Mutual Fund FAQ

Table of contents

1) What is a mutual fund? 2) Why do people use mutual funds? 3) Are there any disadvantages to using a mutual fund? 4) What is a "closed-end fund" vs. an "open-end fund"? 5) What is "net asset value"? 6) A fund is "closed". Is that the same as a closed-end fund? 7) What expenses are there for a mutual fund? 8) What are typical expenses of a mutual fund? 9) Can mutual fund performance be guaranteed? 10) What is a "prospectus"? 11) What is a "statement of additional information"? 12) What is a "signature guarantee"? 13) What are "dividend distributions"? 14) What are "capital gain distributions"? 15) What else is there to know about distributions? 16) What is the difference between yield and return? 17) What do mutual funds invest in? 18) What is a "socially responsible" fund? 19) Where can I get comparative information on mutual funds? 20) How does buying funds directly compare with buying through a broker? 21) What does family of funds do compared to a single fund? 22) What are the tax implications of mutual funds for individuals? 23) What dates are important when investing in mutual funds? 24) How do I put mutual funds in an IRA? 25) Can mutual funds trade on margin? 26) Who is the typical fund owner? 27) How are mutual funds structured? 28) When should I sell a mutual fund?

What is a mutual fund?

A mutual fund, otherwise known as an investment company, is a corporation which pools together investor's money generally to purchase stocks and bonds. Investors participate in the mutual fund by purchasing shares of the entire pool of assets, thus diversifying their investment. The pooled assets are invested by professional managers who buy and sell securities on behalf of the investors.

Because mutual funds pass all gains, losses and tax obligations/benefits through to investors, mutual funds receive preferential tax treatment under the U.S. Internal Revenue Code.

Why do people use mutual funds?

Many people purchase mutual funds because they are a convenient and cost effective method of obtaining diversification and professional management. Because mutual funds hold anywhere from a few securities to several thousand, risk is spread out over a number of investments. Additionally, mutual funds generally buy and sell securities in volume, which allows investors to benefit from lower trading, management and research costs.

Another advantage that mutual funds offer is that fund performance is subject to frequent reviews by various publications and rating agencies, making it possible for investors to conduct direct comparisons between funds.

Are there any disadvantages to using a mutual fund?

Although what one person may view as a disadvantage another may see as a desirable quality, below are some factors which may be disadvantages depending on your point of view:

(a) All mutual funds charge expenses. Whether they be marketing, management or brokerage fees fund expenses are generally passed back to the investors.

(b) Investors exercise no control over what securities the fund buys or sells.

(c) The buying and selling of securities within the mutual fund portfolio generates capital gains and losses which are passed back to investors even if they have not sold any of their mutual fund shares.

What is a "closed-end fund" vs. an "open-end fund"?

A closed-end fund has a fixed number of shares outstanding and is traded just like other stocks on an exchange or over the counter. The more common open-end funds sell and redeem shares at any time directly to shareholders. Sales and redemption prices of open-end funds are fixed by the sponsor based on the fund's net asset value; closed-end funds may trade a discount (usually) or premium to net asset value.

What is "net asset value"?

The net asset value (NAV) is the value of the fund's underlying securities. It is calculated at the end of the trading day. Any open-end fund buy or sell order received on that day is traded based on the net asset value calculated at the end of the day. A few funds calculate net asset value at more frequent intervals and process trades at those values.

A fund is "closed". Is that the same as a closed-end fund?

No. Some open-end funds are closed to new investors because the fund manager feels that it cannot be as effective with a very large amount of money. This typically happens with funds that invest in small companies. The open-end format remains the same, but investments are not accepted from those who do not already have accounts.

What expenses are there for a mutual fund?

(1) Closed-end funds charge annual expenses for research and trading expenses. To buy and sell closed-end fund shares, the investor must usually pay additional brokerage fees, unless the investor finds someone to buy from or sell to directly.

