Mutual Fund Investing

Mutual Fund Report

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.

Likewise, another type of fund, hedge funds, which are restricted to the wealthy, are allowed to invest in real estate (as well as sell short and certain other practices which mutual funds may not do). 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.

The majority of actively managed funds usually only match the performance of the index fund, but since they have higher costs they then under perform the index funds. Three fourths of all mutual funds under perform the S&P 500 index. This means the majority of the professional managers can't execute a better stock picking strategy than simply buying the 500 S&P companies equally. For this reason, many advisors strongly suggest avoiding mutual funds.

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.

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 (for example, if your car breaks down) should be in a money market account. Money you will not need until you retire in 30 years (or for a newborn's college education) should be in longer-term investments, such as stock or bond funds. Putting money you will need soon in stocks risks having to sell them when the market is low and missing out on the rebound.

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 bonds 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?). Also some secters are vulnerable to industry-wide events (airlines do come to mind). 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. Be sure to pay attention to performance over both the long-term and the short-term. A fund that gained 53% over a 1-yr. period (which is impressive), but only 11% over a 5-yr. period should raise some suspicion, as that would imply that the returns on four out of those five years were actually very low (if not straight losses) as 11% compounded over 5 years is only 68%.

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. Buying individual stocks exposes you to company-specific risks, and if you buy a large number of stocks the commissions may cost more than a fund will.

The compounding effect is your best friend. A little money invested for a long time equals a lot of money later.