Mutual Funds

Introduction

Mutual funds are a popular way to invest in securities. Because mutual funds can offer built-in diversification and professional management, they offer certain advantages over purchasing individual stocks and bonds. But, like investing in any security, investing in a mutual fund involves certain risks, including the possibility that you may lose money.

Technically known as an "open-end company," a mutual fund is an investment company that pools money from many investors and invests it based on specific investment goals. The mutual fund raises money by selling its own shares to investors. The money is used to purchase a portfolio of stocks, bonds, short-term money-market instruments, other securities or assets, or some combination of these investments. Each share represents an ownership slice of the fund and gives the investor a proportional right, based on the number of shares he or she owns, to income and capital gains that the fund generates from its investments.

The particular investments a fund makes are determined by its objectives and, in the case of an actively managed fund, by the investment style and skill of the fund's professional manager or managers. The holdings of the mutual fund are known as its underlying investments, and the performance of those investments, minus fund fees, determine the fund's investment return

While there are literally thousands of individual mutual funds, there are only a handful of major fund categories:

  • Stock funds invest in stocks
  • Bond funds invest in bonds
  • Balanced funds invest in a combination of stocks and bonds
  • Money market funds invest in very short-term investments and are sometimes described as cash equivalents

Most fund companies also offer one or more money market funds, which make very short-term investments and are sometimes described as cash equivalents.

You can find all of the details about a mutual fund—including its investment strategy, risk profile, performance history, management, and fees—in a document called the prospectus. You should always read the prospectus before investing in a fund.

Mutual funds are equity investments, as individual stocks are. When you buy shares of a fund you become a part owner of the fund. This is true of bond funds as well as stock funds, which means there is an important distinction between owning an individual bond and owning a fund that owns the bond. When you buy a bond, you are promised a specific rate of interest and return of your principal. That's not the case with a bond fund, which owns a number of bonds with different rates and maturities. What your equity ownership of the fund provides is the right to a share of what the fund collects in interest, realizes in capital gains, and receives back if it holds a bond to maturity.


 

How Mutual Funds Work

If you own shares in a mutual fund you share in its profits. For example, when the fund's underlying stocks or bonds pay income from dividends or interest, the fund pays those profits, after expenses, to its shareholders in payments known as income distributions. Also, when the fund has capital gains from selling investments in its portfolio at a profit, it passes on those after-expense profits to shareholders as capital gains distributions. You generally have the option of receiving these distributions in cash or having them automatically reinvested in the fund to increase the number of shares you own.

Of course, you have to pay taxes on the fund's income distributions, and usually on its capital gains, if you own the fund in a taxable account. When you invest in a mutual fund you may have short-term capital gains, which are taxed at the same rate as your ordinary income—something you may try to avoid when you sell your individual securities. You may also owe capital gains taxes if the fund sells some investments for more than it paid to buy them, even if the overall return on the fund is down for the year or if you became an investor of the fund after the fund bought those investments in question.

However, if you own the mutual fund in a tax-deferred or tax-free account, such as an individual retirement account, no tax is due on any of these distributions when you receive them. But you will owe tax at your regular rate on all withdrawals from a tax-deferred account.

You may also make money from your fund shares by selling them back to the fund, or redeeming them, if the underlying investments in the fund have increased in value since the time you purchased shares in the funds. In that case, your profit will be the increase in the fund's per-share value, also known as its net asset value or NAV. Here, too, taxes are due the year you realize gains in a taxable account, but not in a tax-deferred or tax-free account. Capital gains for mutual funds are calculated somewhat differently than gains for individual investments, and the fund will let you know each year your taxable share of the fund's gains.


 

Active vs. Passive Management

When a fund is actively managed, it employs a professional portfolio manager, or team of managers, to decide which underlying investments to choose for its portfolio. In fact, one reason you might choose a specific fund is to benefit from the expertise of its professional managers. A successful fund manager has the experience, the knowledge, and the time to seek and track investments—key attributes that you may lack.

The goal of an active fund manager is to beat the market—to get better returns by choosing investments he or she believes to be top-performing selections. While there is a range of ways to measure market performance, each fund is measured against the appropriate market index, or benchmark, based on its stated investment strategy and the types of investments it makes.

For instance, many large-cap stock funds typically use the Standard & Poor's 500 Index as the benchmark for their performance. A fund that invests in stocks across market capitalizations might use the Dow Jones Wilshire 5000 Total Stock Market Index, which despite its name measures more than 5,000 stocks, including small-, mid-, and large-company stocks. Other indexes that track only stocks issued by companies of a certain size, or that follow stocks in a particular industry, are the benchmarks for mutual funds investing in those segments of the market. Similarly, bond funds measure their performance against a standard, such as the yield from the 10-year Treasury bond, or against a broad bond index that tracks the yields of many bonds.