(2) Open-end funds charge annual expenses for research and trading expenses. In addition, they sometimes charge the following:

(a) A front end load or sales charge. These vary from 1% to 8.5% subtracted from the amount paid and are usually used to pay commissions to brokers and financial advisors who sell the funds. Very large investors can sometimes get discounts on the front end loads. Currently, fund sponsors determine loads, but the SEC is proposing a rule to allow brokers and other salespeople to discount loads. (b) A redemption fee, deferred sales charge, or back end load. These work the same way as front end loads, but are charged when you redeem shares. In many cases, they decline or disappear after a long enough holding period. (c) A Rule 12b-1 fee. Used to pay marketing expenses, which means either commissions or advertising expenses. This is a fee that adds to the annual expenses; it may be as large as 1.25% per year. Declining back end loads are common in funds with large 12b-1 fees.

A mutual fund that has neither (a) nor (b) is generally referred to as a no-load fund. No-load funds are generally not sold through brokers or financial advisors, but are sold directly to investors. Many advertise in business and financial periodicals. All of the above expenses for open-end funds are described on the first or second page of the prospectus in a standardized form. Brokerage fees paid by the fund in its trading activity are not normally included in such expense tables as they are usually accounted for in the cost of securities bought.

What are typical expenses of a mutual fund?

Stock funds tend to be the most expensive, with annual expenses ranging from 0.2% to 3.0% with most between 1.0% and 1.5%. Small company and international funds tend to be more expensive. Bond fund expenses range from 0.2% to 2.0%, with most around 1.0%. Money market funds tend to be the least expensive, ranging from about 0.2% to 1.0%. See a later answer for a more detailed description of these funds. Note that some funds, particularly money market funds, waive expenses for a limited time to boost yield (and make good ad copy). About one half of stock and bond funds have loads (front or back end), but money market funds do not normally have loads, though some have 12b-1 fees.

Can mutual fund performance be guaranteed?

No. As many funds state, past performance is no guarantee of future results, and the fund shares are not backed or guaranteed by the FDIC or other government agency. Note that while some funds buy government backed securities, that is not the same as backing the market value of the fund shares.

What is a "prospectus"?

It is a document which an open-end fund, or newly issued closed-end fund, is required to provide to investors. Funds say that investors should read it carefully before investing or sending money. A prospectus contains descriptions of:

(1) fees, in a standardized format (2) investment objective (3) some financial data (4) investment methods, risk description (5) investment manager and compensation (6) how to buy shares (7) how to sell shares, including signature guarantee requirements (8) dividend and capital gain distributions (9) other services

What is a "statement of additional information"?

It is a document that is designed to be read along with the prospectus; however, it is not required to be given to investors before or after they invest (i.e. investors have to ask for it). It contains information such as brokerage selection, description of the fund's investment adviser, etc.

What is a "signature guarantee"?

It is a guarantee by a financial institution that your signature is genuine and the financial institution accepts liability for any forgery. It is typically required for large or unusual redemptions of open-end mutual funds, though some funds require it for all redemptions. At many funds, the guarantor must be a commercial bank or NYSE member brokerage firm; some funds accept savings and loan associations or credit unions (be careful, some savings and loan associations have bank-like names).

What are "dividend distributions"?

A mutual fund may receive dividend or interest income from the securities it owns; it is required to pay out this income to its investors. Most open-end funds offer an option to purchase additional shares with the distributions. Dividend distributions are often made monthly or quarterly, though many funds make distributions only yearly.

What are "capital gain distributions"?

A mutual fund may, in the process of trading, realize capital gains. These must be distributed to investors. As with dividends, there is usually the option to reinvest in additional fund shares. Capital gain distributions generally occur late in the year, but some funds make additional distributions at other times. Funds with high turnover of securities often make significant capital gain distributions every year, while funds with low turnover of securities may accumulate unrealized gains for several years before making a large capital gain distribution. Also, funds that are increasing in size tend to make smaller capital gain distributions because they buy more than they sell, while funds decreasing in size tend to make larger capital gain distributions because they sell more than they buy.

