What Are Mutual Funds?

A mutual fund is a managed group of owned securities of several corporations. These corporations receive dividends on the shares that they hold and realize capital gains or losses on their securities traded. Investors purchase shares in the mutual fund as if it was an individual security. After paying operating costs, the earnings (dividends, capital gains or loses) of the mutual fund are distributed to the investors, in proportion to the amount of money invested. Investors hope that a loss on one holding will be made up by a gain on another. Heeding the adage "Don't put all your eggs in one basket" the holders of mutual fund shares are able collectively to gain the advantage by diversifying their investments, which might be beyond their financial means individually. A mutual fund may be either an open-end or a closed-end fund. An open-end mutual fund does not have a set number of shares; it may be considered as a fluid capital stock. The number of shares changes as investors buys or sell their shares. Investors are able to buy and sell their shares of the company at any time for a market price. However the open-end market price is influenced greatly by the fund managers. On the other hand, closed-end mutual fund has a fixed number of shares and the value of the shares fluctuates with the market. But with close-end funds, the fund manager has less influence because the price of the underlining owned securities has greater influence.

Mutual funds vs. other investments

From an investors' viewpoint mutual funds have several advantages such as:

Professional management and research to select quality securities Spreading risk over a larger quantity of stock whereas the investor has limited to buy only a hand full of stocks. The investor is not putting all his eggs in one basket Ability to add funds at set amounts and smaller quantities such as $100 per month Ability to take advantage of the stock market which has generally out performed other investment in the long run Fund manager are able to buy securities in large quantities thus reducing brokerage fees

However there are some disadvantages with mutual funds such as:

The investor must rely on the integrity of the professional fund manager Fund management fees may be unreasonable for the services rendered The fund manager may not pass transaction savings to the investor The fund manager is not liable for poor judgment when the investor's fund loses value There may be too many transactions in the fund resulting in higher fee/cost to the investor - This is sometimes call "Churn and Earn" Prospectus and Annual report are hard to understand

Investor may feel a lost of control of his investment dollars There may be restrictions on when and how an investor sells/redeems his mutual fund shares

Types of mutual funds

Most funds have a particular strategy they focus on when investing. For instance, some invest only in Blue Chip companies that are more established and are relatively low risk. On the other hand, some focus on high-risk start up companies that have the potential for double and triple digit growth. Finding a mutual fund that fits your investment criteria and style is important. Types of mutual funds are:

Value stocks Stocks from firms with relative low Price to Earning (P/E) Ratio, usually pay good dividends. The investor is looking for income rather than capital gains. Growth stock Stocks from firms with higher low Price to Earning (P/E) Ratio, usually pay small dividends. The investor is looking for capital gains rather than income. Based on company size, large, mid, and small cap Stocks from firms with various asset levels such as over $2 Billion for large; in between $2 and $1 Billion for mid and below $1 Billion for small. Income stock The investor is looking for income which usually come from dividends or interest. These stocks are from firms which pay relative high dividends. This fund may include bonds which pay high dividends. This fund is much like the value stock fund, but accepts a little more risk and is not limited to stocks. Index funds The securities in this fund are the same as in an Index fund such as the Dow Jones Average or Standard and Poor's. The number and ratios or securities are maintained by the fund manager to mimic the Index fund it is following. Enhanced index This is an index fund which has been modified by either adding value or reducing volatility through selective stock-picking. Stock market sector

The securities in this fund are chosen from a particular marked sector such as Aerospace, retail, utilities, etc.

Defensive stock The securities in this fund are chosen from a stock which usually is not impacted by economic down turns. International Stocks from international firms. Real estate Stocks from firms involved in real estate such as builder, supplier, architects and engineers, financial lenders, etc. Socially responsible This fund would invests according to non-economic guidelines. Funds may make investments based on such issues as environmental responsibility, human rights, or religious views. For example, socially responsible funds may take a proactive stance by selectively investing in environmentally-friendly companies or firms with good employee relations. Therefore the fund would avoid securities from firms who profit from alcohol, tobacco, gambling, pornography etc. Balanced funds The investor may wish to balance his risk between various sectors such as asset size, income or growth. Therefore the fund is a balance between various attributes desired. Tax efficient Aims to minimize tax bills, such as keeping turnover levels low or shying away from companies that provide dividends, which are regular payouts in cash or stock that are taxable in the year that they are received. These funds still shoot for solid returns; they just want less of them showing up on the tax returns. Convertible Bonds or Preferred stock which may be converted into common stock. Junk bond Bonds which pay higher that market interest, but carry higher risk for failure and are rated below AAA. Mutual funds of mutual funds This funds that specializes in buying shares in other mutual funds rather than individual securities. Closed end

