Investing in Mutual Funds

A mutual fund is an investment company that sells shares and invests the proceeds in a portfolio of securities. These securities include stocks, bond, cash, or other asset classes.

Two significant benefits of investing in mutual funds are diversification and lower transaction costs. By investing in the securities whose prices do not move together, the fund achieves a level of diversification at a lower price than what you would pay to diversify with individual securities. Mutual funds often manage billions of dollars for investors. Their size allows them to spread out brokerage commissions and other transaction fees, or even negotiate lower fees. This results in lower transaction costs for you.

Finally, buying shares in a mutual fund gives you access to the trading decisions of a team of analysts and portfolio managers. Although some funds rely on one fund manager to make the investing decisions, most funds use a team-based approach that includes the views of other fund managers. Analysts pore over extensive financial data and research to make well-informed decisions. They often use modeling and other software tools that you likely don't have access to.

A mutual fund's prospectus explains to potential investors the fund's investment objective. (See a table of fund categories.) The investment objective describes the types of securities the mutual fund invests in. This helps to you to evaluate the investment risk of the fund. (See a table of fund categories, by degree of risk.) Important information on a fund's expenses is also included in the prospectus.

Like stocks and bonds, the Securities and Exchange Commission regulates the mutual fund industry. However, unlike bank deposits such as CDs or money market accounts, the FDIC does not guarantee mutual fund investments.

Mutual funds are required to distribute their income to shareholders once a year. As a result, shareholders rather than the fund pay taxes on the fund's earnings. Mutual funds distribute dividends and interest that they receive from their investments. They also distribute capital gains that they incur when they sell investments. When a fund buys back its shares, it usually has to sell holdings to raise cash. These sales may result in a tax bill that is also passed on to shareholders. Depending on the length of time the fund holds an investment, a capital gain is classified for tax purposes as a short- or long-term gain. (The cutoff is one year).

A fund's tax-efficiency indicates the size of the tax bill it incurs. A mutual fund's portfolio turnover ratio is also a fairly good indicator of tax efficiency. In general, the higher the ratio is, the lower the tax efficiency. Since February 2002, the SEC has required all funds to report after-tax returns for fund shareholders. Investors who use a tax-advantaged account can defer, or avoid, paying taxes on mutual fund distributions. Similarly, buying tax-exempt money market and municipal bond funds allows you to minimize taxes.

Shares of mutual funds are bought and sold at the fund's net asset value. A fund's NAV is calculated by subtracting the fund's liabilities from its assets, and dividing by the number of shares of the fund. For example, a fund with $101 million in assets, $1 million in liabilities and 10 million shares has a NAV of $10.

Some mutual funds have sales charges, or loads, that you pay when you buy or redeem (sell) shares. If a fund has more than one class of shares, chances are each class is used to distinguish shares that charge a front-end load from those that charge a back-end load.

Not all funds have loads, however. There are thousands of no-load mutual funds. Given a choice of paying a load versus not paying one, the answer seems clear. However, some funds with loads have better investment performance than no-load funds. It may be worth paying a load if you think you'll earn a higher investment return over the long term.

To discourage you from selling your shares of a fund too soon, most funds impose a redemption fee.

In addition to loads, some mutual funds also charge annual fees. These are explained in the fund prospectus. These include management and 12(b)-1 fees. Together with any miscellaneous fees, these make up the fund's operating expense ratio. The operating expense ratio is stated as a percentage of the fund's assets. It is generally in the range of 1 to 2 percent of fund assets.

Mutual funds come in two basic packages: open-end and closed-end. A third structure, unit investment trusts, is beyond the scope of this topic. Open-end mutual funds buy back shares whenever a current shareholder wants to sell them. In addition, they sell shares whenever a new investor wants to buy into the fund. For example, if 1,000 shareholders each held 100 shares, the fund's total number of shares is 100,000. If a large shareholder were to buy 100,000 shares, the mutual fund would sell new shares. Now there would be 200,000 shares. According to the Investment Company Institute, open-end funds had more than $12.07 trillion in assets at the end of November 2007:

Mutual fund category:	Assets, $ billions (November 2005)
Stock funds	$6,604.3
Hybrid funds	$718.9
Taxable bond funds	$1,300.2
Municipal bond funds	$338.3
Taxable money market funds	$2,625.6
Tax-free money market funds	$448.9
Total	$12,076.2

Source: Investment Company Institute

Closed-end mutual funds have a limited supply of shares. To buy or sell shares of a closed-end fund, you place an order with a broker. As a result of the interaction of supply and demand for shares of closed-end funds, their share prices often deviate from their NAVs. Assets invested in closed-end funds were about $328 billion at the end of September 2007, according to the ICI. Because of the dominance of open-end funds, the ICI calls open-end funds "mutual funds."

Mutual funds come in four main types: stock, bond, balanced, and money market funds. Bond and money market funds are further divided into taxable and tax-exempt funds. The investment performance of a stock or bond fund is measured by total return. For money market funds, performance is measured by simple and compounded yields. Because they invest in short-term securities, a money market fund's average maturity in days is also included in its investment performance.

Index mutual funds invest in a portfolio of securities that mirrors a benchmark index and are called passive funds. Index funds generate a smaller capital-gains tax bill, since the fund only buys and sells shares when the index changes. As a result, index funds also have lower expense ratios than funds that are actively managed. Exchange-traded funds, or ETFs, are newcomers. These index funds sell shares whose price changes throughout the day the way a stock's price does. This gives ETFs more liquidity than a regular mutual fund, which is only priced once a day. Judging by the billions of dollars that they have attracted over a relatively short period, ETFs appear likely to succeed as a useful financial product.

The following table shows five mutual fund categories, listed by 33 different investment objectives:

Fund Category	Subcategory	Investment Objective
Equity	Capital appreciation	Aggressive growth
--	--	Growth
--	--	Sector
--	Total return	Growth-and-income
--	--	Income-equity
--	World equity	Emerging market
--	--	Global equity
--	--	International equity
--	--	Regional equity
Hybrid	Hybrid	Asset allocation
--	--	Balanced
--	--	Flexible portfolio
--	--	Income-mixed
Taxable bond	Corporate	General
--	--	Intermediate-term
--	--	Short-term
--	High yield	High yield
--	World	Global bond, general
--	--	Global bond, short-term
--	--	Other world bond
--	Government	General
--	--	Intermediate-term
--	--	Short-term
--	Mortgage-backed	Mortgage-backed securities
--	Strategic income	Strategic income
Tax-free bond	State municipal	General
--	--	Short-term
--	National municipal	General
--	--	Short-term
Money market	Taxable	Government
--	--	Non-government
--	Tax-exempt	National
--	--	State

Source: Investment Company Institute, "Mutual Fund Fact Book."

The following table shows mutual funds by risk-return trade-off. In the first column, funds with the highest degree of investment risk are shown at top. In the third column, funds that are safest are shown at top. A mutual fund's risk is determined by the risk of securities held in its portfolio:

Higher Risk & Return	Moderate Risk & Return	Lower Risk & Return
Aggressive Growth Stock		Money Market
Growth Stock	Balanced	Short- and Intermediate-Term Bond
Growth & Income Stock		Long-Term Bond

Source: Investment Company Institute, "Guide to Mutual Funds."