One of the challenges that portfolio managers face in providing stronger-than-benchmark returns is that their funds' performance needs to compensate for their operating costs. The returns of actively managed funds are reduced first by the cost of hiring a professional fund manager and second by the cost of buying and selling investments in the fund. Suppose, for example, that the management and administrative fees of an actively managed fund are 1.5 percent of the fund's total assets and the fund's benchmark provided a 9 percent return. To beat that benchmark, the portfolio manager would need to assemble a fund portfolio that returned better than 10.5 percent before fees were taken out. Anything less, and the fund's returns would lag its benchmark.

In any given year, most actively managed funds do not beat the market. In fact, studies show that very few actively managed funds provide stronger-than-benchmark returns over long periods of time, including those with impressive short term performance records. That's why many individuals invest in funds that don't try to beat the market at all. These are passively managed funds, otherwise known as index funds.

Passive funds seek to replicate the performance of their benchmarks instead of outperforming them. For instance, the manager of an index fund that tracks the performance of the S&P 500 typically buys a portfolio that includes all of the stocks in that index in the same proportions as they are represented in the index. If the S&P 500 were to drop a company from the list, the fund would sell it, and if the S&P 500 were to add a company, the fund would buy it. Because index funds don't need to retain active professional managers, and because their holdings aren't as frequently traded, they normally have lower operating costs than actively managed funds. However, the fees vary from index fund to index fund, which means the return on these funds varies as well.

Some index funds, which go by names such as enhanced index funds, are hybrids. Their managers pick and choose among the investments tracked by the benchmark index in order to provide a superior return. In bad years, this hybrid approach may produce positive returns, or returns that are slightly better than the overall index. Of course, it's always possible that this type of hybrid fund will not do as well as the overall index. In addition, the fees for these enhanced funds may be higher than the average for index funds.

 

Fund Objectives

Within the major categories of mutual funds, there are individual funds with a variety of investment objectives, or goals the fund wants to meet on behalf of its shareholders. Here is just a sampling of the many you'll find:


 

Stock funds:

  • Growth funds invest in stocks that the fund's portfolio manager believes have potential for significant price appreciation.

     
  • Value funds invest in stocks that the fund's portfolio manager believes are underpriced in the secondary market.

     
  • Equity income funds invest in stocks that regularly pay dividends.

     
  • Stock index funds are passively managed funds, which attempt to replicate the performance of a specific stock market index by investing in the stocks held by that index.

     
  • Small-cap, mid-cap, or large-cap stock funds stick to companies within a certain size range. Economic cycles tend to favor different sized companies at different times, so, for example, a small-cap fund may be doing very well at a time when large-cap funds are stagnant, and vice versa.

     
  • Socially responsible funds invest according to political, social, religious, or ethical guidelines, which you'll find described in the fund's prospectus. Many socially responsible funds also take an activist role in the companies where they invest by representing their shareholders' ethical concerns at meetings with company management.

     
  • Sector funds specialize in stocks of particular segments of the economy. For example, you may find funds that specialize solely in technology stocks, in healthcare stocks, and so on. Sector funds tend to be less diversified than funds that invest across sectors, but they do provide a way to participate in a profitable segment of the economy without having to identify specific companies.

     
  • International, global, regional, country-specific, or emerging markets funds extend their reach beyond the United States. International funds invest exclusively in non-U.S. companies. Global funds may invest in stocks of companies all over the world, including U.S. companies with global businesses. Regional funds focus on stocks of companies in a particular region, such as Europe, Asia, or Latin America, while country-specific funds narrow their range to stocks from a single country. Funds that invest in emerging markets look for stocks in developing countries.

 

Bond funds:

  • Corporate, agency, or municipal bond funds focus on bonds from a single type of issuer, across a range of different maturities.

     
  • Short-term or intermediate-term bond funds focus on short- or intermediate-term bonds from a wide variety of issuers.

     
  • Treasury bond funds invest in Treasury issues.

     
  • High-yield bond funds invest in lower-rated bonds with higher coupon rates.

 

Other funds:

  • Balanced funds invest in a mixture of stocks and bonds to build a portfolio diversified across both asset classes. The target percentages for each type of investment are stated in the prospectus. Because stocks and bonds tend to do well during different phases of an economic cycle, balanced funds may be less volatile than pure stock or bond funds.

     
  • Funds of funds are mutual funds that invest in other mutual funds. While these funds can achieve much greater diversification than any single fund, their returns are affected by the fees of both the fund itself and the underlying funds. There may also be redundancy, which can cut down on diversification, since several of the underlying funds may hold the same investments.

