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Understanding Mutual Funds

What is a Mutual Fund? I hope to answer this question and give you a better perspective about Mutual Funds. Understanding Mutual Funds can help you reach your short term and long term investment goals. Different types of funds will be examined as well as the essentials of buying and selling mutual funds. Also, investment strategy will be closely examined as well as some of my own ideas on Mutual Fund Investments.

A Mutual Fund is an investment company that pools the money of many individual investors. When the fund takes in money from investors, it issues shares. The price of a mutual fund share is the total net assets (the funds assets less liabilities) divided by shares outstanding. This is also referred to as the firms Net Asset Value (NAV). Unlike stocks, whose prices are subject to change at each trade, mutual fund NAV’s are calculated at the end of each day.

Understanding Mutual Funds

Open and Closed End Funds

A mutual fund is also an “open-end” vehicle. That means the fund doesn’t have a fixed number of shares, but issues new shares as it takes in money and redeems them as investors withdraw. This type of mutual fund offers liquidity for investors.

A smaller number of funds are “closed-end” funds. They raise their capital during offering periods, and once the pool is closed, investors can only get into the fund or out of it by buying or selling the shares on a stock exchange or in the over-the-counter market.

Understanding Mutual Funds

Types of Mutual Funds

There are many different types of mutual funds that the intelligent investor would want to look at before making an investment. One type of fund might suit one type of investor better than another type of investor. The four different types that we will look at in detail are Equity Funds, Bond Funds, Money-Market Funds, and Closed-End Funds. There are many types and categories of funds within each of these four different types of funds and I will list each type (subcategory). However, I will not go into detail on the subcategories because this would be too lengthy of a process.

Equity funds are those funds that invest in equities, or in common stocks. Many of the companies most widely held by equity funds are household names – IBM, AT&T, Philip Morris, General Electric, etc.

There are many types and categories of Equity Funds. A few examples of the categories Equity Funds fall into are Maximum Growth Funds, Small Company Funds, Growth Funds, Growth and Income Funds Equity Income Funds, Balanced Funds, Asset Allocation and Multiasset Global Funds, International Funds, Precious Metals Funds, Specialty Funds, and Index and Social Investing Funds.

Bond Funds may be the most difficult or easiest to understand depending on the way you want to look at it. Bond funds are composed of a number of different types of bonds and measured by interest rates and derivatives. When interest rates decrease (increase) bond prices increase (decrease). If you understand this you have an idea of how bond, or fixed income, mutual funds operate.

There are many types and categories of Bond Funds. A few examples of the categories Bond Funds fall into are Corporate – High Yield Funds, Corporate – High Quality Funds, Corporate – General Funds, Multisector Bond Funds, International – World Bond and Short-Term World Income Funds, Government – Treasury Funds, Government – General Funds, Government – Mortgage Funds, Government – Adjustable Rate Mortgage Funds, Municipal – National Funds, Single State Funds, Convertible Funds.

Money-market funds are much different from stock and bond funds. Their principal difference is that they keep their share prices at a constant $1 per share. They’re able to do this because they invest in very short-term debt instruments. Usually those investments are so small that funds can maintain their constant dollar price. As such, a money-market mutual fund account will look much like a bank account.

There are many types and categories of Money Market Funds. A few examples of the categories Money Market Funds fall into are U.S. Treasury Bills, Bank Certificates of Deposit, Bankers acceptances, Commercial Paper, and Tax Exempt Funds.

Closed End-Funds are similar to regular mutual funds in that they are professionally managed portfolios of securities and are regulated by the same laws. Many mutual fund management companies run closed-end funds, and for many of those funds the portfolios look a lot like their regular mutual fund counterparts. The returns from the best closed-end funds are much like the returns from regular mutual funds.

Closed End-Funds developed before mutual funds, and they have characteristics that are similar to the stocks and bonds traded in the security markets. A closed end investment company has a set capital structure that may be composed of all stock or a combination of stock and debt. The number of shares and the dollar amount of debts that the company may issue are specified. The shares in a closed end investment company are bought and sold in the open market, just as the stock of IBM is traded. Shares of these companies are traded on the New York Stock Exchange (i.e., Adams Express), on the American Stock Exchange (i.e., First Australia Fund) and in over-the-counter markets (i.e., Z Seven Fund).

