Laymans Guide to Mutual Funds
A mutual fund is simply a mutual investing arrangement where many investors combine their money into an investment pool. They then collectively hire a money manager to invest the money on their behalf, typically in stocks, bonds, cash equivalents such as money markets, treasuries and, occasionally, options. Mutual funds provide lay investors with access to professional investment expertise for much less than it would cost to hire an investment manager individually. Mutual funds also provide instant diversification as investors can invest in hundreds, or even thousands of securities with a single transaction.
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Structure
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A mutual fund has a manager, who, together with a staff of researchers and traders, is responsible for the performance of the fund. He picks investments, and decides when to buy and sell them. He also decides how much to hold in stocks, bonds and cash -- a decision called "asset allocation." To pay for his salary and staff, the fund charges investors an expense ratio. This is the percentage of assets the fund deducts from the shareholder's account each year. The fund may also charge a 12(b)1 fee, which is an additional percentage of assets designed to pay for the costs of marketing the fund.
Load
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Load funds are funds sold through a broker or financial advisor who charges a commission on the sale. When you buy a load fund, you also pay the broker for her time and expertise via a sales load, or sales charge. Funds frequently offer multiple share classes, each with a different load structure, with "A" shares being the most common. Typically, when you purchase "A" shares through a broker and write a check for $100,000, the first 6 percent goes to the broker and her firm, while the remainder goes to the mutual fund company. With a no-load fund, you buy shares directly from the fund company, and there is no sales charge. However, you may not get the benefit of a professional advisor.
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Asset Classes
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Mutual funds invest in a variety of securities that are divided into broad asset classes. The major asset classes are equities, or stocks, which represent a fraction of ownership interest in a corporation; bonds, which represent money lent to corporations and government entities in exchange for a series of regular interest payments; and cash, which is typically deposited in money market accounts. Funds can also invest in treasuries, which are bonds issued by the U.S. government, gold and related stocks and real estate investment trusts, or REITs.
Index Funds
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An index fund's objective is to replicate the performance of an index, such as the S&P 500 or the Russell 2000 index of small-cap stocks. The fund manager buys a proportionate share of every stock in the index, without analysis and without regard to future prospects. Because no research is involved, fund expenses are typically much lower than comparable funds that have managers actively trying to pick winning investments. Index funds will not typically outperform the market. However, experience shows that active managers have had a hard time beating index funds over time, when their expenses are taken into account.
Considerations
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Mutual funds are not guaranteed by the Federal Deposit Insurance Corporation or by any other entity. All mutual funds carry the inherent risk of loss. If this risk is unacceptable to you, you may wish to consider fixed investments, such as fixed annuities, CDs and whole life insurance.
Unless held inside retirement accounts like IRAs or 401ks, where investments grow taxed deferred, mutual funds are taxed at capital gains rates -- currently 15 percent and scheduled to increase to 20 percent in 2011, for shares held longer than one year. If a fund issues a dividend, or cash payment, the IRS taxes it as income. If the fund sells shares at a gain, it may distribute those gains to shareholders in taxable accounts, generating a capital gains tax liability -- even if you haven't sold shares.
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