This fund has a fixed number of shares. The value of the shares fluctuates with the market, but fund manager has less influence because the price of the underlining owned securities has greater influence.

Exchange traded funds (ETFs) Baskets of securities (stocks or bonds) that track highly recognized indexes. Similar to mutual funds, except that they trade the same way that a stock trades, on a stock exchange.

Mutual fund expenses

There are many expenses associated with mutual funds. Explore this section to learn more.

Load vs. no-load funds

Load funds are mutual funds that have sales charges. When an investor purchases shares of a mutual fund the investor pays a fee for the sale (transaction) of the shares. Sales charges are required by law to be no more than 8.5% of the price of the shares bought. A load fund is where the broker receives all his commission with the first funds received from the investor. Therefore the investor must pay the brokers commission completely before any of his funds go toward the purchase of shares. No-load funds do not charge an upfront fee for the sale transaction. In a no-load fund the broker receives his commission as he receives the investor's funds and shares are purchased with the investor's initial funds.

Mutual fund fees

In order to cover their expenses mutual funds charge fees to the investors. Although these fees are only a few percentage points a year and seem like a minor expense, they create a serious drain on the performance over a period of years. Some fees to consider are: Redemption fees A mutual fund may charge fees when the investor sells shares back to the mutual fund. Contingent deferred sales charge A mutual fund may charge sales charges that are reduced at certain time intervals. For example, the fund may charge 6% of the sale price the first year after the shares are

bought. Each year thereafter the fee would be reduced by 1% until no fee would be charged. This is an incentive for investors to leave their money in the fund. Management fees Mutual funds may charge fees to cover expenses such as advertising, brokers' costs and toll-free telephone lines. These are 12b-1 fees, regulated by law. Transfer fees A fee is charged each time the investor transfers money within the company.

Distribution of capital gains and dividends

After paying operating costs, the earnings and losses of the mutual fund are distributed to the investors in proportion to the amount of money invested. An investor may chose to receive dividends as cash, or he can reinvest them into the fund. Many funds will automatically reinvest dividends with the investor authorization.

Mutual fund taxation

The mutual fund manager must send the investor a tax information statement so the investor can declare taxes. The investor must account for all capital gains or loses and dividends even if the dividends and capital gains are reinvested into the mutual fund. When mutual funds shares are sold/redeemed the mutual fund manager should aid the investor in determining the purchase bases for the shares sold/redeemed. Recent federal tax codes have modified the treatment of dividends and capital gains depending on the investor's income level and tax bracket.

What to look out for

Repeating some of the concerns expressed in the mutual fund disadvantages.

Performance below other mutual funds in the same sector or against a recognized index. There may be too many transactions in the fund resulting in higher fee/cost to the investor - This is sometimes call "Churn and Earn". Prospectus, Annual report and Statement of Additional Information are hard to understand. There are restrictions on when and how an investor sells/redeems his mutual fund shares.

Recent scandals
Unfortunately there have been incidences in which mutual fund managers have traded stocks at prices other than reported to the investor. An example is the use of closing share price for reported trades for the day the investor request an execution of his shares. Whereas the mutual fund manager may have received a more advantageous share price before the closing share price is set. The mutual fund manager retains the additional gain for himself or his firm. Since there are usually large volume trades the gain may be substantial even with a fraction of a share price.

