investors have come to rely on mutual funds as their primary investments. The
growth of funds has been explosive, with individuals, retirement plans and
others putting well over $1 trillion in the funds by the mid-90`s.
If you are thinking of investing in a mutual fund, you should remember that they
are only one of many types of investments and that, as with any investment, you
should know and understand the nature and risks of mutual funds and options
available to you before you invest any of your money.
This edition of "The Informed Investor" provides a concise overview of
how these funds work, and attempts to answer the questions prospective mutual
fund investors most frequently ask about them. It is not an exhaustive treatment
of the subject, but rather a guide that can help you begin your investigation of
mutual funds with some basic understanding of the product.
What is a Mutual Fund?
Mutual funds belong to the class of firms known as investment companies. While
companies may offer a "family" of funds under a single umbrella name and common
administration - for example, the Vanguard Group, Fidelity Investments, or
Strong Funds - each fund offered is a separately incorporated investment
company. These are entities that pool investor money to buy the securities that
make up the fundís portfolio.
The idea behind this pooling of investor money is to give each investor the
benefits that come from the ownership of a diversified portfolio of securities
chosen and monitored daily by experience, professional advisers.
The funds create and sell new shares on demand. Investors` shares represent a
portion of the fundís portfolio and income proportional to the number of shares
they purchase. Individual shareholders of the mutual funds have voting rights in
the operation of the fund, just as most holders of common stocks in corporations
have the right to vote on certain issues involving the running of the company.
The key attribute of a mutual fund, regardless of how it is structured, is that
the investor is entitled to receive on demand, or within a specified period
after demand, an amount computed by reference to the value of the investorís
proportionate interest in the net assets of the mutual fund. This means that the
owner of mutual fund shares can "cash in," or redeem his or her shares at any
Mutual funds, therefore, are considered a liquid investment. The investorís
selling (redemption) price may be higher or lower than the purchase price. It
all depends on the performance of the fundís portfolio.
The fund has an adviser who charges a fee for managing the portfolio. The
adviser decides when and what securities to buy and sell, and is responsible for
providing or causing to be provided all services required by the mutual fund in
carrying on its day-to-day activities. All fund investors get this built-in
portfolio management whether they own 50 shares or 10,000.
The adviser generally purchases many different securities for the portfolio,
since investment theory holds that diversification reduces risk. It is this
diminished risk that is one of the attractions of mutual funds.
The fund also has a custodian, usually a financial institution such as a bank,
which holds all cash and securities for the fund.
Mutual funds are regulated by both the federal Securities and Exchange
Commission and the securities regulators of each state.
Types of Mutual Funds
Mutual funds can be classified by their investment objectives and the types of
securities they hold.
- Aggressive Growth Common Stock funds invest primarily in common stocks
to maximize capital gains. They may invest in out-of-favor companies or
companies in new industries. Current income, that is dividends, is not a
- Income Funds seek a high level of current income by investing in both
equity securities (generally high yielding common and preferred stocks) and debt
instruments (e.g., high yielding bonds).
- Money-market Funds invest in securities with short-term maturities.
Portfolios can include commercial paper issued by corporations, negotiable
certificates of deposit, short-term corporate obligations, and U.S. government
issued or backed securities, such as Treasury bills and notes.
- Corporate Bond Funds seek income by investing primarily in the bonds of
- Municipal Bond Funds invest in bonds issued by states and
municipalities to finance public projects.
- U.S. Government Income Funds invest in a variety of government
- Specialty funds focus on a single industry sector or geographical area,
such as pharmaceuticals or companies in the "Pacific rim" countries.
A fund seeks to attain its investment objectives by choosing a portfolio that
fits its investment policies or strategies.
The fundís portfolio has investment risk directly related to the securities it
contains as well as to general market and business conditions. For example, an
aggressive growth fund, because the prices of securities in its portfolio are
more volatile, is generally riskier than an income fund, which may invest in
conservative stocks and bonds whose prices do not fluctuate greatly but that pay
high dividends or interest. Regardless of the investment strategy or portfolio
no fund can escape market risk.
Disclosure: Where to get the Facts
The key disclosure documents for mutual funds are the prospectus and the
Statement of Additional Information (SAI). The prospectus explains, among other
things, the fundís investment objectives, risks, sales charges, expenses, fees,
and services. The SAI includes the fundís audited financial statements, a list
of securities in the fundís portfolio at the end of its fiscal year, a list of
the fundís officers and directors, and other important information. Sometimes
the SAI will elaborate on information in the prospectus, but frequently it
contains important information that does not appear in the prospectus at all.
