Mutual Funds

Overview

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.

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.

How They Work

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.

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.

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.

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.

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

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.

Investing in mutual funds through a broker or other investment professional sometimes means choosing among different mutual fund classes. One of the main differences among these classes is how much you will pay in expenses and how much your broker will be paid for selling you the fund. Before deciding on a share class within a fund, it is important for you to understand the differences between them.

What Are Mutual Fund Share Classes?

A single mutual fund, with one investment portfolio and one investment adviser, may offer more than one "class" of its shares to investors. Each class represents a similar interest in the mutual fund's portfolio. The mutual fund will charge you different fees and expenses depending on the class you choose. Some classes provide rights or benefits that others do not.

When deciding which share class is best for you, carefully consider:

• How long you plan to hold the fund.
• The size of your investment.
• Whether you qualify for any sales charge discounts or other fee waivers.

You can find out whether a mutual fund has different classes by looking at the prospectus. The most common share classes — A, B, C, and Transaction (or “clean”) shares — that retail investors might encounter outside a 401(k) or other retirement plan are described below.

What Types of Fees and Expenses Will I Pay?

All mutual funds charge fees and expenses, some of which you pay directly (like sales charges and redemption fees) and others that come out of the fund's assets (to pay for such things as managing the fund’s portfolio, or marketing and distribution). These fees and expenses can vary widely from fund to fund or fund class to fund class. Even small differences in expenses can make a big difference in your return over time.

When choosing among different mutual fund share classes, be aware that your investment professional might receive higher (or lower) commissions or payments from the sale of one share class relative to another. You can use FINRA’s Fund Analyzer to see the impact of these fees over time on your account value — and to assess which share class might be best for you, given your goals, investment amount, and expected holding period.

Here are the most common differences among shares of mutual funds:

Class A Shares

Class A shares typically impose a front-end sales charge, which means a portion of your dollars is not invested, and is instead paid in part to the brokerage firm selling you the fund. Let’s say you spend $1,000 to purchase Class A shares, and the fund imposes a front-end sales charge of 5 percent. You pay the $50 (5% of $1,000) up front and receive shares with a market value of $950. Class A shares may impose an asset-based sales charge (often 0.25 percent per year), but it generally is lower than the charge imposed by the other classes (often 1 percent per year for Class B and C shares).

Depending on the size of your purchase, the mutual fund might offer you discounts, called breakpoints, on the front-end sales charge. For example, a fund may charge a smaller percentage front-end sales charge (4.5 percent instead of 5 percent if you invest at least $50,000 in the fund. There are different ways you can qualify for a sales charge breakpoint. Often you can qualify for a breakpoint in your sales charge if you:

• Make a large purchase.
• Already have investments in the same fund or other mutual funds offered by the same fund family, which count toward the investment amount needed to get a breakpoint (Rights of Accumulation).
• Have family members (or others with whom you may link according to fund rules) who have invested in the same fund family.
• Commit to regularly purchasing the mutual fund's shares over a specified time period with a Letter of Intent (LOI).

Another way to invest in Class A shares without paying a front-end sales charge is by exchanging your investment in one fund for an investment in another fund in the same fund family. For example, let’s say you redeem (sell) $25,000 of your Class A Shares of the ABC Growth Fund and invest the proceeds in Class A Shares of the ABC International Fund. Since you already paid a sales charge when you invested in the Growth Fund, you won’t be charged a new sales charge for your $25,000 investment in the International Fund.

Always ask your investment professional whether any breakpoint discounts or sales charge waivers are available to you.

Class A shares also charge management fees and 12b-1 fees. Management fees are the same for all share classes of any fund, but different funds often have different management fees. However, 12b-1 fees for Class A shares are generally lower than the 12b-1 fees for class B and C shares. Because of lower 12b-1 fees, total operating expenses on class A shares, over time, are generally lower, too.

Class B Shares

Class B shares typically do not charge a front-end sales charge when you buy shares, but they normally impose what’s called a contingent deferred sales charge (CDSC) if you sell your shares within a certain period, often six years. Sometimes called a back-end load, the CDSC normally declines the longer your hold your shares and, eventually, is eliminated. Within two years after the CDSC is eliminated, Class B shares often "convert" into lower-cost Class A shares. When they convert, they begin to charge the same fees as Class A shares.

Because Class B shares do not impose a sales charge at the time of purchase, all of your dollars are immediately invested — unlike Class A shares. But your annual expenses, as measured by the expense ratio, may be higher. You also may pay a sales commission when you sell your Class B shares. B shares generally impose a 12b-1 fee that is higher than what you would incur if you purchased class A shares.

If you intend to purchase a large amount of Class B shares (over $50,000 or $100,000, for example), you may want to discuss with your investment professional whether Class A shares would be preferable. The expense ratio charged on Class A shares is generally lower than for Class B or C shares. The mutual fund also may offer large-purchase breakpoint discounts from the front-end sales charge for Class A shares.

Most mutual funds no longer offer Class B shares, so they may not be an option for you.

Class C Shares

Class C shares do not impose a front-end sales charge on the purchase, so the full dollar amount that you pay is invested. Often Class C shares impose a small charge (often 1 percent) if you sell your shares within a short time, usually one year. They typically impose higher asset-based sales charges than Class A shares. Unlike B shares, they typically do not convert to class A shares and, instead, continue to charge higher annual expenses (including 12b-1 fees) for as long as the shares are held.

Like class B shares, C shares typically impose higher annual operating expenses than class A shares due, primarily, to higher 12b-1 fees.

Class C shares may be less expensive than class A or B shares if you have a shorter-term investment horizon because you will pay little or no sales charge. However, your annual expenses could be higher than class A shares, and even class B shares, if you hold your shares for a long time.

Transaction (“Clean”) Shares

"Transaction Shares" is a term that applies to a class of fund shares without any front-end load, deferred sales charge, 12b-1 fees, or other asset-based fee for sales or distribution. Even though Transaction Shares do not impose any sales charges, in some cases, a brokerage firm may separately require you to pay a sales commission when you invest in these shares. If your trades generate a commission, work with your financial professional to estimate your trading frequency (also called annual turnover) for the fund. This frequency may be related to how often you rebalance, reallocate, or redeploy assets in your portfolio. Also, if you invest in Transaction Shares through an investment advisory account, normally you will pay the investment adviser a fee equal to a percentage of your assets in the account for providing ongoing advice to you. 

There is no one-size-fits-all when it comes to these shares, so you should talk to your financial professional about what rights and benefits you are eligible for. It is also important to know that with Transaction Shares, some brokerage firms may not offer sales charge breakpoint discounts or waivers that would be available if you invested in Class A Shares, such as through rights of accumulation, letters of intent, and exchanging shares of one fund for shares of another fund in the same family.

FINRA Fund Analyzer

One of the best ways to evaluate a fund, compare share classes, and especially to compare costs and fees, is to use FINRA’s Fund Analyzer. The Fund Analyzer helps both investors and financial professionals understand the impact of fees and potential available discounts on mutual funds, exchange-traded funds, exchange-traded notes and money market funds. The Fund Analyzer allows you to sort through and compare more than 30,000 products and calculates how a fund's fees, expenses and discounts impact the value of a fund over time. With a focus on the impact of fund fees and expenses as well as account-based fees, you can better determine which funds might best meet your investing needs at the lowest cost while providing the best value. See our overview of the Fund Analyzer and the different comparisons that can be modeled in the tool.

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. Here are four terms to know:

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.

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, a front-end load 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.

Sales Charge Waivers

To maximize your investment, be sure to understand and explore any potential sales charge waivers. Here are five to be aware of: