Basics of Mutual Funds

Mutual Funds

A mutual fund is a type of investment vehicle where investors pool their money in order to allow each investor participate in a portfolio of securities. The individual investor doesn't actually own each security but instead, he owns shares of the mutual fund. The main benefit of a mutual fund is that it provides a way for the investor to achieve diversification in his investments without having to invest a a lot of money.The first mutual fund was the Massachusetts Investors Trust introduced in 1924. At the end of it's first year, the fund had 200 investors with $63,600 in assets. At the end of 1995, the fund grew to 73,500 investors with assets totalling $1.8 billion! Now there are over 7000 different mutual funds available for you to choose from. You may be wondering why you should choose a mutual fund. Simple - a mutual fund offers 2 large benefits over owning the stocks individually. Those benefits are diversification with professional management without having to invest a lot of money.Diversification is important because it helps to reduce the risk. By owning shares of multiple companies, the fund's share value is not devastated if an individual company has a poor performance.Selecting which securities to buy, the allocation of cash and securities, and when to purchase is all done by the fund manager or the management team. The fund manager has the training, time and the resources to make the best informed investment decisions.Also, he fund may be part of a family of funds where the investor can switch between funds at no additional cost, including switching in and out of a money market funds. Most mutual funds include some degree of check writing privileges and may offer automatic transfer of funds on a periodic basis like monthly for those who want to regularly invest a set dollar amount. This type of investment is called dollar cost averaging.

Types of Mutual Funds Available:

Domestic Equity Funds - These mutual funds mainly focus on stocks offered by different U.S. companies. With this type of fund there is a wide range of offerings that takes into consideration the size of the company, the stability of the company, growth and the potential valueof the company.
Global/International Funds - Global or International mutual funds mainly allow the investor to include foreign equities into their investments. Although deemed slightly riskier their values do tend to go up when domestic equities drop, offering a balance to the investors portfolio.
Sector Funds - sector funds give the investor a way to focus on specific parts of the business world. For example, niches like real estate, precious metals or financials. If an investor is able to tolerate an amount of risk, they may end up benefiting from investing in this way. Particularly if the investor knows something about that market segment.
Fixed Income Funds - fixed income mutual funds tend to be less volatile. This is the right fund for an investor who is looking for income. Fixed mutual funds for the most part are made up of bonds, CD's and money market funds. Yes, they do fluctuate with interest rates, still are a sound investment for someone looking for an income generating portforlio.
Hybrid Funds - Hybrid mutual funds are generally made up of different investment sectors in one mutual fund. For example, a usual mix may be the pairing of equities with bonds or blue chip stocks with riskier ones.
Index Funds - Index mutual funds imitate the selections and amounts of specified market indexes like the S&P 500. They are generally unmanaged keeping costs down.
Enhanced Index Funds - Enhanced index funds are actively managed funds applying a portion of their resources to outperform their benchmark indces.
Asset Allocation Funds - Asset allocation funds target investors who want a single product solution. They are designed to invest across the primary asset classes including equities, fixed income securities and money market. Each fund is allocated among different asset classes according to their risk tolerances.
Conservative Allocation Funds - Conservative allocation mutual funds are usually for investors with a minimum five-year investment timeframe.How to Select a Mutual FundUnfortunately, there's no one size fits all strategy when it comes to any type of investing. You need to take into consideration what your needs are and what your future financial goals are. Everyone's situation is unique. We encourage you to talk with your financial advisor to find out which mutual funds would best complement your portfolio. When choosing a mutual fund you should first get a prospectus then, call the fund company. In many cases, the prospectus is available right on the company's website. Also, Morningstar rates mutual funds. Each year end, many financial publications list the year's best performing mutual funds. Naturally, very eager investors will rush out to purchase shares of last year's top performers. That's a big mistake. Remember, changing market conditions make it rare that last year's top performer repeats that ranking for the current year. Mutual fund investors would be well advised to consider the fund prospectus, the fund manager, and the current market conditions. Never rely on last year's top performers.The ProspectusA prospectus for a mutual fund is a publication that has all the information that is required by the Securities Exchange Commission (SEC). The funds propectus includes objectives and policies, roles, services, fees, and major features of the fund.The prospectus also defines the boundaries within which the fund manager can operate. Using a hypothetical example, we will assume that the prospectus of the Chicken Farms Mutual Fund says "the fund will only invest in chicken farms in the USA that have shown a profit for at least the last two years." The fund manager would have the freedom to buy stock in any chicken farm meeting that criteria. However, the fund could not buy any chicken farm shares anywhere else other than the U.S. The prospectus also tells you the costs of the fund.Costs of Mutual FundsUsually, mutual funds are offered with several classes of shares, or they are no-load funds. Mutual fund companies exist to make money. That money can come from many different sources:
A sales charge: incurred upon purchase of shares
A deferred sales charge: incurred upon the sale of shares
Management fees: an on going operating cost
Distribution fees: on-going costs usually associated with advertising
Trading costs: costs charged by the broker for executing trades within the fund. These can be high in funds that have high turnover rates.
Other expenses: another category for on going expenses
No load funds will typically have no sales charge and no deferred sales charge, but will have the other fees listed.Load funds will offer different classes of shares such as A, B, or C shares. These will be defined by varied cost structures. An example of the impact of an investment which is held for different time periods will also be included in the prospectus. The best deal for you primarily depends on how long you hold the shares. No-load funds that are held for many years can be more expensive than load funds.In conclusion, mutual funds are a way for investors to diversify their risk and still benefit from professional money management. The prospectus identifies key information about the mutual fund including its operating boundaries and its costs. The fund manager operates within those boundaries and is important in order to achieve good results within those boundaries. Do your research, then talk to a professional investment advisor about mutual fund investing.