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The Basics of Mutual Funds
Mutual Funds are a part of almost everyone's investment portfolio. They
are offered through banks, stock accounts, employee retirement accounts and can
even be bought directly from the mutual fund company. But do you really
know what a mutual fund is and why it makes a good investment? Here are
some of the basics of mutual funds.
Definiton of Mutual
Funds. A mutual fund is a fund that buys and holds shares of
multiple securities. The holdings can consist of any type of security, but
are usually stocks or bonds. The fund buys a large number of shares in
different securities and then sells shares of its fund to individual
shareholders. Mutual funds are not listed on an exchange, buth their share
prices are calculated and reported at the end of each trading day. Mutual
funds can be bought and sold through most broker accounts, some banks, through
retirement plans, and directly from the mutual fund company. The funds are
regulated by the Securities and Exchange Commission (SEC) and there are strict
rules as to how their prices, returns and tax implications are measured and
Benefits of Mutual Funds. The benefits of
mutual funds are easy to define. They offer small and individual investors
a way to buy a large number of diversified stocks and bonds with a small amount
of money. For example, if you have $1,000 to invest you could buy a 10
shares of 5 different $20 stocks. Your trading fee would be for 5
transactions (maybe around $50, or 5%). Furthermore, you would not own a
well diversified portfolio and would be subject to extra risk. However,
you could buy $1,000 worth of a well diversified mutual fund for a small or no
transaction fee and then indirectly own 100s or even 1000s of different company
stocks, thereby offering you the protection of diversification. Another
benefit is that you do not have to be a stock picker or rely on market timing to
buy mutual funds. You can know nothing about individual stocks and still
easily select a mutual fund. Also, because mutual funds pool people's
money, they have a lot of assets and are therefore able to buy IPOs and other
offerings directly that individual investors are excluded from.
Important Aspects of Mutual Funds. A few basic mutual fund
attributes that you should be aware of are the goals, asset types, fee
structures, load, turnover, top holdings, and tax implications of mutual funds.
All of these attributes are reported by the fund company and can be found on the
detail page of the mutual fund on yahoo finance, google finance, or your
brokerage account (etrade, ameritrade, etc.). You can also get copies of
the fund's prospectus, which give more detailed information. You can get
this information online or on paper.
- Goals. Each mutual fund has a specific goal. It
could be to attain high growth, high income, stability or to minimize taxes.
It could be to invest in emerging companies, green technologies, or a
specific region or industry.
- Asset Types. Each mutual fund spells out what
type off assets it buys. They can vary widely and include small,
medium or large cap stocks, treasury, corporate or junk bonds, derivatives
or real estate assets, foreign, domestic or emerging market assets, or any
other asset type. This will be disclosed by the fund.
- Fee Structure. Most funds charge a flat expense
fee that will be clearly displayed. Some funds charge a fraction of a
percent and some charge as much as 5%. Also, some funds have varying
fees based on their performance. The best fund companies do not charge
the higher fees, so be very vigilant. T Rowe Price and Vanguard offer
thousands of low cost funds and have some of the best performing funds.
Every percent you pay in fees is subtracted from your returns, so a few
percent a year can really cost you a lot in the long run. Buy the low
- No Load or Load Mutual Funds. Some funds charge
loads, or fees to buy the fund. Be wary of any fund charging a load.
Your broker or some third party is getting paid the load to sell you the
fund. In our opinion there is no reason to buy a load fund. Look
for a similar no load fund.
- Turnover. Turnover is the percentage of the
mutual fund portfolio that is sold each year. Low turnover means the
fund does not trade very often. This usually means that they don't
have to pay as much in capital gains taxes and trading costs. These
savings get passed on to you if you buy a fund with low turnover. Some
funds have turnover over 100%, this means that they are more like traders
than investors which is a red flag when looking at mutual fund attributes.
- Top Holdings. Each fund must disclose its top
holdings. Look at the list and make sure that the companies
represented in this list are in line with the type of investments you want
to invest in. When buying multiple funds, look at the lists and make
sure there isn't too much overlap. For example, if you are buying
several high growth funds, there is a good chance that the same stock is in
all of them (like Apple or Cisco). Check the top holdings to get an
idea of the kind of stocks the fund holds.
- Tax Implications. Turnover factors into the cost
of ownership by increasing the annual tax burden on a mutual fund.
Dividend funds also have higher payouts and hence higher taxes.
Municipal or federal bond funds can sometimes be state and local tax free.
Know how your fund handles taxes so you can be prepared.