A mutual fund, according to the U.S. Securities and Exchange Commission, is “a company that brings together money from many people and invests it in stocks, bonds or other assets.” When you buy a mutual fund, you are basically purchasing a piece of the fund, which usually consists of a “basket” of stocks. You do not actually own any of the assets the mutual fund owns. While you may not own the stocks themselves, they are important, because the value of the fund is based on the value of the stocks it holds. As the value of the stocks within the fund go up, the value of the fund also increases. But as the value of the stocks within the fund go down, the value of the fund goes down as well.
Benefits of Trading Mutual Funds
The two primary benefits of trading mutual funds are diversification and professional management.
Diversification means owning many different stocks at one time and gives the investor’s portfolio more stability. Buying mutual funds gives you instant diversification through the funds use of a basket of stocks.
The mutual funds are also managed by professional investors who dedicate their time solely to finding the best stocks for their specific funds investment goals and risk level.
Now that you know what the benefits of mutual funds are, what types of mutual funds are available?
Types of Mutual Funds
The types of mutual funds available are seperated into two categories:
Closed-End Mutual Funds
Closed-end funds have a limited number of shares.
If you want to purchase a piece of the fund, you have to purchase an existing share.
Open-End Mutual Funds
Open-end funds have an unlimited number of shares.
If you want to purchase a piece of the fund, the fund creates a new share and sells it to you.
There are significantly more open-end funds than there are closed-end funds.
Investors like to see not only the rate of return for an individual mutual fund, but also how that fund compares to other similar funds. To see the performance of a fund, investors need look no further than the newspaper or some other quote source. To see how a fund compares to other funds, investors can consult either the Morningstar Ratings or the Lipper Ratings.
The SEC requires mutual funds to furnish historical returns for the following time periods so you can easily see how well a fund has performed:
–Year to date
While seeing how a fund has performed in the past is extremely useful, you don’t have a complete picture of how well the fund has done unless you compare it to other similar funds. For this comparison, Morningstar and Lipper compile comparative performance-based information.
Morningstar rates funds using a “star” system–with five stars being the highest rating and one star being the lowest rating.
–Five stars indicates the fund is in the top 10% of its Morningstar category.
–Four stars indicates the fund is in the next 22.5% of its category.
–Three stars indicates the fund is in the next 35% of its category.
–Two stars indicates the fund is in the next 22.5% of its category.
–One star indicates the fund is in the last 10% of its category.
Lipper rates funds using a numeric score–with a “1″ being the highest rating and a “5″ being the lowest.
Now that you know how to measure a fund’s performance, what are the expenses that can affect a fund’s overall performance?
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Every mutual fund has expenses. Some funds’ expenses are relatively low, while other funds’ have extremely high expenses. You should be aware of a fund’s expenses before you invest, because those expenses can have a dramatic effect on your investment returns. The three expenses you should always identify are loads, redemption fees and operating expenses.
Loads are fees that can be charged either when you buy a mutual fund (front-end load) or when you sell a mutual fund (back-end load). These loads are usually used to pay a commission to the agent who sold you the fund. By law, front-end loads cannot be higher than 8.5%, but most fund companies opt for loads lower than the maximum. Some fund companies have even gone so far as to not charge a load (no-load) on their mutual funds.
Redemption fees are stipulations indicating that if you sell your mutual fund before a certain date, you will be charged a fee. Fund companies impose redemption fees to discourage turnover in the fund.
Operating expenses–management fees and 12(b)-1 fees–are charged as a normal part of doing business for the fund. Management fees go to pay the fund manager for his expertise and time; 12(b)-1 fees cover advertising and distribution expenses for the fund.
Now that you know what expenses you have to account for, where can you go to find out what expenses a fund charges?
A mutual fund company outlines everything you could ever want to know about a fund in the fund’s prospectus. A prospectus is a booklet that will identify and discuss everything from the fund’s objectives and its past performance to a description of the fund manager and the fees associated with the fund. If there is something you can’t find in the prospectus, the prospectus provides you will all of the company’s contact information so you can get your questions answered.
Unfortunately, most investors never read through their funds’ prospectuses. But if you want to access this tremendous information, Forbes.com offers an incredible tool to help you locate a fund’s prospectus: The Fund Info Service.
You can search for your fund’s prospectus by “Fund Family,” “Investment Object” or by the name of the fund itself.
Now that you know virtually everything about a fund thanks to the prospectus, how do you go about buying that fund?
Buying Mutual Funds
As an individual investor, you have many avenues available to you if you want to invest in mutual funds. You can invest through a company-sponsored 401(k) plan, through a personal IRA account or through a standard brokerage account. But regardless of which avenue you choose, you should be aware that mutual funds don’t trade like stocks. You can buy or sell shares of stock any time during market hours, but you can only buy or sell mutual funds at the end of the day. Also SeeETF’s.
Mutual funds only trade at the end of the day because you trade mutual funds based on their net asset value (NAV). To determine the NAV at the end of the trading day, the mutual fund company looks at all of the assets that are in the basket, determines their value and divides that number by the total number of outstanding shares in the fund. As you can imagine, this can be a complicated process, and the fund company only wants to go through it once a day, after the market closes.
Mutual fund companies recognize that the inflexibility associated with only being able to trade once a day can be difficult. So, to offset a portion of this inflexibility, they allow you to purchase fractional shares of the mutual fund.
Imagine a mutual fund is trading at $58.50, and you have $100 you want to invest. If fund companies didn’t allow fractional shares, you would be able to buy one share for $58.50, but the rest of your money would have to wait until you could save enough to buy another full share. But because funds do allow fractional trading, you can use your entire $100 and own 1.71 shares.