The prospectus must include appropriate instructions as to how to obtain the SAI
and whether any of the material contained in the SAI has been incorporated by
reference into the prospectus.
Details of the fundís investment objectives and policies may appear in the SAI.
A fund that advertises performance data must disclose total return in the SAI.
Restrictions on the type of investments a fund may make are often disclosed only
in the SAI.
It follows that you may not get a complete picture of the mutual fund if you
donít read the SAI before you send money.
Federal law entitles you to a prospectus when you invest in mutual funds. There
is no federal requirement that you be furnished an SAI.
You should obtain the prospectus and SAI from the salesperson or directly from
the company before you make the decision to invest.
YOU SHOULD NOT AGREE TO BUY ANY MUTUAL FUND SHARES UNTIL YOU HAVE READ BOTH THE
PROSPECTUS AND THE SAI (EVEN IF YOU ARE PRESENTED WITH THE OPPORTUNITY AND THE
SALESPERSON PRESSURES YOU TO BUY).
There has been a trend in recent years to consolidate a number of funds into a
"complex" or "series" and then produce one massive disclosure document covering
them all. You must be even more careful about these so-called "telephone book
disclosure" of fund complexes. Trying to track a single fund through such a
"telephone book" can be daunting, even for professionals.
Mutual Fund Sales Charges (Loads) and Other Expenses
Sales Charges or "The Load"
Sales charges on mutual funds are often referred to as the "load." There are
no-load funds, front-end load funds and back-end load funds. Look in the front
of the prospectus for a summary of fees. Federal law requires they be disclosed.
Funds that sell their shares to investors without a direct sales charge are
called "no-load" funds. No-load fund shares are sold to investors at the fundís
net asset value per share. The fund calculates net asset value each day by
adding the value of its securities and other assets, subtracting liabilities,
and dividing by the number of fund shares outstanding.
Some mutual funds use a sales organization of distributors and dealers - for
example, brokerage houses and large financial planners. These funds sell their
shares not at net asset value but at a higher offering price, or "asked price."
The difference between net asset value and the offering price goes to the fundís
sales organization. For example, assuming a load of 8% for $10,000 invested in a
fund, $9,200 would be used to purchase fund shares; the rest would be
A load fund can charge up to 9.3 percent of the amount invested. If there is no
load, all of the investorís money is used to purchase fund shares.
Some funds use an indirect charge, known as a Rule 12b-1 fee, named for a
Securities and Exchange Commission rule, which can range from one-tenth to
one-and-one quarter percent of the fundís average annual assets. Over a period
of a year the Rule 12b-1 fee, which has the effect of lowering the shares` net
asset value by subtracting the fee from the fund, can cost the investor more
than the sales fee charged by load funds.
Loads can be classified as front-end and back-end. You pay the front-end load
when you purchase shares, as in the example cited above. You pay the back-end
load when you redeem your shares. If, for example, you cash in shares worth
$10,000 and were charged a 4% back-end load, you would receive a final payout of
One type of back-end load is the "contingent deferred sales charge," which is
usually expressed as a percentage of the original purchase price or value of
shares redeemed. In most cases, the longer you hold the shares, the lower the
contingent deferred sales charge.
Another fee that acts like a back-end load is the redemption fee. This fee can
be as high as 2% and is charged when you redeem your shares. Funds can have both
a redemption fee and a back-end load.
Prices for most mutual funds appear in the business or financial sections of
newspapers. For a no-load fund, the sale price and net asset value are
identical. For a load fund, the sale price is the "offer price" or "asked
If you are investing in any fund with a load, make sure you know exactly how
much the sales charges are. The broker dealer who sells you the shares is not
required to disclose sales charges on the confirmation slip that is provided
after the sale is complete. You must ask for this information.
Sales charges or loads are distinct from fund operating expenses; that is, a
fund will have operating expenses whether or not it charges a load. These
expenses are usually deducted from the fundís dividend and interest income and
directly affect the investorís rate of return.
Expenses include the adviserís fee for managing the portfolio, the custodianís
and transfer agentís fees, the fundís brokerage commissions, expenses for annual
Some funds also charge an annual Rule 12b-1 fee, as mentioned above, which
permits them to use fund assets to pay for advertising and other marketing
For a full understanding of fund expenses, you must review both the prospectus
and the SAI.
To maintain a personal regular investment program, some investors buy shares
periodically under a contractual plan. These accumulation shareholders make a
commitment to pay for new shares on a regular basis over a period of several
One drawback of the contractual plan is that if you redeem your shares early or
discontinue payments, you may have to pay a substantial penalty. This factor
might make contractual plans unsuitable for some investors.
