Mutual Fund

A mutual fund is a company that pools the money of all its investors and invests in a variety of securities according to a stated investment objective.  Equity funds invest primarily in stocks of other companies; bond funds invest in bonds; balanced funds invest in both stocks and bonds; government bond funds invest only in government bonds; aggressive growth funds invest in stocks that the fund manager(s) believes will offer the maximum price appreciation.  There are funds that invest in both domestic and foreign securities, while some invest only in the securities of a specific country or region, like the Japan Fund offered by Fidelity.  And the list goes on.

When an investor purchases shares of a mutual fund, he or she becomes a part owner  of the fund and is entitled to his or her proportionate share of the income that the fund generates from the portfolio of securities in which it invests.  

Buying and selling mutual funds

Unlike stocks, mutual funds are not bought and sold on exchanges.  Rather, they are bought and sold through the fund itself.  There is not a fixed number of shares.  If an investor wants to buy shares of a fund and there are no shares of the fund for sale, the fund simply creates new shares.  Because of this, the price of a mutual fund is not set by supply and demand as the price of a stock is.  Instead, the price is based on the net asset value (NAV) of the fund.  The net asset value is calculated by subtracting the total liabilities of the fund from the total assets of the fund.  This number, divided by the number of fund shares outstanding, is referred to as the net asset value per share (NAVPS).  

The NAVPS is not calculated continuously throughout the day.  It is typically calculated at the close of the trading day.  Thus, when you contact the fund, either directly or through your broker, with an order to buy or sell your fund shares, you won’t know the price at which you will be buying or selling the shares.  

Load or no load

Some funds add a sales charge to the NAVPS in determining the price at which the shares can be purchases.  This sales charge is referred to as a front-end load.  When you buy shares of a fund that has a front-end load, not all the money you pay will be used to purchase the shares.  For example, if you invest $1,000 in a fund that has a front-end load of 5%, the fund will deduct $50 (= 0.05 x $1,000) up front, leaving only $950 to buy shares.

Investors buying a fund with a front-end load may receive a reduced load depending on the amount they are investing.  The different investment levels that enable investors to receive reduced sales charges are called breakpoints.  These are usually listed in a fund’s prospectus, a document that provides the investor with financial data and other information about the fund, such as its investment objective, the specific types of securities in which it invests, and the minimum initial and subsequent investment amounts required.  Investors must be provided with the fund’s prospectus prior to investing in the fund, and the fund’s sales agent is also required to inform prospective buyers about any breakpoints.  

Many funds will allow an investor to pay a lower sales charge if he or she signs a letter of intent.  By signing this document, the investor indicates that he plans on purchasing enough shares within the next 13-month period to meet one of the breakpoints.  The fund will then allow all purchases to be made as if the breakpoint was met with that first purchase.  If the investor fails to fulfil his or her end of the agreement, he or she will be required to pay the difference between the reduced sales charge and the load that would have had to be paid if a letter of intent had not been signed.  No other penalty is inflicted.

Some funds charge back-end loads.  These are also called deferred sales charges. In other words, investors must pay a fee when they sell their shares back to the fund.  If you were to invest $1,000 in a fund with no front-end load, but with a 5% back-end load, your entire $1,000 would be used to purchase the fund shares, but 5% would be deducted from the proceeds when you sell your shares.  For example, if the NAV of your shares at the time you sell them has risen to $1,500, the fund would deduct $75 (= $1,500 x 0.75) from the proceeds, leaving you with $1,425.  Most funds calculate the amount of the back-end load on either the value of the initial investment or the value of the shares at redemption, whichever is lower.  Again, this would be detailed in the prospectus.

Most back-end loads are contingent deferred sales loads.  This simply means that the percentage load charged will depend on how long the investor has held the shares.  The load typically will be eliminated entirely if the shares are held long enough.

There is a cap on the amount of sales charges a fund can assess.  The sum of all front- and back-end loads and 12b-1 fees (discussed later) cannot exceed 8 ½%.  

