Saturday, October 17, 2009


A fund is a pooled investment vehicle--where many individuals pool their money to purchase many investment products, each owning a percentage of the whole, or a share. There are three basic types of pooled investment vehicles: open-end funds, closed-end funds, and unit investments trusts (UITs).

Open-end funds are called open-ended because the number of shares they can sell is is not fixed; they continuously issue new shares and redeem existing ones. Mutual funds are the best-known examples of open-end funds.

Closed-end funds, unlike mutual funds, sell a fixed number of shares at one time (in an initial public offering) that later trade on a secondary market.

Unit Investment Trusts (UITs) make a one-time public offering of only a specific, fixed number of redeemable securities called "units," which will terminate and dissolve on a date specified at the creation of the UIT.

Exchange-traded funds (ETFs) can be either open-end funds or UITs and aim to achieve the same return as a particular market index.

**Hedge funds**
A "hedge fund" is a non-legal term meaning a private, unregistered investment pool traditionally limited to experienced, wealthy investors. Because hedge funds are not mutual funds, they are not subject to the regulations that govern mutual funds and therefore do not offer the same protection for investors.

There are even "funds of hedge funds," which often have lower minimum investment thresholds so that they can sell to more investors that traditional hedge funds, but offers more limited rights of redemption than mutual funds. Funds of hedge funds are usually not listed on any exchange.

Chances are, if you're reading this, you're not an experienced, wealthy investor, so you should probably steer clear of hedge funds for the time being. To learn more about hedge funds and funds of hedge funds, see FINRA's Investor Alert, "Funds of Hedge Funds--Higher Costs and Risks for Higher Potential Returns."

Mutual Funds (open-end funds)

How they work

Mutual funds are established so that individual investors can pool their money and create a diversified portfolio. When you buy mutual fund shares, you become a shareholder of a fund that holds a variety of investments. By diversifying, a mutual fund spreads risk across numerous investments sources (often including stocks, bonds, and money market assets) rather than relying on just one to perform well. Many investors choose to buy mutual funds that spread their investments across a range of industry sectors to further diversify their holdings, while others

Mutual funds have varying degrees of risk. They also have costs associated with owning them, such as management fees, that will vary depending on the type of investments the fund makes. The price that investors pay for a mutual fund share is called the NAV or net asset value per share, plus any shareholder fees such as sales loads. All mutual fund shares have a high degree of liquidity, meaning that investors can decide to sell their shares back to the fund at any time (at the current NAV plus any redemption fees and charges).

Mutual funds are run by investment professionals who decide which investments to buy or sell for the fund. Their decisions are guided by the fund's investment goals. For example, some mutual funds are designed for people who want to have easy access to their money and invest only for a short time. These funds invest primarily in government securities or very short-term bank CDs, where the investment risks are moderate. Other mutual funds appeal to people who are willing to take on more risk with the goal of a higher return. Such funds invest primarily in corporate or municipal bonds. Most mutual funds, however, are more diverse, offering a mix of investments. A typical fund portfolio includes between 30 and 300 different stocks, bonds, and other investments.

Since mutual funds are managed by financial professionals, they can be a good choice for a beginning investor. This is not to say, however, that mutual funds are risk-free because even financial investment planners aren't perfect (despite what they may tell you). But in general, the potential gains from investing in a mutual fund outweigh the potential losses if you're in it for the long haul.

Funds can earn money in 3 ways: dividend payments, capital gains distributions, and increased NAV.
  • A fund may earn income in the form of dividends and interest on the securities in its portfolio. The fund then pays its shareholders the income (minus disclosed expenses) it has earned in the form of dividends, or the shareholder can choose to have the dividends reinvested in the fun to buy more shares.
  • The price of the securities a fund owns may increase. When a fund sells a security that has increased in price, the fund has a capital gain. At the end of the year, most funds distribute these capital gains (minus any capital losses) to investors, unless the investor has chosen to have these earnings reinvested.
  • If the market value of a fund's portfolio increases after deduction of expenses and liabilities, then the value (NAV) of the fund and its shares increases. This increase is not paid to the investor, but reflects the higher value of the investment.

The share price (the price that investors pay to purchase mutual fund shares) is the approximate per share NAV, plus any fees that the fund imposes at purchase (such as sales loads or purchase fees, discussed below). The price that investors receive on redemptions is the approximate per share NAV at redemption, minus any fees that the fund deducts at that time (such as deferred sales loads or redemption fees, also discussed below).

Fees and Expenses
When choosing a mutual fund, you'll want to look at not only its holdings, stated goals, risks, and past rate-of-return, but also any fees and expenses incurred--all of which you can find in a fund's prospectus. All mutual funds charge fees (hey, those fund managers have to pay for their BMWs somehow), which are usually listed as a percentage of average net assets, called the total annual fund operating expense (aka expense ratio). Obviously, the lower the percentage, the better, as fees and taxes diminish a fund's return. Unfortunately, investors must pay the shareholder fees, sales charges, and other expenses (see below) regardless of the fund's performance. All shareholder fees and operating expenses (see below) must be displayed in a fund's prospectus in the fee table.

Shareholder Fees
A sales charge (aka front-end load) is a fee expressed as a percentage of your investment. For instance, if you want to invest $1,000 in a fund with a 5% sales charge, $50 will go to the broker for the front-end load and the remaining $950 will be invested. Some mutual funds reduce the front-end load as the size of your investment increases. Similar to the sales charge is the purchase fee, which some funds charge in order to pay some of the administrative costs of trading shares. When you sell your shares, another fee, called a deferred sales charge (aka back-end load), which goes to the broker who makes the sale. Usually it depends on the length of time the investor owned the shares (decreasing with time); this type of back-end load is called a contingent deferred sales load (aka CDSC or CDSL). A redemption fee is basically the same as a purchase fee, except that it's paid when you sell your shares rather than when you buy. Some funds charge what they call an account fee that they use for account maintenance and administration; it's usually imposed on accounts with a low value.

Note that even no-load funds may charge shareholder fees, such as purchase, redemption, and account fees, as well as operating expenses.

Some mutual funds that charge front-end sales loads will charge lower sales loads for larger investments. The investment levels required to obtain a reduced sales load are commonly referred to as breakpoints. You should always ask how a fund you're interested in establishes eligibility for breakpoint discounts (if it has them), as well as what the fund's breakpoint amounts are. NASD's Mutual Fund Breakpoint Search Tool can help you determine whether you're entitled to breakpoint discounts.

Annual Fund Operating Expenses
These fees are paid out of fund assets. Management fees are administrative fees that go to the fund's adviser or manager; distribution (and/or service) fees (aka 12b-1 fees) cover the costs of marketing and selling shares and investor services. Other fees may be imposed to defer custodial, legal, and accounting expenses.

When choosing a fund, pay close attention to the fee tables as even a small difference in fees can translate into a big difference in returns over a long period of time. You can compare the fees and expenses of up to three mutual funds, or the share classes of the same mutual fund with FINRA's (Financial Industry Regulatory Authority) Mutual Fund Expense Analyzer. It also allows you to compare the fees and expenses of up to three mutual funds. Enter each fund's ticker symbol or select the fund through the drop down menu. If you can't remember the exact name of the fund, you can search for it using key words.

The SEC's (U.S. Securities and Exchange Commission) online interactive Mutual Fund Cost Calculator can also help you compare the costs of different mutual funds and understand the impact that many types of fees and expenses can have over time. Unlike NASD's Mutual Fund Expense Analyzer, you'll need to enter fee and expense information manually from a prospectus or other disclosure document when using this tool.

Share Classes
Many mutual funds have what they call share classes, usually denoted as Class A, Class B, etc. All the share classes of one fund will invest in the same portfolio and have the same investment goals, etc.; the difference is in the shareholder services and/or distribution arrangements (and correspondingly, different fees and expenses. In general, mutual fund class structures work like this:

Class A shares
typically have a front-end sales load, a lower 12b-1 fee, and lower annual expenses than other share classes. If you're considering Class A shares, be sure to ask about breakpoints.

Class B shares
typically do not have a front-end sales load, but may impose a contingent deferred sales load and a 12b-1 fee (along with other annual expenses). Class B shares also might convert automatically to a class with a lower 12b-1 fee if they're held long enough.

Class C shares
may or may not have a 12b-1 fee and either a front- or back-end sales load, but the loads for Class C shares tends to be lower than other classes. This class of shares generally does not convert to another class and tends to have higher annual expenses than other classes.

Categories of Mutual Funds

There are thousands of mutual funds to choose from; most of them fall into one of three categories: money market funds, bond funds (aka fixed income funds), and stock funds (aka equity funds), each having different features, advantages, and disadvantages.

Money Market Mutual Funds (MMMFs)
MMMFs are low-risk, low-return mutual funds that invest in the short-term money market. By law, they can only invest in certain high-quality investments issued by the U.S. federal, state, and local governments, as well as U.S. corporations. Money market mutual funds pay dividends based on current short-term interest rates, and because returns for these funds are generally lower than for bond or stock funds, inflation risk can be a concern. Do not confuse a money market fund with a money market deposit account. The names are similar, but they are completely different:

Bond Funds
Bond funds usually have higher risks and higher returns that money market funds. These risks may include credit risk, interest rate risk, and prepayment risk. Credit risk, the possibility that the companies whose bonds the fund owns default on their debts (the bonds), can be kept low by choosing a fund that invests in insured bonds or bonds issued by the U.S. Treasury. Interest rate risk is the possibility that the market value of the individual bonds will go down when interest rates rise; longer-term bonds are generally at higher risk for this. If interest rates fall, a bond issuer may decide to pay off its debt (your bonds) early and issue new bonds paying a lower interest rate that is more in line with the market. Your fund will then have to try to reinvest that money in another set of bonds; the risk here is that if prepayment happens, the fund may not be able to find another bond that pays as high a return as the original bond (since interest rates have lowered). This is called prepayment risk, and since it depends on the market, there's really no way to prevent it.

Stock Funds (aka equity funds)
Stocks have historically performed better than bonds and treasury securities over the long run. The biggest risk with investing in stocks (and stock funds) is overall market risk--the danger that stock prices will go down because of the general state of the economy (as is happening now) or because of a fall in demand for particular products or services that the companies you've invested in provides.

Types of Stock Funds
There are several types of stock funds, including growth funds, which invest in stocks that have the potential for large capital gains but that may not pay regular dividends, income funds which instead focus on stocks the do pay regular dividends, index funds, which invest only in companies of a specific market index in hopes that the fund will achieve the same return as that index, and sector funds, which invest mainly in a particular industry, such as technology or energy.

There are three basic styles used by fund managers in choosing which stocks to include in their funds' portfolios: the value approach, the growth approach, and the blend approach. In the value approach, managers choose stocks that are undervalued compared to similar companies; in the growth approach, managers look for stocks that are growing faster than their competitors or than the market as a whole; these are often well-known, established companies. The blend approach is used to build a portfolio of both value and growth stocks.

The stocks in a fund's portfolio can be U.S. companies or foreign companies. Since in the past U.S. and international economies have not been in sync, i.e. their stocks experience, as a whole, growth at different times, most financial advisers recommend diversifying by choosing both domestic and international funds for your portfolio.

Depending on your investment goals, of course, it is usually wise to further diversify your asset allocation further between different types of funds (stocks, bonds, cash/stable value funds) and to include all three "caps" in your portfolio. Cap or capitalization is a measurement of the size of a company, and is relevant because size/worth is related to growth potential and risk. Generally, large-cap companies are worth over $5 billion, mid-cap companies are worth $500 million to $5 billion, and small-cap companies are worth less than $500 million. Larger cap funds tend to have slower but more stable growth and usually have relatively low risk, while smaller cap funds may have faster growth potential but also might carry a higher risk.

