Mutual funds are an excellent way to invest in stocks, bonds and other securities. They are a good choice of investment because:
Before getting into our discussion of mutual funds, there are three important points to keep in mind:
How To Choose A Mutual Fund
Once you determine your asset allocation model, you can implement the recommended portfolio with mutual funds. You need only six to ten funds to achieve diversification and your asset allocation objectives, as opposed to having to buy many more individual securities to achieve the same results.
Once you identify the asset classes that will be represented in your portfolio, it’s time to select specific funds in those categories-i.e., funds that meet your investment goals. To choose wisely, it’s necessary to assess:
What About Recommendations?
Most sources of mutual fund recommendations are inadequate. They either depend solely on past performance or fail to take into account your particular needs. Newsletters and magazines, for example, often simply recommend last year’s hot fund-which, even though it may remain hot for the current year, may be totally wrong for you.
A fund’s past performance is not as important as you might think. Advertisements, rankings, and ratings tell you how well a fund has performed in the past. But studies show that the future is often different. This year’s “No. 1” fund can easily become next year’s dog.
Here are some tips for comparing fund performances:
Costs are important because they lower your returns. A fund that has a sales load and high expenses will have to perform better than a low-cost fund, just to stay even.
Find the fee table near the front of the fund’s prospectus, where the fund’s costs are laid out. You can use the fee table to compare the costs of different funds.
The fee table breaks costs into two main categories:
The first part of the fee table will tell you if the fund charges any sales loads. No-load funds by definition, do not charge sales loads. There are no-load funds in every major fund category. Even no-load funds have ongoing expenses, however, such as management fees.
A sales load usually pays for commissions to the brokers who sell the fund’s shares to you, as well as other marketing costs. Sales loads buy you a broker’s services and advice; they do not assure superior performance.
Front-end load: A front-end load is a sales charge you pay when you buy shares. This type of load, which by law cannot be higher than 8.5 percent of your investment-although in practice are often much less-reduces the amount of your investment in the fund.
Back-end load: A back-end load (also called a deferred load) is a sales charge you pay when you sell or exchange your shares. It usually starts out at 5 or 6 percent for the first year and gets smaller each year after that until it reaches zero say, in year six or seven year of your investment.
The second part of the fee table tells you the kinds of ongoing expenses you will pay while you remain invested in the fund. It shows expenses as a percentage of the fund’s assets, generally for the most recent fiscal year. Here, the table will tell you the management fee for managing the fund’s portfolio, along with any other fees and expenses.
High expenses do not assure superior performance. Higher-expense funds do not, on average, perform better than lower-expense funds. But there may be circumstances in which you decide it is appropriate to pay higher expenses. For example, you can expect to pay higher expenses for certain types of funds that require extra work by managers, such as international stock funds, which require sophisticated research.
A difference in expenses that may look small to you can make a big difference in the value of your investment over time.
Rule 12b-1 fee: One type of ongoing fee that is taken out of fund assets has come to be known as a Rule 12b-1 fee. It most often is used to pay commissions to brokers and other salespersons, and occasionally to pay for advertising and other costs of promoting the fund to investors. It usually is between 0.25 percent and 1.00 percent of assets annually.
Funds with back-end loads usually have higher Rule 12b-1 fees. If you are considering whether to pay a front-end load or a back-end load, think about how long you plan to stay in the fund. If you plan to stay in for six years or more, a back-end load will usually cost less than a front-end load.
Comparing Investment Philosophy
Here are some suggestions for examining a fund’s approach to investing.
1. Determine the fund’s overall investment objectives.
2. Determine whether the fund’s portfolio matches its stated investment objectives. The fund should fully reveal how it invests.
3. Determine whether the fund invests overseas.
4. For an equity fund, determine the industry sectors in which it’s invested.
5. For a bond fund, determine the years to maturity of its holdings and whether it holds any tax-exempt bonds.
6. Find out how long the fund’s management has been in place and whether one particular manager has been responsible for the success of the fund.
Comparing Customer Service
You’ll want to find out what services the fund offers. Among the questions you should ask are:
Risk Factors In General
You take risks when you invest in any mutual fund. You may lose some or all of the money you invest (your principal) because the securities held by a fund go up and down in value. What you earn on your investment (dividends and interest) also may go up or down. The various types of risk are:
Each kind of mutual fund has different risks and rewards. Generally, the higher the potential return, the higher the risk of loss. The following discussion of risk for the various types of funds is intended to aid you in choosing a fund that meets your requirements as an investor.
Money Market Fund Risks
Money market funds are relatively low risk compared to other mutual funds. They are limited by law to certain high-quality, short-term investments. They try to keep their net asset value (NAV) at a stable $1.00 per share.
Bond Fund Risks
Bond funds (also called fixed-income funds) have higher risks than money market funds, but usually pay higher yields. Unlike money market funds, bond funds are not restricted to high-quality or short-term investments. Because there are many different types of bonds, bond funds can vary dramatically in their risks and rewards.
Most bond funds have credit risk, the risk that companies or other issuers whose bonds are owned by the fund may fail to pay their bond holders. Some funds have little credit risk, however, such as those that invest in insured bonds or U.S. Treasury bonds. Keep in mind that nearly all bond funds have interest rate risk, which means that the market value of their bonds will go down when interest rates go up. Because of this, you can lose money in any bond fund, including those that invest only in insured bonds or Treasury bonds. Long-term bond funds invest in bonds with longer maturities (the length of time until the final payout). The net asset values (NAVs) of long-term bond funds can go up or down more rapidly than those of shorter-term bond funds.
Stock Fund Risks
Stock funds (also called equity funds) generally involve more risk-volatility-than money market or bond funds, but they also offer the highest returns. A stock fund’s value can rise and fall quickly over the short term, but historically stocks have performed better over the long term than other types of investments.
Mutual fund rating companies use “beta” to measure risk. Beta measures a fund’s price fluctuations relative to those of the whole market-that is, its sensitivity to market movements.
Not all stock funds are the same. For example, growth funds focus on stocks that may not pay a regular dividend but have the potential for large capital gains. Others specialize in a particular industry segment such as technology stocks.
The level of volatility in a stock fund depends on the fund’s investments, e.g., small-cap growth stocks are more volatile than large-cap value stocks. The level of volatility is also affected by industry sector. Also, international stocks are generally more volatile than domestic stocks.
The foregoing generalizations are intended only as such. It is important, when examining a fund for risk/reward characteristics, to analyze each fund on a case-by-case basis.
There are a number of sources of information that you should explore before investing in mutual funds. The most important of these is the prospectus, which is the fund’s selling document and contains information about costs, risks, past performance and the fund’s investment goals. Request the prospectus from the fund or from a financial professional if you are using one. Read the prospectus, and exercise your judgment carefully, before you invest.
Read the sections of the prospectus that discuss the risks, investment goals and investment policies of the fund you are considering. Funds of the same type can have significantly different risks, objectives and policies.
All mutual funds must prepare a Statement of Additional Information (SAI, also called Part B of the prospectus). It explains a fund’s operations in greater detail than the prospectus. If you ask, the fund must send you an SAI.
You can get a clearer picture of a fund’s investment goals and policies by reading its annual and semi-annual reports to shareholders. If you ask, the fund will send you these reports. You can also research funds at most libraries or by using an on-line service.
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