Other fees

A fund can call itself a no-load fund if it doesn’t charge a front-end or back-end load.  However, there are other fees the shareholders might have to pay.  They just aren’t called sales loads.  These include purchase fees, redemption fees, exchange fees and account fees.  A purchase fee may be charged when an investor purchases shares, but this is not considered a sales load since the fund (not a broker or sales agent) gets the money.  Similarly, a redemption fee may be charged when the sales are sold, but again, it is not considered a load since it is not paid to a sales agent, but, instead, is used by the fund to defray costs associated with the sale.  The redemption fee is not allowed to exceed 2%.  Some funds assess an exchange fee when an investor exchanges shares of one fund for shares of another fund in the same family of funds.  And some funds charge an account maintenance fee if the amount invested is below a certain level.

Fund expenses

Mutual funds have operating expenses. These are paid out of the fund’s assets, thus reducing the net asset value of the fund—and, therefore, the value of the shares an investor has.  One of these is a 12b-1 fee. These fees are deducted from the assets of the fund to cover marketing and distribution costs.  These include payments to brokers or others who sell shares of the fund and the costs of printing and mailing prospectuses to prospective investors.  The 12b-1 fee is not allowed to exceed 0.75% of the average net assets of the fund.  Another fee is a management fee that is used to pay the fund manager(s) and for some other administrative costs.  This fee typically ranges from 0.25 to 1% of the total fund value.  There are also a number of other expenses, such as legal and accounting fees and general record keeping costs.

These expenses are captured in a number known as the expense ratio of the fund, which is calculated as the sum of these expenses divided by the total assets of the fund.  The lower it is, the better.  Actively managed funds, such as aggressive growth funds, tend to have higher expense ratios than passively managed index funds in which the fund managers typically buy and hold the securities for a longer period of time.  In general, when choosing a stock fund, look for an expense ratio that is no greater than 1%, and when choosing a bond fund, look for one that has an expense ratio of less than 0.7%.

Choosing a fund

The first consideration when choosing from the great number of funds available is to choose one (or more than one) that meets your investment objective.  If you need liquidity, direct some of your investment monies into a money market mutual fund, which invests only in short-term debt securities.  If you want an investment that will provide you with growth as well as some income in the form of interest and dividend income, choose a balanced fund or income and growth fund.  If you don’t need any current income, consider investing in a growth or an aggressive growth fund. These funds invest primarily in stocks of firms that are expected to grow, thus offering a return in the form of price appreciation (capital gains). 

Choose a fund with a minimum initial and subsequent investment amount that meets your needs.  Many funds, such as the Vanguard S&P 500 Index Fund, have neither.  These funds are ideal instruments to use to begin to build your wealth.  Almost everyone can scrape together $100 as an initial investment.  Just drink fewer Starbucks. You can then sign up to have $100 automatically deducted from your checking account and invested in the fund every month. You won’t miss it.  As mentioned earlier, you can find minimum investment information in the fund prospectus.

The fund prospectus is also required to contain a table of the fees and charges discussed in this article.  All else equal, look for a no-load fund that charges no additional fees and has a low expense ratio.  You will find the fund’s turnover ratio in the prospectus, too.  This is an indicator of how many times the fund buys and sells its securities throughout the year.  The more actively managed the fund, the greater this ratio will be.  This points to higher brokerage fees that the fund must pay and can also result in a higher tax bill for you.  The fund itself doesn’t pay taxes on the capital gains it earns when it sells any of its holdings for a profit.  Instead, the fund owners—i.e., its investors—pay taxes on their proportionate share of those capital gains.

Information on the fund’s past performance is also provided in the prospectus.  While you might not want to invest in a fund that has been performing poorly, you should also keep in mind that past performance is no guarantee of future performance.  Also keep in mind that the returns the fund reports do not take any load charges into account.  Nevertheless, past performance can give you an indication of the volatility of the fund over time.

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