How mutual funds earn money

A mutual fund is a means of investing that enables individuals to share the risks of investing with other investors. All contributors to the fund experience an equal share of gains and losses for each dollar invested. A mutual fund owns the securities of several corporations. A mutual fund pools money from hundreds and thousands of investors to construct a portfolio of stocks, bonds, real estate, or other securities, according to the kind of investments the mutual fund trades. Investors purchase shares in the mutual fund as if it was an individual security. Fund managers hired by the mutual fund company are paid to invest the money that the investors have placed in the fund. Heeding the adage "Don't put all your eggs in one basket" the holders of mutual fund shares are able to gain the advantage of diversification which might be beyond their financial means individually.

Professional management of mutual funds

Mutual funds use professional managers to make the decisions regarding which companies' securities should be bought and sold. The managers of the mutual fund decide how the pooled funds will be invested. Investment opportunities are abundant and complex. Fund managers are expected to know what is available, the risks and gains possible, the cost of acquiring and selling the investments, and the laws and regulations in the industry. The ability of the managers to select profitable investments and to sell those likely to decline in value is a key factor for the mutual fund to earn money for the investors.

MorningStar is a generally accepted authority on divides most stocks into classes or types. The use eight type designations: Distressed, Hard Asset, Cyclical, Speculative Growth, Aggressive Growth, Classic Growth, Slow Growth and High Yield. Each designation defines a broad category of investment characteristics. Stocks are assigned to a type based on objective financial

criteria and MorningStar's proprietary algorithm, so stocks of the same type have similar economic fundamentals. Every stock has individual idiosyncrasies, but in general, when evaluating investments, many of the same concerns and evaluation methods will apply across the stocks in one type. By establishing stock types one has an easy way to narrow down the stock universe to those best filling specific investment needs. Stock Types also help you quickly determine the diversification level of portfolios. For instance, you might discover that most of your holdings are categorized as Speculative Growth. If you want to lessen the portfolio's risk, you could invest in other types of stocks.

Mutual fund share classes

MorningStar's classes/types are: Distressed These companies are having serious operating problems. This could mean declining cash flow, negative earnings, high debt, or some combination of these. Such "turnaround" stocks tend to be highly risky but also harbor some intriguing investments. Hard Asset These companies' main businesses revolve around the ownership or exploitation of hard assets like real estate, metals, timber, etc. Such companies typically sport a low correlation with the overall stock market and investors have traditionally looked to them for inflation hedges. Cyclical Cyclical companies core businesses can be expected to fluctuate in line with the overall economy. In a booming economy such companies will look excellent; in a recession, their growth stalls, and they might even lose money. Speculative Growth Don't expect consistency from speculative growth-companies. At best their profits are spotty. At worst they lose money. In fact, many companies never make it beyond speculative growth, going instead to bankruptcy court. That's why they're speculative. But current profitability isn't what makes speculative-growth companies interesting. It's future profits. Hopefully, a speculative-growth company will eventually blossom into a world-class company. Aggressive Growth Aggressive-growth companies show a bit more maturity than their speculative-growth counterparts: They post rapid growth in profits, not just in sales-a sign of more staying power. At this point, it's time to make some money. Classic Growth These firms are in their prime and have little left to prove. The best classic growers have blossomed into money machines, churning out steady growth, high returns on capital, positive free cash flows, and rising dividends. The catch is, their growth is nowhere near that of the aggressive-growth group. Slow Growth and High Yield

The growth of these companies is a fading memory. Having run out of attractive investment opportunities, most of them pay out the bulk of their earnings in dividends expect - high payout ratios - rather than plow the profits back into their businesses.

Mutual fund ranking

Funds are ranked based upon their performance as a whole and performance against their peers by such companies as MorningStar which has an industry recognized rating system for mutual funds. They have a one-to-five star system in which five stars is the best. Usually the higher the rank, the higher the quality of the fund. For example MorningStar rates mutual funds from 1 to 5 stars based on how well they've performed (after adjusting for risk and accounting for sales charges) in comparison to similar funds. Within each MorningStar Category, the top 10% of funds receive 5 stars and the bottom 10% receive 1 star. Funds are rated for up to three time periods: three-, five- and 10- years and these ratings are combined to produce an overall rating. Funds with less than three years of history are not rated. Ratings are objective, based entirely on a mathematical evaluation of past performance. The ratings are a useful tool for identifying funds worthy of further research, but should not be considered signals to buy or sell.