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Mutual Funds

Read about the advantages and disadvantages of mutual funds.

A mutual fund pools money from many investors. [©Jupiter Images, 2009]
©Jupiter Images, 2009
A mutual fund pools money from many investors.

Mutual funds are companies that pool investor monies to acquire a variety of stocks, bonds and securities. According to the Securities Exchange Commission (SEC) mutual funds differ from other investment companies such as closed-end funds and Unit Investment Trusts. Unlike other investments, shares must be purchased directly from the fund or one of its brokers, the fund shares must be redeemed by selling them back to the fund, and fund shares are most often sold continuously. Funds turn the management of their portfolios over to investment advisers registered with the SEC.

Shares can be redeemed for the Net Asset Value, or the company's total assets minus its total liabilities, which means share values can change daily. Any fees imposed by the fund will be deducted from the share values upon redemption.

Fund Types

Mutual funds generally fall into three categories: stock, bond or money market funds. Within those categories, investment strategies can vary. Indexed stock funds seek to tie their returns to a specific market index (e.g., Standard & Poor's 500 or Wilshire 5000) by investing in the stocks and bonds listed with that index. The reduced management expenses allowed by indexing can also reduce fees and expenses and lower taxable gains. Stock funds can also concentrate on particular industries. Bond funds concentrate on investing in a variety of bonds with the goal of producing higher yields. This tends to create higher risk for bond funds.

Stock and bond funds both incur risks involved with those investments (e.g., stock price fluctuations, a company's financial fortunes, bond defaults and interest rate declines). Money market funds, on the other hand, invest in low-risk securities such as government bonds and certificates of deposit. As a consequence, they tend to yield lower dividends.

Advantages of Mutual Fund Investing

Mutual funds provide professional management to a large pool of smaller investments. This allows fund managers to offer the full-time oversight of the investments, track performance and make larger and more cost-effective trades. Funds also reduce investor risk by creating a more diversified portfolio that can offset a decline in a single security's value. In addition, smaller investors can buy into a market with a lower up-front investment and without paying broker commissions. The Mutual Fund Investor's Center  lists a number of investment advantages including:

  • Personalized service through Web sites and phone assistance
  • Simplified investment and withdrawal
  • The ability to plan for retirement or college
  • The ability to move funds to different securities as market cycles change
  • Regular updates on investment performance
  • Periodic withdrawals or dividend payments
  • Records of investor transactions and necessary tax forms

Mutual Fund Risks

As with any investment, investing in a mutual fund carries some financial risk. One rule of thumb potential investors should consider is that the level of reward is a trade-off with the level of risk. Another consideration is that past performance is not a guaranteed indicator of future fund performance. The Investment Company Institute suggests that in addition to the general investment risk of a fund's assets losing value, mutual funds carry more specific risks:

  • Investment values could decline with a rise in interest rates
  • The fund company might lose the ability to pay its obligations
  • The opportunities to buy or sell investments quickly may become more limited
  • Fluctuations in exchange rates could cause investments made in foreign currency to lose value
  • Foreign investments could lose value due to political or regulatory changes

How to Research a Fund

Potential investors should always take the time to thoroughly research a fund before investing. Potential sources for research include the fund's most recent prospectus (which will include fee and return tables), investor profiles, the fund's Statement of Additional Information and shareholder reports. The funds make all of this information available to the public. Investors should consider a fund's size and age, turnover, taxability, risk and recent operational changes. A fund's size and history can be important even though it shouldn't be the only factor considered. Smaller, recently launched funds may perform well in the beginning because of their limited portfolio, only to lose value as the fund grows over time. More established funds might have weathered market turmoil better, which indicates more reliable, if not spectacular, performance.

Funds that turn over their securities more frequently in search of larger yields may also incur higher trading costs and capital gains taxes for investors. Funds with a history of volatility may be poor short-term investment strategies. The fund's investment strategies can provide a good indicator of risk. For example, focusing on high-tech stocks can be riskier than other investments, whereas funds invested in bonds may be more sensitive to interest rate changes. Recent mergers or changes in a fund's investment advisors or operations could be a sign of changes in future returns.

Management and Sales Fees

Fund research should include an investigation of fund costs and fees charged. Fund costs may include individual investor transactions, advisory fees, marketing expenses, and brokerage and legal fees incurred by the fund for day-to-day operations. Funds may recover the costs of individual transactions by imposing fees on the investors and pay for general operation costs from fund assets (which creates an indirect cost for the investors).

All funds charge fees, which can range from standard management fees to sales charges incurred when shares are purchased or sold. They may also charge exchange fees for transferring funds and fees for general account maintenance. Funds that use brokers charge sales loads to investors to compensate the brokers. Sales loads may be charged up front or when shares are redeemed. Funds may even charge fees for buying or selling investor shares, check-writing privileges and automatic investment. Small differences between fee charges can cut into investment returns as the charges accumulate over time. The SEC offers an online Mutual Fund Cost Calculator to help investors to compare fund costs.

How to Invest

Individual investment strategies will differ with the investor's financial abilities, needs and financial goals. Small investors can look for no-load funds that don't charge commissions and require minimal investment thresholds. Funds that divide investments between stocks and bonds provide a balance of risk and return, but yield will be delivered only over the long-term. Investors should also decide whether they want a fund that yields dividends.

Investors have a number of options for buying into funds. Many investors begin by investing through a 401(k) retirement plan at work, although these funds will have a number of restrictions on investment and redemptions. Shares can also be purchased directly from a number of companies through direct-marketed or no-load funds that charge a minimal sales fee, if any. Funds are also offered through financial advisors, banks and investment planners who charge fees for advice and services. Investors should always remember that mutual funds are not bank accounts and carry no insurance or federal government guarantees.

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