     
  • Target-date funds, sometimes called lifecycle funds, are funds of funds that change their investments over time to meet goals you plan to reach at a specific time, such as retirement. Typically, target-date funds are sold by date, such as a 2025 fund. The farther away the date is, the greater the risks the fund usually takes. As the target date approaches, the fund changes its balance of investments to emphasize conserving the value it has built up and to shift toward income-producing investments.

     
  • Money market funds invest in short-term debt, such as Treasury bills and the very short-term corporate debt known as commercial paper. These investments are considered cash equivalents. Money market funds invest with the goal of maintaining a share price of $1. They are sometimes considered an alternative to a bank savings account although they aren't insured by the FDIC. Some funds have private insurance.

 

It's important to keep in mind that funds don't always invest 100 percent of their assets in line with the strategy implied by their stated objectives. Some funds undergo what's called style drift when the fund manager invests a portion of assets in a category that the fund would typically exclude—for example, the manager of large-company fund may invest in some mid-sized or small companies. Fund managers may make this type of adjustment to compensate for lagging performance, but it may expose you to risks you weren't prepared for.

The SEC has issued rules that require a mutual fund to invest at least 80 percent of its assets in the type of investment suggested by its name. But funds can still invest up to one-fifth of their holdings in other types of securities—including securities that you might consider too risky or perhaps not aggressive enough. You might want to check the latest quarterly report showing the fund's major investment holdings to see how closely the fund manager is sticking to the strategy described in the prospectus, which is presumably why you invested in the fund.

 

Understanding Fees

All mutual funds charge fees. Because small percentage differences can add up to a big dollar difference in the returns on your mutual funds, it's important to be aware of all the fees associated with any fund you invest in. Some fees are charged at specific times, based on actions you take, and some are charged on an ongoing basis. Fees are described in detail in each fund's prospectus, which you should be sure to read before investing in any fund.

Here are types of fees that may be charged on an ongoing basis:

  • Management fees. These fees pay the fund's portfolio manager.

     
  • 12b-1 fees. These fees, capped at 1 percent of your assets in the fund, are taken out of the fund's assets to pay for the cost of marketing and selling the fund, for some shareholder services, and sometimes to pay employee bonuses.

     
  • Other expenses. This miscellaneous category includes the costs of providing services to shareholders outside of the expenses covered by 12b-1 fees or portfolio management fees. You also pay transaction fees for the trades the fund makes, though this amount is not reported separately as the other fees are.
     

The following fees are based on actions you may take, so may or may not be amounts you pay:

  • Account fees. Funds may charge you a separate fee to maintain your account, especially if your investment falls below a set dollar amount.

     
  • Redemption fees. To discourage very short-term trading, funds often charge a redemption fee to investors who sell shares shortly after buying them. Redemption fees may be charged anywhere from a few days to over a year. So it's important to understand if and how your fund assesses redemption fees before you buy, especially if you think you might need to sell your shares shortly after purchasing them.

     
  • Exchange fees. Some funds also charge exchange fees for moving your money from one fund to another fund offered by the same investment company.

     
  • Purchase fees. Whether or not a fund charges a front-end sales charge, it may assess a purchase fee at the time you buy shares of the fund.
     

One easy way to compare mutual funds fees is to look for a number called the fund's Total Annual Fund Operating Expenses, otherwise known as the fund's expense ratio. This percentage, which you can find in a fund's prospectus, on the fund's website, or in financial publications, will tell you the percentage of the fund's total assets that goes toward paying its recurring fees every year. The higher the fund's fees, the greater its handicap in terms of doing better than the overall market as measured by the appropriate benchmark.

For example, if you were considering two similar funds, Fund ABC and Fund XYZ, you might want to look at their expense ratios. Suppose Fund ABC had an expense ratio of 0.75 percent of assets, while Fund XYZ had an expense ratio of 1.85 percent. For Fund XYZ to match Fund ABC in annual returns, it would need a portfolio that outperformed Fund ABC by more than a full percentage point. Remember, though, that the expense ratio does not include loads, which are fees you may pay when you buy or sell your fund.

FINRA provides an easy-to-use, online Fund Analyzer that allows you to compare expenses among funds—or among different share classes of the same fund. Using a live data feed that captures expense information for thousands of funds, the analyzer can help you understand the impact fees have on your investment over time. Once you select up to three funds, type in the amount you plan to invest and how long you plan to keep the fund, the analyzer does the rest.

You should also be aware of transaction fees, which the mutual fund pays to a brokerage firm to execute its buy and sell orders. Those fees are not included in the expense ratio, but are subtracted before the fund's return is calculated. The more the fund buys and sells in its portfolio, which is reported as its turnover rate, the higher its transaction costs may be.