What else is there to know about distributions?

A distribution lowers the net asset value of the fund by the amount of the distribution. The shareholder does not actually lose money because of the distribution, since s/he gets cash or additional shares to compensate for the lower net asset value. Distributions have important tax consequences as detailed later.

What is the difference between yield and return?

Do not confuse the two terms. Return is sometimes called total return. The formula for total return (ignoring any taxes paid on gains and income during the holding period) is: TR=((Ending Market Value)/(Beginning Market Value))-1

Yield is a very different number it is prospective not retrospective. It is a measure of income not capital gains. It is usually associated with debt not equity. For instance, the yield quoted on a bond will almost never be the same as the total return realized after the bond matures or is sold.

What do mutual funds invest in?

Almost anything. There are funds that invest in almost anything an investor could want to invest in. The most common types are described below.

(1) Money market funds: these try to maintain a constant (usually $1) NAV per share (though they cannot guarantee that), while yielding dividends from their investments in short term debt securities. They offer very low risk, but usually low long term return. Most restrict investments to the top two (out of four) Moody's and Standard and Poor ratings for short term debt; some (including national government only funds) restrict themselves to only the top rating, providing a bit of extra credit safety, usually at a slightly lower yield. Most also invest in repurchase agreements (repos) collateralized by short term debt securities; these are subject to credit or fraud risk of the other party in the repo (regardless of the credit risk of the securities being repoed). Their market value is NOT insured by the FDIC or other government agency. Enough defaults in the fund's securities can cause it to be unable to maintain its constant NAV.

(a) Regular funds: invest in short term debt of all types. (b) Government funds: invest only in national government or government agency debt or repos involving such debt. Slightly lower credit risk than regular funds. (c) Treasury funds: invest only in direct obligations of the national government or repos involving these securities. Lowest credit risk and dividend distributions are exempt from state income taxes in most states. (d) Municipal funds: invest only in debt of state or local governments. For most individuals, dividend distributions are exempt from national income taxes. (e) Single state municipal funds: invest only in debt of one state or its political subdivisions. For most individuals, dividend distributions are exempt from national income taxes and that state's income taxes. Note that a single state fund is usually less diversified than a regular municipal fund and might be considered riskier for this reason.

(2) Bond funds. These invest in longer term debt securities. Thus the short term risk is greater than the infinitesimal risk of the money market. But returns are usually higher. Their NAVs may fluctuate due to both interest rate risk and defaults. Unlike individual bonds, most bond funds do not mature; they trade to maintain their stated future maturity. The types of debt are similar to those of money funds (but longer term); however, futures and options are sometimes used for hedging purposes. The other classifications are described below:

Time to maturity, interest rate risk: (a) Short term: usually less than 5 years maturity. Interest rate risk is low. (b) Long term: up to 30 year average maturity. Interest rate risk is high. (c) Mortgage backed securities: have some unusual interest rate risks. When interest rates rise, they lose value like other bonds. When interest rates fall, homebuyers refinance, causing them to prepay old mortgages, which in turn causes bonds backed by these mortgages to be called. In addition, when rates rise, the MBSs extend due to slower prepayments thus their duration goes up with interest rates and the bonds lose money at an accelerating rate. When rates fall the prepayments speed up and the bond gains money at an ever slower rate. This property is called Negative Convexity. It is also a gross over-simplification. There are MBSs with positive convexity. A 14 year old 13% MBS's prepayments are functionally independent of rate moves for example, also prepayment risk is shuffled all over the place in CMOs.

The compensation paid to MBS holders for the negative convexity is in higher yield. Basically the buyer of a mainstream MBS is betting that rates will not change too much (that interest rate volatility will be lower than the volatility implicit in the price). Over time this is true. MBS indices have outperformed Treasuries in all but a couple of the last 12 years.