Trading Mutual Fund Shares
Once you've found a fund you want to buy in to, you can either contact the fund directly, your broker, financial planner, or bank.

Exchanging shares
Some funds offer exchange privileges within the fund family, a group of funds that share administrative and distribution systems but that may have different objectives, strategies, and risks. Not all funds are part of a family, but if they are, you can often transfer your holdings from one fund to another as your investment goals change, usually without any fees. Taxes consequences do apply on exchanges, though--you'll have to pay taxes on the capital gains of your old shares (or if you've lost, you'll be able to take a capital loss).

Tax Consequences of mutual funds
When you own individual stocks or bonds, you must pay income tax each year on the dividends or interest you receive, but you won't have to pay any capital gains tax until you actually sell and unless you make a profit. Mutual funds work differently. When you buy and hold mutual fund shares, you will owe income tax on any ordinary dividends in the year you receive or reinvest them, and when you sell your shares, you will owe taxes on any personal capital gains. You may even have to pay capital gains taxes each year you hold the shares (since law requires mutual funds to distribute capital gains to shareholders if they sell securities for a profit that can't be offset by a loss.)

Tax Exempt Mutual Funds
Though some or all of the dividends from tax-exempt funds such as municipal bond funds are exempt from federal (and sometimes state and local) income tax, you do have to pay taxes on capital gains.

Here's the trick: if you receive a capital gains distribution, you will probably have to pay taxes even if the fund has had a negative return since the point during the year when you purchased your shares. For this reason, you should contact the fund to find out when it makes distributions so you won't pay more than your fair share of taxes. Sometime that information can be found on the fund's website.

Comparing mutual funds
When comparing mutual funds, be sure to take each of the following into account:
  • category/type of fund
  • tax consequences
  • fund objectives/goals and strategies
  • level of risk vs. return
  • share classes available
  • dividends
  • fees and expenses
  • level of diversification
  • types of holdings (industry, company size and health, etc.)
  • past performance (though this is not necessarily a reliable indicator of future performance)
  • price/affordability of shares
  • minimum initial investment
  • how shares are purchased and redeemed
You can find all this information (except perhaps the share price, which varies) in the fund's prospectus. Always request a prospectus (and read it!) before you invest in any fund.

Here's some of what you'll find in mutual fund prospectuses:
  • Date of Issue — The date of the prospectus should appear on the front cover. Mutual funds must update their prospectuses at least once a year, so always check to make sure you're looking at the most recent version.
  • Risk/Return Bar Chart and Table — Right after the fund's narrative description of its investment objectives or goals, strategies, and risks, you'll find a bar chart showing the fund's annual total returns for each of the last 10 years (or for the life of the fund if it is less than 10 years old). Except in limited circumstances, funds also must include a table that sets forth returns, both before and after taxes, for the past 1-, 5-, and 10-year periods. The table will also include the returns of an appropriate broad-based index for comparison purposes. Bear in mind that the bar chart and table for a multiple-class fund will typically show performance data and returns for only one class.
  • Fee Table — The fee table includes an example that will help you compare costs among different funds by showing you the costs associated with investing a hypothetical $10,000 over a 1-, 3-, 5-, and 10-year period.
  • Financial Highlights — This section contains audited data concerning the fund's financial performance for each of the past 5 years. Here you'll find net asset values (for both the beginning and end of each period), total returns, and various ratios, including the ratio of expenses to average net assets, the ratio of net income to average net assets, and the portfolio turnover rate.

Closed-End Funds

Generally, closed-end funds sell a fixed number of shares at one time (in an initial public offering) after which the shares typically trade on a secondary market, such as the NYSE or the Nasdaq. Closed-end fund shares are also generally not redeemable, i.e. the investment company is not required to buy its shares back from investors upon request. Some closed-end funds, commonly referred to as interval funds (see below), offer to repurchase their shares at specified intervals.

The investment portfolios of closed-end funds are usually not managed by the company itself, but by independent investment advisers that are registered with the SEC. Be aware that closed-end funds are permitted to invest in a greater amount of illiquid securities than are mutual funds. Because of this feature, funds that seek to invest in markets where the securities tend to be more illiquid are typically organized as closed-end funds.

