The Investment Series: Mutual Fund Basics

Mutual Fund Basics  (Go to the Investment Series for other Basics)

This is the third article in a series on investment basics. If you are new to investing, it is recommended that the articles be read in order. Prior articles introduce terminology that is used in later articles.

What is a Mutual Fund? The Myth of the Best Performing Funds
Why a Mutual Fund? Obtaining Information About Mutual Funds
A Brief Discussion of Risk Bond Funds
The Role of the Prospectus Closed-End Mutual Funds
Costs of Funds Beta
How Funds Make Money for Investors Conclusions
The Fund Manager

What is a Mutual Fund?

A mutual fund is an investment vehicle in which investors pool their money in order to allow each investor to participate in a portfolio of securities. The investor does not own the individual securities but instead owns a shares of the mutual fund. A mutual fund provides a method for an investor to have diversification of investments without investing a lot of money

The first mutual fund in the nation was the Massachusetts Investors Trust introduced publicly in Boston in 1924. At the end of that first year, the fund had 200 investors and $63,600 in assets. At the end of 1995, the fund had 73,500 investors and assets of 1.8 billion dollars. There are now well over 7000 mutual funds available.

Why a Mutual Fund?

Bond Funds
A bond fund is a mutual fund targeted at the buying and selling of bonds. When you own an individual bond, the par value is yours upon maturity providing the issuer has remained viable. When you own a share of a bond fund, you do not have this assurance.

A mutual fund offers two major advantages over ownership of individual stock: diversification and professional management.

Diversification helps to reduce risk. By owning shares of multiple companies, the fund's share value is not devastated by the poor performance of an individual company. (Conversely, the impact on fund share value due to the success of an individual company is also cushioned.)

The selection of which securities to buy, the allocation of cash and securities, and the timing of purchases is performed by the fund manager or management team. These individuals have the resources, time, and training to make well informed investment decisions subject, of course, to their individual style, skill, and experience.

There may be other advantages to a mutual fund as well.

The fund may be part of a family of funds in which the investor can switch between different funds at no cost, including switching in and out of a money market fund.

Many mutual funds include some degree of check writing privileges.

Many mutual funds offer automatic transfer of funds on a periodic basis (e.g. monthly) for those wishing to regularly invest a set dollar amount. This investment technique is called "dollar cost averaging".

A Brief Discussion of Risk

In the booming market of the last several years, it may be easy to forget that risk is real. Individuals making risky investments can and do lose money- sometimes lots of it. The reason for investing with higher risk is to realize a higher potential for gain. Be aware that the mere fact that something is risky does not mean that it has good gain potential.

When it comes to risk, not all mutual funds are created equal. Some may invest in risky businesses or risky sectors, thereby placing the value of a fund share at greater risk. Other may only invest in "blue chip" stocks and have a lower risk of loss of fund share value.

The investment focus and latitude is specified in the prospectus.

The "beta" of a fund is a calculated number that predicts the volatility of the fund relative to a specified index. For example, if the underlying index were the S&P500, then a beta of 1.2 would predict that the fund would move up or down 20 percent more than  movements of the S&P500.

The Role of the Prospectus

A prospectus for a mutual fund is a publication containing information required by the Securities Exchange Commission (SEC). It will include objectives and policies, roles, services, fees, and major features of the fund.

The prospectus defines the boundaries within which the fund manager can operate. Using a hypothetical example, we will assume that the prospectus of the Duck Farms Mutual Fund states "the fund will only invest in duck 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 duck farm meeting those criteria. However, the fund could not buy duck farm shares in France even if a great year in France were expected.

The prospectus will also identify the costs of the fund.

Costs of Funds

Typically 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 any of several sources:

    1. A sales charge: incurred upon purchase of shares
    2. A deferred sales charge: incurred upon sale of shares
    3. Management fees: an on-going operating cost
    4. Distribution fees (12b-1 fees): on-going costs generally associated with advertising
    5. Trading costs: costs charged by the broker for executing trades within the fund. These can be high in finds with high turnover rates.
    6. Other expenses: another category of 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 different cost structures. An example of the impact of an investment held for different periods of time will be included in the prospectus.

The best deal for you is largely dependent on how long you hold the shares. No-load funds held for several years can be more expensive than load funds.

How Funds Make Money for Investors

Closed-end mutual finds
Some mutual funds issue a limited number of shares. In the more common open-end funds, new investors are accommodated by creating more shares. In a closed end fund, the number of shares are fixed, so new investors only get into the fund if an existing investor sells shares. This creates a supply and demand situation for the shares that is somewhat independent of the value of the underlying holdings, i.e. the NAV. Therefore closed-end funds trade at a premium or a discount to their NAV depending on the investor's perception of the future value the fund.

Since funds include securities, funds provide investors a return via dividends and distribution of capital gains realized by the sale of individual securities by the fund.

In addition, the shares of the fund itself have a Net Asset Value (NAV). The NAV is the value of all of the fund's holdings divided by the number of shares minus expenses. If the holdings of the fund do well, the NAV will increase and the investor may chose to sell shares to take the gain or to hold shares in the hope of even greater future gain. Most mutual funds are open-end funds and the share price is the same as the NAV. The NAV is calculated nightly.

The Fund Manager

The fund manager is critical for a fund whose prospectus allows investment latitude. As with any profession, fund managers will vary in skill. Furthermore, a manager whose skills apply very well in one set of market conditions may find those same approaches inappropriate for a different set of conditions. Some managers have compiled a steady record of excellent performance through a variety of market conditions. With so many mutual funds available, it would be unreasonable to expect all to have the best managers. Fund managers may move during the life of a fund. The great manager in charge of your fund today could chose to work somewhere else tomorrow. The replacement manager might not be as good. And remember, an excellent fund manager can have a bad year simply because the prospectus limited the investments to an underperforming market area.

The Myth of the Best Performing Funds

At each year end, numerous financial publications list the year's best performing mutual funds. Eager investors who rush out to buy shares of last year's top performer are usually making a mistake. Changing market conditions make it rare that last year's top performer repeats that ranking for the current year. Fund investors would do well to consider the prospectus, the fund manager, and the current market conditions; and not just last year's winners.

Obtaining Information About Mutual Funds

To obtain the prospectus for a mutual fund, call the fund company. In many cases, the prospectus is available at the company's website.

Morningstar rates mutual funds. At their comprehensive website, information for individual funds includes:

Morningstar's rating of the fund

Morningstar's categorization of the fund (You will find funds titled as "value funds" but classified as "growth funds" by Morningstar.) Morningstar also includes some free tools to help you select funds that meet certain criteria that you can specify.


Mutual funds are a method for investors to diversify risk and to benefit from professional money management. The prospectus identifies key information about the fund including its operating boundaries and its costs. The fund manager operates within those boundaries and is a critical to achieving strong results within those boundaries.

Our next article will discuss a powerful investment strategy: Asset allocation. Check back for it.

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