(d) Adjustable rate: this type of fund is like other mortgage backed funds, but it invests in adjustable rate mortgages. Therefore, the two sided interest rate risk faced by fixed rate mortgage backed bonds in considerably reduced. However, the interest income will fluctuate widely, even though the principal value is more stable. Since most adjustable rate mortgages have caps on how high the rate can go (typical limits are a 2% increase during a year and 6% increase during the life of the loan), risk increases if interest rates increase quickly or by a large amount. (e) Target maturity: the few funds in this category buy only bonds of the given maturity date. Thus one can actually hold these to maturity.

Credit risk: (a) Investment grade: restricted only to bonds with low to medium-low credit risk (national government bonds are usually considered lowest risk). This generally means the fourth highest Standard and Poor's or Moody's rating (S&P BBB or Moody's Baa). Some funds have higher standards. (b) High yield or junk: buys bonds of any credit rating, seeking maximum interest yield at a greater risk of default.

(3) Stock funds. These invest in common and/or preferred stocks. Stocks usually have higher short term risk than bonds, but have historically produced the best long term returns. Stock funds often hold small amounts of money market investments to meet redemptions; some hold larger amounts of money market investments when they cannot find any stock worth investing in or if they believe the market is about to head downward. Some of the possible investment goals are described below. They are not necessarily mutually exclusive.

(a) Growth. These funds seek maximum growth of earnings and share price, with little regard for dividends. Usually tend to be volatile. (b) Aggressive growth. Similar to growth funds, but even more aggressive; tend to be the most volatile. (c) Equity income. These funds are more conservative and seek maximum dividends. (d) Growth and income. In between growth funds and income funds, they seek both growth and a reasonable amount of income. (e) Small company. Focuses on smaller companies. Usually of the growth or aggressive growth variety, since smaller companies usually don't pay much dividends. (f) International. Focuses on stocks outside the USA, generally investing in many nations' companies. (g) Country or regional funds. These funds buy stocks primarily in the designated country or region. (h) Index funds. These funds do no management, but just buy some index, like the Standard and Poor 500. Some index funds, particularly those emulating indices with large numbers of stocks such as the Wilshire 4500 or Russell 2000, emulate the index by buying a subset with similar industry mix, capitalization, price/earnings ratio, etc. Expenses are usually very low. (i) Sector funds. These funds buy stocks only in one industry. Usually considered among the riskiest stock funds, though different sectors tend to have different levels and types of risk.

(4) Balanced funds. By mixing stocks and bonds (and sometimes other types of assets) a balanced fund is likely to give a return between the return of stocks and bonds, usually at a lower risk than investing in either alone, since different types of assets rise and fall at different times. An investor can create his/her own balanced fund by buying shares of his/her favorite stock fund(s) and his/her favorite bond fund(s) (and other funds, if desired) in the desired allocation.

(a) Regular balanced funds: These funds usually hold a fixed or rarely changed allocation between stocks and bonds. (b) Asset allocation funds: These funds may switch to any allocation, usually based on market timing to some degree.

(5) Multifunds. These funds buy primarily other mutual funds. They choose other funds based on one or more of the investment goals outlined above.

(a) No-management funds: These funds hold fixed proportions of other funds. They are offered by fund companies as cheap balanced funds the underlying funds are other funds managed by the same company. There are generally little or no expenses other than those of the underlying funds. (b) Managed funds: In these funds, a manager picks which other funds s/he believes are managed well. Sometimes these funds are market timing funds which prefer to leave the stock picking to other managers. These funds have expenses above and beyond those of the underlying funds.

What is a "socially responsible" fund?

In addition to the usual investment goals, these funds restrict their investments to whatever they define as socially responsible. Such criteria can include: avoiding military, alcohol, tobacco, and gambling industries, preferring companies that treat their employees and the environment well. Different funds have different social and investment criteria.

Where can I get comparative information on mutual funds?

