Investors have literally thousands of choices when it comes to selecting a mutual fund. Before selecting to invest in any given fund, however, you should determine your investment strategy and your level of acceptable risk. In this first step, you may decide to consult a financial advisor. Whether you get help with your decision making or decide to go it alone, once you have (1) established what you are saving for, (2) determined when you will need the money, and (3) decided how much risk you can tolerate, narrowing the choices of mutual funds will become much easier.
Mutual Fund Types
Most mutual funds fall into one of three different categories:
* Money Market Funds
The risk associated with this type of fund is relatively low. By law, these funds can only invest in short-term, high quality investments issued by the US government, by US companies, or state and local governments. Although the risk with this type of fund is lower, no fund is “safe.” There is always the risk that inflation will outpace these mutual funds, and returns may be eroded over a period of time.
* Bond Funds (also called “Fixed Income Funds”)
These funds can vary widely in risk, and are subject to the following three factors: (1) credit risk, (2) interest rate risk, and (3) pre-payment risk.
* Stock Funds (also called “Equity Funds”)
The overall risk with this type of mutual fund is the highest of the three types listed. The potential danger lies with the wide fluctuation of stock prices for a broad range of factors, including the overall strength or weakness of the economy and demand (or lack thereof) for particular products and services.
Degrees of Risk
All mutual funds carry some risk. Investors may lose some or all of the money they invest (the principal) as a result of the fluctuations in securities held by the fund groups, which go both up and down. Dividend and interest payments may also fluctuate with market conditions.
Before investing, you should read any mutual funds’ prospectus and shareholder reports carefully to see just what investment strategy the fund is pursuing and determine the attendant risk. Funds with higher potential rewards may also take risks that are beyond what you are comfortable with or be inconsistent with your financial goals. No matter how good the promises look, these are not good funds for you.
In addition to determining your long-term strategies and level of risk tolerance, there are also fees and taxes that are important to consider. These additional deductions will affect the size of your returns over time.
Fees and Expenses
Like any other business, running a mutual fund costs money, including shareholder costs, investment advisory fees, advertising, marketing, and distribution expenses. These costs are passed along to customers (investors like you) by imposing fees and expenses. By examining and understanding these additional charges, you can determine if this is a good place to put your money or not.
Every fund has regular, recurring operating expenses. Typically these charges to investors come directly out of fund assets, which means that investors pay for these charges indirectly. In addition, some fund groups also impose “shareholder fees” directly when you buy or sell shares of these funds. The SEC (Securities and Exchange Commission) requires these fund groups to disclose operating expenses and shareholder fees in their prospectuses in a “fee table” near the front of the prospectus. Examining this fee table is key to understanding the costs of owning a particular mutual fund.
Among the types of shareholder fees an investor might find are the following:
* Sales Charge (or “load”) on Purchases
This is the amount you pay when you purchase shares (known as “front-end load”). This cannot be more than 8.5% of the investment by Federal law.
* Purchase Fee
While the front-end load goes directly to the broker, the purchase fee goes to the fund group to defray the fund’s costs associated with purchase.
* Deferred Sales Charge (or “load”)
This is the fee charged when shares of the fund are sold by the investor (known as the “back-end load”). The most common type is referred to as CDSL or CDSC (or “contingent deferred sales load”). The amount paid depends on how long the investor keeps his or her shares.
* Redemption Fee
This fee goes directly to the company when an investor sells or redeems shares, unlike the deferred sales load, which goes to the broker.
* Exchange Fee
This is a cost imposed by the fund group when funds are exchanged or transferred within the same group or family of funds.
* Account Fee
These are fees for maintenance of the investor’s shares, and are often imposed when the dollar amount invested is below a certain threshold.
Asset Fund Operating Expenses
In addition to the fees listed above, there are also additional costs that may occur:
* Management Fees
These are costs paid to the investment advisor for his or her management of the overall portfolio.
* Distribution and Service Fees
Frequently called 12b-1, these refer to fees that cover marketing and selling fund shares, as well any other services provided to a shareholder.
This is a catch-all group for any fees not covered under management fees or 12b-1 fees. Included in this group may be legal and accounting services, custodial expenses, transfer agent costs, and other administrative expenses.
Investors should look for the Total Annual Operating Expenses (or “Expense Ratio”) when examining a prospectus. This figure represents the total of all these fees and expenses (listed above) as a percentage of the net assets of a mutual fund. By studying the expense ratio, investors can make comparisons across funds.
It is important to review fee tables carefully. Even negligible differences in fees can translate into huge differences in the amount of money you will make over the long term. It is also important to understand breakpoints: These are the investment levels required to achieve a reduced sales load (usually reserved for bigger investments). Always ask when purchasing a fund how a fund establishes eligibility for breakpoints.
Valuable SEC Tool
The SEC offers investors a valuable interactive tool, the mutual fund cost calculator, which can help you understand the impact that fees and expenses have over time. It will also help you to compare funds. See
Classes of Funds
Many mutual funds have more than one class of shares (you may have seen Class A or Class B shares mentioned, for example). Each class invests in the same portfolio of funds and has the same goals and policies. However, each may differ in the shareholder services and distribution policies in place; this also means that each class will have different fees and expenses-and different performance results.
Investors should keep in mind that when they buy mutual funds, they owe income taxes on any ordinary dividends earned or reinvested that year. These taxes are in addition to the capital gains taxes that occur when you sell your shares. The SEC rules require mutual fund companies to spell out in their prospectuses the after-tax returns. To locate this information, look for the “Risk/Return Summary.” Figuring in the additional cost of taxes is important to calculating the overall money you can anticipate.
In the end, investors need to have their eyes wide open when selecting a mutual fund. It is important to match the fund with your needs and financial strategy, as well as to consider all of the money that will be deducted as a result of fees, expenses, and taxes. Although investors may not be able to control (or even predict) what the economy will do, they can be informed about the costs extracted by the fund company (through expenses and fees) and Federal government (through taxes). This is important information you need to know before you buy mutual funds!