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Mutual Funds Explained and What To Look For.

The following is a quick illustration of the mutual fund market and a subsequent list of questions investor’s may find useful when considering which mutual fund to invest in. Mutual funds have many rules, fees, and information associated with them that may seem confusing. The following is an attempt to clarify some of the details and help investors look in the right places when comparing funds.

Overview

Mutual Funds are an investment that take advantage of collective public investment. Essentially investors pool their money together, and that money is managed (invested) by the mutual fund manager. Mutual funds are beneficial for the investor who wants diversification but may not want, or have the time to pick individual stocks themselves. By adding your own capital to the pool you give the decision making privilege to the manager who oversee’s the fund you’ve chosen.

Mutual funds are generally considered safer investments relative to alternatives such as a hedge fund because of the strict regulation governing them. The Investment Company Act of 1940 requires that each fund is managed by a registered financial advisor as well a overseen by a board. Mutual funds also present another advantage over alternative investment vehicles in the form of a prospectus the details the composition of each fund, giving the investor clear insight in to where their hard earned money will be invested.

Some words that might be associated with mutual funds include:

  • investment companies
  • open-ended
  • closed-end
  • passively managed
  • actively managed
  • Front-end load
  • Back-end load
  • No-load

Investment Companies or Registered Investment Companies are merely different terms to describe a mutual fund while the other terms are useful in describing either the type of or costs associated with any specific fund. Though every mutual fund generally behaves based on the fundamental principles explained above, it’s important to be able to discern between the types of funds in order to cut costs or utilize a fund that more closely matches the individual investor’s investment style.

Mutual Fund Terms Defined

Before looking in to what type of fund you want to invest in, it’s important to define a few of the terms listed earlier. In addition when looking at mutual funds there are a few key financial terms that give insight in to performance and/or illustrate costs associated with the fund in question. Therefor it’s important to learn and understand the following terms.

Open-End Vs. Closed-End

Mutual funds are classified either as open-end funds or closed-end funds. Though many of the mutual funds today are open-end funds, it’s important to know the difference between the two in the event that the fund you have been researching is considered closed-end.

An open-end fund always has a market for trade, you can buy or sell shares of the fund whenever the market is open and as a result these funds are not only more popular, but also more transparent. Open-end funds are priced based on their Net Asset Value (NAV) which is the total value of all the securities that compose the fund divided by the total share count. Open-end funds never trade for more or less than the NAV of the fund at any time. These funds have little to no limit on how much investor money is pooled in most cases, and as a result the NAV changes regularly to represent these fluctuations in asset value.

A closed-end fund functions much like the open-end fund does from an investment standpoint, however these funds are distributed to the public through Initial Public Offerings (IPOs). This means that in most cases the fund manager has a pre-determined amount of capital for investment, then investors who want to invest in the fund buy shares issued through an exchange in much the same way they would buy shares in a publicly traded company.

Front-End, Back-End, and No-Load Funds

Essentially the load is the sales charge investors pay for investing in a fund. These charges can be attributed to the services offered by financial planners and analysts who recommend or work on the fund. They can also be the profit that large money management companies take for offering the funds to investors. In any case these sales charges, or loads, should be reviewed carefully to make sure that the price investors pay to invest doesn’t negate the potential gains associated with investing in the fund.

A Front-End Load is the sales charge paid up front for investing in the fund. In many cases this charge decreases as the original investment amount increases. For example, as an investor with $5,000 to invest in fund XYZ which has a front-end load, the fund would in many cases charge 4% of the first $1,000 dollars invested while only charging 3% on the subsequent $1,000 dollars and 2% on any amount thereafter. This is to add incentive to larger investments added to the pool, where in the past some investors may have invested $1,000 slowly over distributed payments, now it may make more sense for the investor to invest a higher amount all at once to reduce fees.

A Back-End Load refers to when a fund charges the investor as they are pulling their money out of the fund. This allows for much easier flow in to the fund and can incentivize investors to stay in the fund longer. This is because in many cases the back-end load will be a contingent deferred sales charge, meaning that the back-end load only applies to money invested that has not matured long enough within the fund.

No-Load funds are what you would expect, there is no sales charge for investing in the fund. These funds leave the research up to investors, rather than the financial advisors, who offer funds with charges in order to pay for their services. Without the middle man, the individual investor can save money on fees by investing in no-load funds and assuming the responsibility for their own financial decision.