Brokers and financial advisors offer information, but they usually give information only on load funds. However, many periodicals have regular mutual fund review issues:

• Barron's (quarterly)
• Money Magazine (Nov.)
• Business Week (Feb.)
• Forbes (Sept.)
• Fortune (fall)
• Consumer Reports
• Wall Street Journal
• Investors Business Daily
• Morningstar Mutual Fund Report
• Value Line Mutual Fund Survey

In addition, there are many books available onmutual fund investing. Different periodicals and books use different criteria to rate funds. These periodicals and books usually have phone numbers which you can call to get the fund's prospectus and other information. Note that some ratings account for loads, while others do not. Past performance is no guarantee of future results of either the fund or the securities markets in general.

How does buying funds directly compare with buying through a broker?

A load fund usually costs the same whether bought directly or through a broker. A no-load fund can be bought directly at no charge; most brokers will charge a commission to buy a no-load fund. Some discount brokers now offer some no-load funds at no transaction fees; normally, they receive a portion of the funds' annual expenses instead. Holding funds in a broker may make it easier to trade from one fund to another, however. Closed-end funds usually need to be traded through a broker, like regular stocks, though some have dividend reinvestment plans.

What does family of funds do compared to a single fund?

Families of funds sometimes offer additional services, such as telephone switching from one fund to another within the family. With load fund families, switching from one load fund to another is sometimes allowed without paying a second load. Some families may make bookkeeping easier by listing all of an investor's different funds on one statement. Others reduce expenses by sharing services which realize economies of scale. Note, however, that the good advertised performance of one fund in a family may or may not be shared by others .

What are the tax implications of mutual funds for individuals?

Like shares of any stock, selling mutual fund shares may cause you to realize a capital gain or loss. Mutual funds also distribute dividends received and their own realized capital gains, usually at the end of the year; these distributions, whether taken in cash or reinvested, are taxable (note that the nontaxability of municipal bond funds applies only to dividend distributions; capital gain distributions are always taxable). Thus it is often a bad idea to buy a mutual fund just before the distribution date, since part of your investment will be immediately returned to you as a taxable distribution, resulting in you paying taxes much earlier than if you bought just after the distribution. Although the distribution lowers the net asset value of your shares, allowing you to "deduct" it when you sell the shares, paying taxes sooner rather than later prevents you from gaining investment income on the amount that is taxed. Note that reinvesting is considered identical to taking the distribution in cash and sending the same amount into the fund as a new investment, so don't forget about it when calculating the basis in your account. When selling, it is best to know the different methods of calculating the basis of shares sold ahead of time, since some methods requirethat you designate which shares are to be sold.

What dates are important when investing in mutual funds?

There are several important distribution related dates to be aware of when buying and selling mutual fund shares.

• Declaration date: This is the date on which the distribution is declared, followed by...
• Ex-dividend date: This is the date the shares trade without the dividend.
• Record date: Shareholders who own shares on this date will receive the distribution on the ....
• Payment date: This is the date on which the dividend is actually paid out.

How do I put mutual funds in an IRA?

Most funds have a bank or trust company arranged to be an IRA custodian for any IRA shareholders. If you buy the fund directly, using this custodian, you must use a different application available from the fund company. The custodian usually charges $10 to $15 per fund account per year. This is a significant expense for small accounts, not too significant for larger accounts. Alternatively, you can open a brokerage account IRA and purchase mutual funds within that. This would be similar to using a broker to buy funds normally, but incurs a single IRA custodian fee (usually $25 to $50). Custodian fees, but not loads or commissions, may be paid separately from the contribution, and may be separately tax deductible. Call 1-800-TAX-FORM and ask for publication 590 and form 8606 for general IRS information about IRAs (but note that tax rules can change since the last tax year). Note that the tax issues of distributions as detailed previously don't affect IRA accounts.

Can mutual funds trade on margin?

While some brokerage firm margin policies may allow for an investor to borrow against their mutual fund positions, mutual funds themselves are prohibited from trading on margin. Additionally, mutual funds are also prohibited from selling short to participating in joint trading ventures.