Buying and Selling Mutual Funds

Buying and Selling Mutual Funds should be very important to the Intelligent Investor as well. When you go out and decide to buy a mutual fund you most likely will buy the fund through a salesperson (i.e. stockbroker, financial planner, or sometimes a dually-licensed life insurance agent) or buy the fund directly from the mutual fund company. If you buy the fund through a salesperson you pay a sales charge or “load”. A “load” is a fee that compensates the salesperson for selling you the fund. If you bought the fund directly from the mutual company there was no salesperson, so the fund was purchased “no load,” without the fee.

Understanding Mutual Funds

“Load” funds sold by brokerage firms were most prevalent until the 1970’s. Up until then, the usual “load” charge (or commission to broker) was 8.5%. In the early 1970’s, the stock market plummeted and so did mutual fund sales. In order to raise capital, some companies started to sell their funds direct to investors without a sales charge – “no load.” Until the mid 1980’s the mutual fund universe was split between the “loads,” which stuck with their 8.5% sales charges, and the no-loads. Then the load funds feeling investor resistance to the stiff fees, started lowering their sales charges. Most of the load funds have now dropped their fees to the 4-6% range. Increasingly they have also offered funds with different methods to pay the sales charge, the “back-end load” and the “level load.”

Back-end loads can be summed up by their name. They call it a back end load, “redemption fee,” “exit fee,” or technically, the “contingent deferred sales charge.” The fee starts at 4 or 5 percent of the value of the funds you’re selling, depending on the fund. If you sell your shares in the first year, you pay the ful

l charge. In the second year, your exit fee drops by 1 percentage point, and so on. By the fifth or sixth year redemption fees are usually gone, so if you’re a long-term investor, you may never pay that fee.

“Hidden loads” are yet another way to buy mutual funds. This load carries what brokers call the “12(b)-1 fee.” The 12(b)-1 charge, named for the U.S. Securities and Exchange Commission rule which enabled funds to levy it, is, like loads, meant to help defray marketing and distributing costs. Sales force fund companies can use the 12(b)-1 revenues to compensate brokers for their selling efforts. Direct marketing companies, on the other use the money to pay for advertising. At least half of all funds levy some sort of 12(b)-1 fee. This 12(b)-1 charge is collected from it’s shareholders in a unique way. Instead of paying the charge once when the investors buy the fund (front-end load) or when they sell it (back-end load), investors pay this fee from the funds assets. Therefore, the 12(b)-1 charges are treated just like the fees shareholders pay for portfolio management, administration, auditing, printing, postage, and other expenses.

Investment Strategy

Investment Strategy is very important when deciding to invest in Mutual Funds. Rather than discussing top performing Mutual Funds (which after extensive research, I found out was much too broad to go into), I thought discussing Investment Strategy would be a much better topic. Individuals will have different investment strategies for different reasons when selecting a mutual fund. One of the most important things to keep in mind is that you are investing your own money so the decisions that you make or your broker makes you will have to live with. After reading several articles on Mutual Fund Investment Strategy in Forbes, U.S. News, and Fortune Magazine I have put together some of the best ideas (in my opinion) that these reports had to offer. In order to be successful in investing in Mutual Funds one must concentrate and look at the markets. This past few years we have encountered what most would consider a “bull” market period followed by a rather sluggish “bear” market period that has been dominant the last 6-8 months. This is what good timing is all about, one must understand the markets moods in order to be successful at making money within it. Learning to live with risk is something the Intelligent Investor may want to consider. Playing it safe in today’s volatile stock market isn’t necessarily less risky, sometimes taking a chance is wiser.

