of a mutual fund

As with all investments, the type of fund(s) in which an investor should choose to invest will depend on his or her personal investment objectives and constraints.  Once you decide on the fund category (i.e., balanced, growth, etc.), you can obtain prospectuses for funds in that category from several different families of funds, compare their fees, view their historical return records (a caveat:  historical returns are not indicative of future returns) and learn more details regarding the types of securities in which the fund invests and the specific risks involved in those types of investments.

You will also find other important information in the fund prospectus, including the minimum initial investment required, if any, and whether this is waived if you sign up for the fund’s automatic investment program.

You might find Yahoo’s fund screener particularly helpful.  You can enter a fund category, a maximum initial investment amount, a maximum expense ratio, and/or several other characteristics and see a list of funds that meet your chosen criteria.  This fund screener can be accessed at http://screener.finance.yahoo.com/funds.html.

You can obtain a copy of the prospectuses of many mutual funds through Yahoo as well.  Or simply contact the fund directly:  Google the name of the fund family, find the specific fund, and you will usually be able to download a copy of the fund prospectus.  If not, you will find contact information on the fund family website. You might also get a copy of the prospectus through your broker if the fund is one that the brokerage firm handles.

Once you decide to invest in a specific fund, you can do so directly through the fund or by utilizing the services of your broker—again if your broker has an agreement with that fund family.  Mutual funds differ from individual stocks and bonds in that, regardless of whether you contact the fund or use the services of your broker to invest in the fund, you will be buying the shares from the fund directly.  The same goes for when you want to sell the shares.  You will be selling the shares back to the fund itself.  The shares are not bought and sold on exchanges, and unlike the prices of stocks and bonds, the price you pay is not determined by supply and demand.

The price at which you will buy or sell your mutual fund shares is determined by something called the net asset value of the fund.  The net asset value per share is simply the value of all the assets of the fund—i.e., the value of the securities in which the fund has invested its shareholders’ monies–minus any liabilities the fund has, divided by the total number of shares.  If the fund is a no load fund, or has no front-end load at least, you will purchase these shares for the net asset value, as calculated at the end of the day on which you place your order to buy.  If the fund has a front-end load, you will pay net asset value plus whatever the sales charge happens to be.

Similarly, when you want to sell your mutual fund shares, you won’t know exactly what price you’ll receive until the net asset value of the fund is calculated at the end of the day.  If the fund has no rear-end load or redemption fee, you will receive net asset value for your shares.

If you choose to execute the transaction through your broker, ensure that the brokerage firm does not charge a commission for handling the purchase or sale.  Some firms have a list of mutual funds that they handle at no charge, another list for which they charge a fee, and a third list, which are mutual funds that they don’t administer at all.

Now you know at least 10 times more about mutual funds than most people. If you have any questions or comments, please ask below. Otherwise, stay tuned for tomorrow’s bootcamp AND don’t forget to sign up for the newsletter.

Also, if you think these posts are helpful, be kind to your friends, colleagues, or classmates and spread the word. You will be doing them a favor.