The main idea of a mutual fund is to enable investors
to pool their money and place it under professional investment
management. The manager makes the trades, realizing a gain or loss,
and collects the dividend
income. The investment proceeds are then passed along to the individual
Most mutual funds are open-end
funds. This means that at the end of every day, the investment
management company sponsoring the fund issues new shares
to investors and buys back shares from investors wishing to leave
the fund. A mutual fund can also be a closed-end
fund. The sponsor of a closed-end fund registers and issues
a fixed number of shares at the initial offering, similar to a common
Investors then can buy or sell these shares through a stock
exchange. The sponsor does not redeem or issue shares after
a closed-end fund is launched, so the investor must trade them through
Mutual funds can invest in many different kinds of securities.
The most common are cash,
stock, and bonds,
but there are hundreds of sub-categories. Stock funds, for instance,
can invest primarily in the shares of a particular industry, such
as high technology or utilities. These are known as sector funds.
Bond funds can vary according to risk (high yield or junk bonds,
investment-grade corporate bonds), type of issuers (government agencies,
corporations, or municipalities), or maturity of the bonds (short
or long term). Both stock and bond funds can invest in primarily
US securities (domestic funds), both US and foreign securities (global
funds), or primarily foreign securities (international funds). By
law, mutual funds cannot invest in commodities and their derivatives
or in real
estate. (However, there do exist real estate investment trusts,
or REITs, which invest solely in real
estate or mortgages, and mutual funds are allowed to hold shares
in REITs.) A mutual fund may restrict itself in other ways. These
restrictions, permissions, and policies are found in the prospectus,
which every open-end mutual fund must make available to a potential
investor before accepting his or her money.
Most mutual funds' investment portfolios are continually adjusted
under the supervision of a professional manager, who forecasts the
future performance of investments appropriate for the fund and chooses
the ones which he or she believes will most closely match the fund's
stated investment objective. This is called active management, in
contrast to indexing, in which a fund's assets are managed to closely
approximate the performance of a particular published index. Because
the composition of an index changes less frequently than the condition
of the market, an index fund manager makes fewer trades, on average,
than does an active fund manager. For this reason, index funds generally
have lower expenses than actively-managed funds, and typically incur
fewer capital gains which must be passed on to shareholders.
Mutual funds are corporations
under US law, but they are subject to a special set of regulatory,
accounting, and tax
rules. Unlike most other types of corporations, they are not taxed
on their income as long as they distribute substantially all of
it to their shareholders. Also, the type of income they earn is
often unchanged as it passes through to the shareholders. Mutual
fund distributions of tax-free municipal bond income are also tax-free
to the shareholder. Taxable distributions can either be ordinary
income or capital gains, depending on how the fund earned it.
You can buy many mutual funds directly from the fund sponsor. These are called "no-load" funds, because the issuer does not charge a sales commission. Some discount brokers will sell no-load funds, some for a flat transaction fee, some for no fee at all. Load funds are sold through intermediaries such as brokers, financial planners, and other types of registered representatives who charge a commission for their services.
Picking a mutual fund from among the thousands offered is not easy. The following is just a rough guide, with some common pitfalls.
- Unless you are in the highest tax bracket, you probably don't need a tax-exempt fund.
- Match the term of the investment to the time you expect to keep it invested. Money you may need right away should be in a money market account. Money you will not need until you retire in 30 years should be in longer-term investments, such as stock or bond funds.
- There are some funds that invest in both stocks and bonds called "balanced funds." These are not generally as good an idea as a do-it-yourself balance of a stock fund and a bond fund, simply because you get to control the mix yourself. More stock is more aggressive, more bond is more conservative.
- Expenses matter over the long term, and of course, cheaper is usually better. You can find the expense ratio in the prospectus. Expense ratios are critical in index funds, which seek to match the market. Actively managed funds need to pay the manager, so they usually have a higher expense ratio.
- Sector funds often make the "best fund" lists you see every year. The problem is that it is usually a different sector each year (internet funds, anyone?). Avoid making these a large part of your portfolio.
- Closed-end bond funds often sell at a discount to the value of their holdings. You can sometimes get extra income by buying these in the market. Hedge fund managers love this trick. This also implies that buying them at the original issue is usually a bad idea, since the price will often drop immediately.
- Mutual funds often make their distributions near the end of the year. If you get the money, you will have to pay taxes on it. Check the fund company's website to see when they plan to pay the dividend, and wait until afterwards if it is coming up soon.
- Do your homework. Read the prospectus, or as much of it as you can stand. It should tell you what these strangers can do with your money, among other vital topics. Check the performance of a fund against its peers with similar investment objectives, and against the index most closely associated with it.
- Diversification is the best way to reduce risk. Most people should own some stocks, some bonds, and some cash. Some of the stocks, at least, should be foreign. You might not get as much diversification as you think if all your stock funds are with the same management company, since there is often a common source of research and recommendations. Too many funds, on the other hand, will give you about the same effect as an index fund, except your expenses will be higher.
- The compounding effect is your best friend. A little money invested for a long time equals a lot of money later.
In September 2003, the US mutual fund industry was beset by a
in which major fund companies permitted and facilitated late trading
and market timing.