Understanding Mutual Funds
The first thing I would recommend in investment strategy is to closely examine the prospectus of the mutual fund you are looking at. It may be boring, but it is for your own good. The language within a prospectus is mostly in legal and financial terms that may sound awfully technical. The language is precise for a reason. The SEC has strict guidelines about what the fund can say about itself and how it must present information on past performance, expenses, and fees. Remember, the SEC’s approval of a prospectus is only that. It is not an endorsement of any particular investment. However, after you read the prospectus on a certain fund it should give you an idea of whether or not that fund is for you or if it meets your investment criteria.

Some of us may ask ourselves the question “should I buy mutual funds on margin?” I will be the first to say buying on margin does work. I will try to illustrate a favorable example of buying on margin. Suppose a fund investor thinks stocks are about to stage a big rally and thinks highly of the Janus Mercury Fund. She decides to invest $10,000 in that fund. If the fund goes up 25 percent in the next six months, the investment is worth $12,500, and the investor can cash out at a profit of $2,500. But if the investor buys on margin she could invest $20,000 in the fund: $10,000 is her money and $10,000 is a loan from the brokerage firm. The interest rate on the loan is usually the brokers loan rate (a figure similar to the banker’s prime rate) plus anywhere from 0.5 to 1.5 percent, depending on the size of the loan. If the fund goes up 25%, the leveraged investor’s holding climbs to $25,000, and if she sells it, there’s a 50% return on the original $10,000 investment – a $5,000 profit less the interest expense. Let’s say the loan of $10,000 was for 6 months at 10% interest. That comes out to $500. The investor nets (before commissions) $4,500 on her original $10,000. In a cash account that does not use margin, the net profit would be $2,500. However, do not “spend” on margin. This can work in the opposite direction as well and the example above is not always what happens. There is nothing like a margin call to ruin your day, or quite possibly your month.

Thinking small may not be a bad idea right now. Small Company stocks have been a dilemma for most investors the past few years. They looked like bargains, and the pundits predicted they would go up. But investors have proved willing to pay dearly for blue chips. Now, small stocks, as measured by the Russell 2000 index are so cheap that their price to earnings ratio is hovering at a 20 year low relative to blue chips, trading at less than 80 percent of the price to earnings ratio on the S&P 500 index. Because earnings at small companies typically grow so much faster than at larger, established businesses, small stock P/E’s usually trade at 1 ½ times that of the S&P P/E. Mutual funds composed of relatively small company stocks may not be a bad investment for the future.

Mutual Funds with Value Stocks are another type of stock that I find promising today and maybe in the future. Value stocks by definition are out-of-favor stocks with prices that, for any number of reasons, are lower than their long-term business prospects warrant. That goes double for the group these days. Investors, focused only on the earnings momentum of growth stocks (and sometimes just the promise of future earnings momentum), couldn’t be less interested in comeback stories. Looking at the annual charts, some of these Value Stocks have shown some rather healthy returns the last few years and should not be ignored.

Junk Bonds sometimes aren’t “junk.” In the third quarter of 1998, the differences between Treasury bonds and high yield “junk” bonds became clear. Bonds overall returned 4.2 percent while investors were uneasy about falling stocks; junk bonds, meanwhile, fell 4.6 percent. Before you avoid junk bonds consider their worst year – 1990 when they lost 9.6 percent – was followed by a 46 percent return in 1991. No one is expecting a comparable rebound, but today’s prices, pushing yields over 10 percent, may reflect an outlook that’s a bit pessimistic. Such high yields are a sign that investors think default rates will rise in an economic slowdown. However, junk bonds could return 8 to 12 percent this year – anything is possible. Sometimes looking at high risk Mutual Funds (i.e. high income funds) with a little bit of “junk” in them may not be a bad thing.

I hope that I have given you a better understanding of mutual funds so that you might be more familiar with them. I have tried to illustrate the different types of Mutual Funds, the buying and selling of Mutual Funds, and Investment Strategy. Also, I have tried to mix in my own investment philosophy as well. I have found that Mutual Funds can be a solid investment for those who are willing to give them a try.

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6 Responses to “Understanding Mutual Funds”

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    i’ve heard this before but i’ts interesting nonetheless.

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  4. admin says:

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