The major reasons why investors purchase mutual funds are professional management and diversification, or investment in a wide variety of securities.
But be warned-even the best portfolio managers make mistakes. As an investor, you have to evaluate an investment in mutual funds just as you would evaluate any other potential investment.
Barron's Dictionary of Finance and Investment Terms defines an
investment company as a firm that, for a management fee, invests
the pooled funds of small investors in securities appropriate to its stated
investment objectives.
There are two ways to invest in the mutual funds offered by investment
companies.
Approximately 10 percent of all mutual funds are closed-end funds
offered by investment companies. A closed-end fund is a mutual
fund whose shares are issued by an investment company only when the
fund is organized. As a result, only a certain number of shares are
available to investors. After all the shares of the originally issued
have been sold, an investor can purchase shares only from another investor
who is willing to sell. Shares of closed-end funds are traded on the
floor of stock exchanges or in the over-the-counter market.
A load fund (sometimes referred to as an "A" fund) is a mutual
fund in which investors pay a commission every time they purchase shares.
The commission charge (sometimes referred to as the sales fee)
for load funds may be as high as 8 1/2 percent of the purchase price for
investments under $10,000.
A no-load fund is a mutual fund in which the individual pays
no sales charge. No-load funds don't charge commissions when you buy shares
because they have no salespeople. If you want to buy shares of a no-load
fund, you must deal directly with the investment company or any discount
broker. The usual means of contact is by telephone, the Internet, or mail.
Since no-load funds offer the same investment opportunities that load
funds offer, you should investigate them further before deciding which
type of mutual fund is best for you.
Some mutual funds charge a management fee that ranges from 0.25 to 1
percent per year.
Some mutual funds charge a contingent deferred sales load (sometimes
referred to as a back-end load or a "B" fund) of 1 to 6 percent that shareholders
pay when they withdraw their investment from a mutual fund. These fees
depend on how long the investor owns the fund.
The managers of mutual funds tailor their investment portfolios to
the investment objectives of their customers. Usually a fund's objectives
are plainly disclosed in its prospectus. In most cases, the name of
the category of mutual funds gives a pretty good clue to the types of
investments included within the category. The major categories
of mutual funds, in terms of the types of securities they invest in,
are as follows:
Most large metropolitan newspapers, The Wall Street Journal,
and Barron's provide information about mutual funds.
The net asset value, offer price, and change in net asset value are
reported in tables in newspapers and on the Internet.
The letters beside the name of a specific fund can be very informative.
You can find out what they mean by looking at the footnotes that accompany
the newspaper's mutual fund quotations. Generally,
"NL" means no load.
"p" means that a 12b-1 fee is charged.
"r" means that a redemption charge may be made.
"t" means that both the p and r footnotes apply.
Financial Objectives-Again
In establishing your own investment goals and objectives, you must evaluate the personal factors of age, family situation, risk tolerance, income, and future earning power. Then, evaluate the relationship between your financial objectives and the financial objectives of a mutual fund. Now your aim is to find a mutual fund whose investment objectives match your own.
An investment company sponsoring a mutual fund must give potential investors a prospectus. The prospectus summarizes the fund's objective. Also, the fee table provides a summary of the fees a fund charges. In addition, the prospectus should provide a statement describing the risk factor, the fund's past performance, type of investments contained in the fund's portfolio, information about dividends, distributions, and taxes, management, limitations or requirements, the process investors can use to buy or sell shares, description of services provided, its turnover ratio, and how to open a mutual fund account with the investment company.
Mutual Fund Annual Report
If you are a prospective investor, you can request an annual report by mail, an 800 telephone number, or on the Internet. Once you are a shareholder, the investment company will send you an annual report.
Another source of information about mutual funds is investment-oriented magazines like Business Week, Forbes, Kiplinger's Personal Finance Magazine, Money, and other finance- or consumer-oriented magazines and financial guidebooks. Most of these publications provide an annual survey of mutual funds and ranks them on a number of important investment criteria.
Professional Advisory Services
A number of subscription services provide detailed information on mutual funds. Standard & Poor's Corporation, Lipper Analytical Services, Morningstar, Inc., and the Wiesenberger Investment Companies are widely used sources of information. In addition, various mutual fund newsletters provide financial information to subscribers for a fee, but their reports may also be available from brokerage firms or libraries.
As with other investments, the purpose of investing in a closed-end or an open-end fund is to earn a financial return. Shareholders in such funds can receive a return in one of two ways.
Both types of funds pay income dividends, capital gain distributions, or both.
Income dividends are the earnings that a fund pays to shareholders after it has deducted expenses from its dividend and interest income.
Capital gain distributions are the payments made to a fund's shareholders that result from the sale of securities in the fund's portfolio.
Income dividends, capital gain distributions, and financial gains and losses from the transactions of closed-end or open-end funds are subject to taxation.
At the end of each year, investment companies are required to send each shareholder a statement specifying how much he or she received in dividends and capital gain distributions.
Be sure you understand the difference between capital gains distributions and capital gains.
Be sure to keep accurate records for tax purposes. The same records will help you monitor the value of your mutual fund investments and make more intelligent decisions with regard to buying and selling these investments.
Purchase Options
The shares of a closed-end fund are traded on various stock exchanges or in the over-the-counter market.
The shares of an open-end fund, no-load fund may be purchased through a salesperson who is authorized to sell them, through an account executive of a brokerage firm, or directly from the investment company that sponsors the fund.
You can also purchase both no-load and load funds from mutual fund supermarkets available through discount brokerage firms.
You may also purchase shares in an open-end fund by using the fund's reinvestment plan. A reinvestment plan is a service provided by an investment company in which income dividends and capital gain distributions are automatically reinvested to purchase additional shares of the fund.
All four purchase options (regular account transactions, voluntary savings plans, contractual savings plans, and reinvestment plans) allow investors to buy shares over a long period of time. As a result, they can use the principle of dollar cost averaging.
Withdrawal Options
Because closed-end funds are listed on securities exchanges, it is possible to sell shares in such a fund to another investor.
Shares in an open-end fund can be sold on any business day to the investment company that sponsors the fund. In this case, shares are redeemed at their net asset value.
In addition to just selling shares, the investor may use at least four options to systematically withdraw money from an open-end mutual fund.
Most funds have a provision that allows investors with a minimum
share value of at least $5,000 to systematically withdraw a specified,
fixed dollar amount of money each investment period until your fund
has been exhausted. (Normally, an investment period is three months.)
A second option allows the investor to liquidate or "sell
off" a certain number of shares each investment period. Once
the specified number of shares has been sold, a check is mailed
directly to the investor.
A third option allows investors to withdraw a fixed percentage
of asset growth. If no asset growth occurs, no payment is made.
Under this option, the principal remains untouched.