The load is one of the most important things to look at when investing in a mutual fund, however it’s very important to look out for some other terms as well. The 12b-1 fee is a a rule passed in to law by the Securities and Exchange Commission (SEC) that allows mutual fund companies to charge ongoing fees for their services. These fees can sneak up on the investor in many cases and should be reviewed carefully in the prospectus. The prospectus is the report required of mutual fund companies by law that illustrates the composition and charges associated with a fund.

In total the costs associated with a mutual fund are known as the expense ratio. In general a lower expense ratio means lower costs and a better value for the investor.

Types of Funds

Mutual funds are generally classified based on the asset that composes the majority of the fund holdings. Essentially if most of the fund make-up are bonds, then generally it will be classified as a “Bond Fund” or “Fixed Income Fund”. The most common types of funds includes:

  1. ”Bond” Funds
  2. ”Stock” or “Equity” Funds
  3. ”Money Market” Funds

Aside from these classifications, most other funds form hybrid funds that are composed of too many different types of assets to be considered any one of the terms listed above. Essentially the investor’s goal when looking at fund classifications is to decide what type of investment vehicle they want to invest in. Once the investor knows which investment they are most bullish on (stocks, bonds, etc.) the fund will act as a way to invest in that specific vehicle while simultaneously adding diversity through various forms of the same asset. For example a Bond fund would be composed of many different bonds maturing at many different times, while an equity fund would do the same but within the stock market rather than the bond market.

However it is important to note, among the three main categories are many sub-categories that tailor to all types of investors. In stock funds investors can choose from a wide variety of funds ranging from growth funds to sector funds. Growth funds are most commonly composed of smaller companies expected to experience a large volume of growth in the years to come. While value funds are funds where fund managers are buying good businesses at cheap prices that are either being overlooked or underestimated by the market. Investors can also choose to invest in international funds and play their hands at the markets overseas, though these funds often require a little extra research to be sure that currency conversion doesn’t eat away at profits. One of the most notable types of stock funds is the index fund which aims to mimic the performance of a specific indexes like the S&P 500 or the Russell 2000.

Bond funds can similarly be found in many sub categories tailored to different investors. U.S. Government bonds are composed of federal debt bonds, considered one of the safest investments due to the government’s ability to print more money. Corporate bonds or debt issued by companies that face the potential for bankruptcy are considered less safe and compose corporate bond funds. The less safe the bonds are, the higher the reward, meaning corporate bond funds will in most cases lead to a higher return. Meanwhile municipal bond funds allow investors to pool money in to the debt of local state governments and offer tax advantages in many cases.

Money Market funds take advantage of very short term investments such as overnight corporate securities or one month bank CD’s. This means that money market funds are often viewed as very liquid and have very little risk associated with them.

Investors who want to take advantage of bonds and stocks all in one fund should look in to total return funds. These funds are composed of many different types of investment vehicles including a variety of bonds and stocks. These funds aim to reach a target return for investors and often tend to be more bullish upon inception while slowly becoming more conservative as the returns start to roll in.

What To Look For

So what should the individual investor look for in a fund? This question is answered in part by the investors time horizon, or the time the investor intends on investing in the market. Mutual funds are in general, considered to be good long term investments and should therefor be approached as such. After highlighting an area of your portfolio you feel to be lacking choose the type of fund that would best fit your investment goals. Some questions to ask here might be:

  • How much risk am I willing to take on?
  • Do I want to speak with a financial advisors about funds?
  • Do I want to invest in stocks, bonds, or a mixture of both?

Once you have decided which type of fund to invest in take a look at the expenses associated with the fund. Ask the following questions:

  • What type of load, if any at all, is associated with the fund?
  • Who manages the fund, who oversees it, and what am I paying for with the fees?
  • Does the fee negate potential returns based on the size of my initial investment?
  • What is the expense ratio associated with the fund?
  • Are there 12-b1 fees associated with the fund and is there an account that can defer them (college savings account, Roth IRA)

Finally if the fees are justifiable, review the holdings of the fund. Are you comfortable with the market of sector that the fund is bullish on? Has the fund performed well over a 5-10 year period. The more data available to you about the fund performance and the strategy of the fund manager, the better. In many cases it’s safer to invest in a fund that is doing well consistently over the long-term rather than a fund doing phenomenally in the short-term. Just as in stocks, investors want to buy low and sell high. Just because a fund has done exceptionally well over the past year does not mean it will continue to. In many cases, the market overreaction to a better-than-expected return from a mutual fund will lead to a correction causing the NAV to go down to equilibrium. When investing in mutual funds, it’s very important to be aware of that fact.

Mutual Fund Resources

Some great resources to reference when looking for information on mutual funds are listed below. These resources give great insight in to the numbers associated with mutual funds and should be taken advantage of when considering investing in one.

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