How you make (or lose) money on a mutual fund
Remember that a mutual fund uses money paid to it by shareholders to buy the
securities for its portfolio consistent with its stated investment objectives.
These securities may generate interest income and pay dividends. They, like all
stocks, may also go up or down in price.
If debt instruments (bills, bonds, notes, etc.) in the portfolio earn interest,
the fund distributes the interest to shareholders as dividends. Stock dividends
the fund receives are also distributed to shareholders as dividends.
If, for example, the fund purchases a common stock at $5 a share and later sells
it at $10 a share, it realizes a capital gain, which is passed to shareholders
as a capital gains distribution.
When redeeming shares, the money investors receive depends on how well the
portfolio has performed since the shares were purchased. The fund will multiply
net asset value at redemption time by the number of shares the investor is
redeeming, subtract applicable loads and fees, and send the proceeds to the
investor. If net asset values have declined, investors will receive less than
their original investment.
Since you have to pay income tax on capital gains, you must match the net asset
values at which shares were purchased against the net asset values at which
shares were sold. If you made money on the redemption of mutual fund shares you
will have to pay the capital gains tax. If you lose money there may be a tax
advantage in taking a capital loss. There is more than one way to perform these
computations; you may want to consult a tax adviser as to the method that best
fits your circumstances.
Mutual Fund Performance
Investors should keep two related principles in mind when they examine mutual
fund advertisements and disclosure materials:
No mutual fund can
guarantee future performance. Any such guarantee is illegal.
The past performance of a fund does not predict its future performance.
Nevertheless, fund performance is one of several factors that should be
examined. When comparing several funds with similar objectives and
characteristics, an investor would probably select a fund that has
consistently outperformed the others.
The two primary measures
of performance are yield and total return.
Yield is the income generated over a specified time period divided by the
fundís current price per share.
While yield is a measure of current performance-how much income an
investment generates--total return measures per share change in total value
over a specified time period. All fund activity that has an effect on net
asset value (dividends, capital gains, unrealized capital gains and losses,
etc.) is represented in this measure. It provides, therefore, a more
complete picture of fund performance than the yield or net asset value
alone. The investor may approximate total return by using data that appears
in the "Per Share Changes and Capital Income" section of the prospectus.
Changes in yield do not reflect a corresponding increase or decrease in the
fundís net asset value. A fund may increase yield by purchasing investments
that are riskier but offer higher interest payments--for example, junk
bonds. But, the higher yield may be offset by a deteriorating capital
position or a lower total return.
A prospective investor should review disclosure documents before investing. But
shareholders should do their homework as well. Although federal law requires
that prospectuses be amended annually, it does not require sending new versions
to shareholders. If you have not recently examined the prospectus for a fund you
own, you should monitor your investment by obtaining and reading the most recent
prospectus, SAI and financial statements--these may contain important changes.
Careful reading of quarterly and annual reports is also necessary to keep up
with changes in your investment.
Tips on Buying Mutual Funds
1. Determine your financial objectives and how much money you have to invest.
Make sure the fundís objectives coincide with your own. Donít change your
objectives or exceed the amount set aside for investment unless you have good
2. Always obtain all available information before you invest. Request the
prospectus, the Statement of Additional Information and the latest shareholder
report from each fund you are considering.
3. Never invest in periodic payment plans unless you are virtually certain
that you will not have to redeem early. If you redeem early or do not
complete the plan, you may have to pay sales charges of up to 51% of your
4. Be on the alert for incorporation by reference. You will have "no
excuse" for not knowing this information, if a problem arises. You may be
legally presumed to know materials incorporated by reference in a prospectus or
5. Always determine all sales charges, fees and expenses before you invest.
Fees such as 12b-1 fees can cost you dearly and charges for reinvestment of
dividends and capital gains distributions can substantially add to your costs.
Shop around among the many funds offered and compare the various fees and costs
connected with funds that appeal to you.
6. Learn the costs of redemption. Sometimes investors are surprised to
learn that they have to pay to get out of funds through back-end loads or
redemption fees. Find out the redemption costs before you invest so you wonít be
unpleasantly surprised when you redeem your shares.
7. Never treat the risks of investment in a fund lightly. Weigh the risks
of the funds you want to buy against your ability to tolerate the ups and downs
of the market and your investment goals. Be extra cautious when considering
investing in funds with high yield/high risk portfolios. Junk bond problems, for
example, invariably affect the fundís performance.