Understanding Loads

When you buy mutual fund shares from a stockbroker or other investment professional, you might have to pay sales charges, called loads, which are calculated as a percentage of the amount you invest. Like commissions on stock or bond transactions, these charges compensate the broker for the time and effort of working with you to select an appropriate investment.

The rate at which you're charged varies from fund company to fund company. In addition, companies may offer different classes of shares, which assess the charge at different times. You'll want to be sure you understand the financial consequences of choosing a specific share class before you purchase a fund. You can use FINRA's Fund Analyzer to compare share classes.

Class A shares have a front-end load, which is a commission you pay at the time you buy the shares. The average range is between 2 percent and 5 percent, though it varies. This amount is subtracted from the total you're investing in the fund. For example, if you invest $1,000 in a fund with a 5 percent front-end load, $950 of your investment would buy fund shares, and $50 would go to your broker.

Class B shares have a back-end load, which you don't pay unless you sell your shares during the period the charge applies, which is usually up to seven years after purchase, though it could be longer or shorter. The load tends to drop, perhaps by a percentage point each year, and then disappears altogether. However, the annual fees that the fund charges on Class B shares are higher than the fees on Class A shares. Back-end loads are also known as contingent deferred sales charges (CDSC).

Class C shares may carry a level load, which a fund collects every year you hold the fund, or they may have a back-end load or CDSC, similar to B shares. Class C shares also tend to have higher annual fees than Class A shares, typically on a par with those that apply to Class B shares. In addition, C shares do not convert to another share class.

As their name implies, no-load funds do not impose sales charges and you typically buy shares directly from the investment company that offers these funds. The same funds may be available, with a load, from investment professionals. Remember, though, that while no-load funds have no sales charges, they may still charge 12b-1 fees, purchase fees, redemption fees, exchange fees, and account fees in addition to the operating fees that all funds charge.


 

Breakpoints

Sometimes load funds offer volume discounts for higher investment amounts, in much the way that supermarkets sometimes offer economy bargains for buying certain things in bulk. In the case of funds, your front-end load, or Class A share sales charges, may be reduced if you invest a certain amount. The amounts at which your sales charges drop are called breakpoints. The breakpoints are different for each fund, and your broker must tell you what they are and must apply breakpoints if your investment qualifies.

Breakpoint rules vary, but some funds let you qualify for breakpoints if all your investments within the same fund family—funds offered by the same fund company—add up to the breakpoint level. Some funds let the total investments made by all the members of your household count toward the breakpoint. In addition, some funds let you qualify for a breakpoint over time, instead of with a single investment, by adding your past investments to your new ones. You might even qualify for a breakpoint if you write a letter of intent, informing the fund that you're planning to invest enough to qualify for the breakpoint in the future.

In short, funds can offer breakpoints any number of ways, or they may not offer them at all. Whenever you're entitled to breakpoints, however, the fund is required to apply them to your investment. To find out whether a fund offers breakpoints, use FINRA's Fund Analyzer.


 

Open-End vs. Closed-End Funds

One of key distinguishing features of a mutual fund, or open-end fund, is that investors can buy and sell shares at any time. Funds create new shares to meet demand for increased sales and buy back shares from investors who want to sell. Sometimes, open-end funds get so large that they are closed to new investors. Even if an open-end fund is closed, however, it still remains an open-end fund since existing shareholders can continue to buy and sell fund shares.

Open-end funds calculate the value of one share, known as the net asset value (NAV), only once a day, when the investment markets close. All purchase and sales for the day are recorded at that NAV. To figure its NAV, a fund adds up the total value of its investment holdings, subtracts the fund's fees and expenses, and divides that amount by the number of fund shares that investors are currently holding.

NAV isn't necessarily a measure of a fund's success, as stock prices are, however. Since open-end funds can issue new shares and buy back old ones all the time, the number of shares and the dollars invested in the fund are constantly changing. That's why in comparing two funds it makes more sense to look at their total return over time rather than to compare their NAVs.

Closed-end funds differ from open-end funds because they raise money only once in a single offering, much the way a stock issue raises money for the company only once, at its initial public offering, or IPO. After the shares are sold, the closed-end fund uses the money to buy a portfolio of underlying investments, and any further growth in the size of the fund depends on the return on its investments, not new investment dollars. The fund is then listed on an exchange, the way an individual stock is, and shares trade throughout the day.

You buy or sell shares of a closed-end fund by placing the order with your stockbroker. The price for closed-end funds rises and falls in response to investor demand, and may be higher or lower than its NAV, or the actual per-share value of the fund's underlying investments.