Unlike mutual funds, the prices of closed-end fund shares that trade on a secondary market after the initial public offering is determined by the market and may be greater or less than the fund's per share NAV.

Interval Funds
An interval fund is a type of investment company that periodically offers to repurchase a certain number of shares from its shareholders. Shareholders, however, are not required to accept these offers.

Even though interval funds are classified as closed-end funds, they differ from traditional closed-end funds in the following ways:
  • Interval fund shares typically do not trade on the secondary market.
  • Interval fund companies are permitted to continuously offer their shares at a priced based on the fund’s NAV.
  • An interval fund will make periodic repurchase offers to its shareholders, generally every three, six, or twelve months, as disclosed in the fund’s prospectus and annual report. The interval fund also will periodically notify its shareholders of the upcoming repurchase dates. When the fund makes a repurchase offer to its shareholders, it will specify the last day shareholders are allowed to accept the repurchase offer. The actual repurchase will occur at a later, specified date.
The price that shareholders will receive on a repurchase will be based on the per share NAV determined as of a specified (and disclosed) date. This date will occur sometime after the close of business on the date that shareholders must submit their acceptances of the repurchase offer (but generally not more than 14 days after the acceptance date).

Fees and expenses

Note that interval funds are permitted to deduct a redemption fee from the repurchase proceeds, not to exceed 2% of the proceeds. The fee is paid to the fund, and generally is intended to compensate the fund for expenses directly related to the repurchase. Interval funds may charge other fees as well.

Exchange-Traded Funds (ETFs)
Like index funds, ETFs seek to achieve the same return as a particular market index and primarily invest in either all of the securities or a representative sample of the securities of companies that are included in a that index. For example, one type of ETF, called a Spider or SPDR, invests in all of the stocks contained in the S&P 500 Composite Stock Price Index. ETFs, as their name suggests, are traded on exchanges, so you can purchase shares via a broker account (like individual stocks).

How they work

Exchange-traded funds, or ETFs, are investment companies that are legally classified as either open-end funds or UITs, but that differ from traditional open-end companies and UITs in the following respects:
  • ETFs do not sell individual shares directly to investors and only issue their shares in large blocks that are known as creation units. Investors generally do not purchase creation units with cash. Instead, they buy creation units with a basket of securities that generally mirrors the ETF’s portfolio. Those who purchase creation units are frequently institutions.
  • After purchasing a creation unit, an investor or institution often splits it up and sells the individual shares on a secondary market. This permits other investors to purchase individual shares (instead of creation units).
  • Investors who want to sell their ETF shares have two options: (1) they can sell individual shares to other investors on the secondary market, or (2) they can sell the creation units back to the ETF.
  • In addition, ETFs generally redeem creation units by giving investors the securities that comprise the portfolio instead of cash. So, for example, an ETF invested in the stocks contained in the Dow Jones Industrial Average (DJIA) would give a redeeming shareholder the actual securities that constitute the DJIA. Because of the limited redeemability of ETF shares, ETFs are not considered to be—and may not call themselves—mutual funds.
An ETF, like any other type of fund, will have a prospectus. All investors that purchase creation units receive a prospectus. Some ETFs also deliver a prospectus to secondary market purchasers. ETFs that do not deliver a prospectus are required to give investors a document known as a Product Description, which summarizes key information about the ETF and explains how to obtain a prospectus.

Fees and Expenses
An ETF will have annual operating expenses and may also impose certain shareholder's fees that are disclosed in the prospectus. However, ETFs are generally more cost efficient than mutual funds because they are based on an index, and do not need to be actively managed, thereby saving you management costs. Like stocks, investors can purchase ETF shares on margin, short sell shares, or hold onto them for the long haul.

See also:
Stocks: What To Look For, How to Trade For Long-Term Gains

: The Basics

Annuities: What Are They? How Do They Work? And How Do I Find the Right One For Me?

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