8. Donít be misled by the name of a fund. Some funds have been given
names denoting safety, stability and low risk, despite the fact that the
underlying investments in the portfolio are volatile and highly risky.
9. Donít base your decisions solely on advertising and sales materials.
Unlike the prospectus and the SAI, advertising and sales literature are not
reviewed by the Securities and Exchange Commission before they are issued. The
picture presented in a fundís advertisement might be rosier than that revealed
by the prospectus and SAI.
Other sources of information
Learn all you can about mutual funds in general. If you need or desire
additional general information on funds and investing, ask your broker-dealer,
the investment companies or state securities regulator for relevant brochures,
pamphlets and other publications. Local libraries are often well stocked with
books that discuss mutual funds in great detail.
If a problem arises
The securities administrator in your state, province or territory is responsible
for policing investments for fraud. If you believe you have encountered an
investment fraud, contact your state securities regulatorís office. In Georgia,
call (888) 733-7427 or (404) 656-3920. Log on to www.georgiainvests.org.
The Council of Better Business Bureaus and Better Business Bureaus in the United
States and Canada answer inquiries on companies located in the areas they serve.
Before putting money in any investment plan, it is a good idea to contact your
Better Business Bureau for a reliability report on the company you intend to
deal with. For more information, contact the BBB office that serves your area.
They are listed in the white pages.
Back-end Load - Charge imposed by a mutual fund when an investor
redeems shares. Redemption fees and contingent deferred sales charges are
Contingent Deferred Sales Charges - Back-end load imposed on an
investor who redeems shares. It is usually expressed as a percentage of the
original purchase price or of the value of shares redeemed. In most cases, the
longer the investor holds his shares, the smaller the deferred sales charge.
Distribution - Payments made to shareholders by the mutual fund.
Interest and stock dividends earned by the fundís portfolio are passed to
shareholders as dividends, while capital gains are passed as capital gains
Dividend Reinvestment Fee - Fee charged when an investor uses
dividends paid by a mutual fund to purchase additional shares of the mutual
Exchange Fee - Fee charged when an investor switches from one
mutual fund to another in the same family of funds.
Front-end Load - Sales charge applied at the time the investor
Investment Companies - The companies that pool investor monies to
purchase securities. The Investment Company Act of 1940 created three types of
investment companies: face-amount certificate companies, unit investment trusts
and management companies.
Management Companies - There are two types: open-end and
closed-end. Open-end funds, which sell and buy shares back on demand, are called
mutual funds. Closed-end funds have a fixed number of shares. After the initial
public offering, shares in closed-end funds trade only on exchanges. The price
is determined by the market and does not necessarily reflect the net asset value
of the shares.
Management Fee - A fee paid by the mutual fund to its investment
adviser and charged against fund assets, generally 1% or less per year.
Net Asset Value - In effect, the share price of a fund computed
daily by adding the value of the fundís securities and other assets, subtracting
liabilities, and dividing by the number of shares outstanding. For a mutual fund
with a front-end load, net asset value is identical to the "asked price" or
Prospectus - A disclosure document which should provide the
investor with full and complete disclosure of all material information needed by
the investor to make a decision whether or not to invest. The prospectus
generally incorporates the SAI by "reference." (See SAI definition.)
Redemption Fee - A fee charged to an investor who redeems shares.
It is generally expressed as a percentage of the value of shares redeemed.
Rule 12b-1 Fee - An asset-based sales load, permitted by SEC Rule
12b-1, representing annual charges of up to 1-1/4% for specific sales or
promotional activities of the mutual fund. Over time, the amount paid in Rule
12b-1 fees can surpass the amount paid in sales fees charged by load funds.
SAI - A disclosure document called a Statement of Additional
Information. The SAI is not required to be furnished by mutual funds to
investors unless investors specifically request it. Investors are responsible
for information in the SAI, even if they donít request it.
Total Return - A computation of mutual fund performance which
measures changes in total value over a specified time period. Included in the
computation are distributions paid to investors, capital gains distributions and
unrealized capital gains and losses. Since all fund activity which has an effect
on net asset value is represented, this measure provides a picture of
performance which is more complete than yield.
Yield - A measure of mutual fund performance, which is figured by
dividing the income generated (dividends, capital gains distribution, etc.) per
share for a specific time period by the fundís current price per share. For
example if, during a year, a single share of a fund had paid income totaling $1
and its share price was $10, the annual yield for that year would be figured by
dividing 1 by 10, which equals one tenth, or a yield of 10%.