Because funds are prohibited from thee more speculative trading practices, investors often form limited partnerships and other legal entities to bypass these rules.

Who is the typical fund owner?

According to several surveys by the Investment Company Institute (ICI) conducted over the last several years:

• 63% of investors own at least two mutual funds.
• 43% of investors own four or more funds.
• The average mutual fund investor holds $18,000 in mutual funds.
• The average median age is 44 with a median household income of $60,000.

Other interesting facts from the ICI surveys include:

• 73% of mutual fund investors own stock funds.
• 49% of mutual fund investors own bond funds.
• 52% of mutual fund investors own money market funds.
• 60% of mutual fund investors purchased their funds through a broker, insurance agent, financial planner or bank rep.

How are mutual funds structured?

Mutual funds are in their most basic form corporations. Investors are the shareholders in the company and the assets of the company are the pooled investments of all the shareholders (investors). The board of directors of a mutual fund act just as a board of directors for any company. They are elected representatives of the investors, who owe shareholders a fiduciary responsibility. The most important function of the board is to select the fund's manager. The fund manager is in a way, the president of the company/fund. The manager traditionally makes all the investment decisions for the fund and supervises the day to day operations.

Managers are paid a management fee which is usually a percentage of the assets under management. Managers may also have incentive clauses in their contracts that reward superior performance. Because the manager is paid a percentage of the assets s/he is responsible for, there is an incentive to do well for investors in the hopes of attracting more investors and in turn, more money to manage.

Typically, open ended funds retain the services of a underwriter to distribute shares. The underwriter is a NASD licensed broker/dealer. This starts to get a little complicated, but generally it works like this;

ABC Growth Fund's board of directors hires ABC Management to run the fund. ABC Growth Fund's board also hires ABC Investments to act as the distributor. ABC Management and ABC Investments are wholly owned by another company (for this example ABC Inc.). While ABC Management, ABC Investments and ABC Inc. may not own ABC Growth Fund, they would likely control many of the seats of the board of directors. For instance, in the Janus Fund's prospectus it states: "Janus Investment Fund (the "Fund") is an open-ended management investment company whose shares are currently offered to the public in eleven series (individually a "Fund" and collectively "Funds"). Eaxh fyund is managed separately by Janus Capital Corp.("Janus Capital") and has its own objective and policies designed to meet different goals. "

Now overlooking the fact that Janus has decided to aggregate each of the individual funds into one investment company trust, you can see that Janus Investment Fund has hired Janus Capital Corp. to manage each of the funds. Additionally, the prospectus later states that the Janus Service Corp, a wholly owned subsidiary of Janus Capital, is the subagent for the transfer agent and Janus Distributors Inc., another wholly owned subsidiary of Janus Capital, is the underwriter/distributor.

When should I sell a mutual fund?

While one could never hope to cover every circumstance that would warrant the sell of a mutual fund investment (or any investment for that matter), here are some sound reasons for considering parting with a particular mutual fund holding.

The fund's style has changed. If you have invested in a large-cap growth fund and fund has begun investing in smaller, riskier investments it might be time to shed this fund. This can also operate conversely. If your fund's objective is to invest in emerging growth and begins becoming heavy with large and medium cap stocks, you might want to shift your money into a fund that more closely fits your investment objective.

The fund consistently lags behind. A single quarter or year does not a bad fund make but if your fund has consistently lagged its peers, you may want to cut this one loose. Also, it's important to keep in mind that you have to make a fair comparison. Do not compare your utility fund against the S&P500. Compare it against similar funds with similar objectives. If you find that your fund has underperformed its peer group over 1, 3 and 5 years it's probably time to move on.

Management has changed hands. While this factor alone is not truely justification for moving your assets, it should send up a red flag for you to scrutinize performance more closely. Most funds have plenty of able managers ready to take the helm but you should be diligent in making sure that your new manager stays competitive with his/her peers.