A&M Systemwide: An introduction to mutual funds

An introduction to mutual funds

Over the past decade, American investors increasingly have turned to mutual funds to save for retirement and other financial goals.

Mutual funds can offer the advantages of diversification and professional management, but they also involve risk. It pays to understand both the advantages and disadvantages of mutual fund investing and how to choose products that match your goals and tolerance for risk.

What is a mutual fund?

A mutual fund is a company that pools money from many investors and invests the money in stocks, bonds, short-term money-market instruments, other securities or assets, or some combination of these investments. The combined holdings the mutual fund owns are known as its portfolio. Each share represents an investor's proportionate ownership of the fund's holdings and the income those holdings generate.

While you can earn money investing in mutual funds, you can also lose money. In addition to market risk, all mutual funds have costs that lower investment returns and fees that are passed on to investors. Mutual funds are not guaranteed or insured by the FDIC or any other government agency—even if you bought the fund through a bank and the fund carries the bank's name.

Types of mutual funds

You have literally thousands of mutual fund choices. Most mutual funds fall into one of three main categories—money market funds, bond (“fixed income”) funds and stock (“equity”) funds. Each type has different features and different risks and rewards. Generally, the higher the potential return, the higher the risk of loss. Before you invest, decide whether the investment strategy and risks of the fund are acceptable to you.

Money market funds have a low risk as compared with other mutual funds and most other investments. By law, the funds can be invested only in certain high-quality, short-term investments issued by the U.S. government, U.S. corporations, and state and local governments.
Bond funds generally have a higher risk than money market funds, largely because bond funds typically pursue strategies aimed at producing higher yields. The Security and Exchange Commission does not restrict bond funds to high-quality or short-term investments. The different types of bond funds can vary dramatically in their risks and rewards.
Stock funds have historically been better performers over the long term than other types of investments. Over the short term, though, a stock fund’s value can rise and fall quickly and dramatically. Stock funds differ depending on if they are:
- Growth funds that focus on stocks that may not pay a regular dividend but have the potential for large capital gains.
- Income funds that invest in stocks that pay regular dividends.
- Index funds that aim to achieve the same return as a particular market index, such as the S&P 500 Composite Stock Price Index, by investing in all or perhaps a representative sample of the companies included in an index.
- Sector funds that may specialize in a particular industry segment such as technology or consumer products stocks.

Advantages and disadvantages

Mutual funds, as with any investment, have advantages and disadvantages. Whether you consider an investment feature an advantage or disadvantage depends on your unique circumstances. Features to consider include:

Professional management—Professional money managers research, select and monitor the performance of the securities the fund purchases.
Diversification—This is a strategy that spreads your investments across a wide range of companies and industry sectors to help lower your risk if a company or sector fails.
Affordability—Some mutual funds accommodate investors who don't have a lot of money to invest by setting relatively low dollar amounts for initial purchases, subsequent monthly purchases, or both.
Liquidity—At any time, you can readily redeem your mutual fund shares at the current net asset value (NAV) plus any fees and charges assessed on redemption.
Costs despite negative returns—You must pay sales charges, annual fees and other expenses regardless of how the fund performs.
Lack of control—You typically cannot ascertain the exact make-up of a fund's portfolio at any given time, nor can you directly influence which securities the fund manager buys and sells or the timing of those trades.
Price uncertainty—With an individual stock, you can obtain real-time pricing information with relative ease by checking financial web sites or by calling your broker. By contrast, with a mutual fund, the price at which you purchase or redeem shares will typically depend on the fund's value (NAV), which the fund might not calculate until many hours after you've placed your order.

Earning money from your investments

You earn money with your investments through:

Dividend payments—A fund may earn income in the form of dividends and interest on the securities in its portfolio. The fund then pays its shareholders nearly all of the income (minus disclosed expenses) it has earned in the form of dividends.
Capital gains distributions—When a fund sells a security that has increased in price, the fund has a capital gain. At the end of the year, most funds distribute these capital gains (minus any capital losses) to investors.
Increased NAV—If the market value of a fund's portfolio increases after deduction of expenses and liabilities, then the NAV of the fund and its shares increases. The higher NAV reflects the higher value of your investment.

Before you invest

Consider how much risk you are willing to take with your investments.
Consider the effect that fees will have on your returns over time.
Don’t assume soundness based solely on a fund’s past performance or its name.
Read the fund’s prospectus and shareholder reports to learn about its investment strategy, potential risks, objectives, the securities it invests in, fees and historical performance.