Mutual Funds

Definition:

Mutual fund is a common pool of money into which investors place

their contributions to be invested in accordance with some objective . It is a
company that brings together a group of people and invests their money in
stocks, bonds, and other securities. The ownership of the fund is joint or
mutual. The fund belongs to all investors. Ownership is proportionate to
contribution made by one.

Advantages of Mutual Funds:

• Professional Management - The primary advantage of funds is the professional

management of your money. Investors purchase funds because they do not have the
time or the expertise to manage their own portfolios. A mutual fund is a relatively
inexpensive way for a small investor to get a full-time manager to make and monitor
investments.

• Portfolio Diversification - By owning shares in a mutual fund instead of owning

individual stocks or bonds, your risk is spread out. The idea behind diversification is to
invest in a large number of assets so that a loss in any particular investment is
minimized by gains in others.

• Liquidity - Just like an individual stock, a mutual fund allows you to request that your
units be converted into cash at any time.

• Flexibility & Convenience - Buying a mutual fund is easy! Pretty well any bank has its
own line of mutual funds, and the minimum investment is small. Most companies also
have automatic purchase plans whereby as little as $100 can be invested on a monthly
basis.

Disadvantages of Mutual Funds

• No Control Over Cost - Creating, distributing, and running a mutual fund is an expensive proposition. Everything
from the manager’s salary to the investors’ statements cost money. Those expenses are passed on to the investors.
Since fees vary widely from fund to fund, failing to pay attention to the fees can have negative long-term
consequences. Remember, every dollar spend on fees is a dollar that has no opportunity to grow over time.

• Managing a Portfolio Funds - It's difficult to manage the funds diversified. Because funds have small holdings in so
many different companies, high returns from a few investments often don't make much difference on the overall
return. It is also the result of a successful fund getting too big. When money pours into funds that have had strong
success, the manager often has trouble finding a good investment for all the new money.

TYPES

It's important to understand that each mutual fund has different risks and rewards. In general, the higher the potential
return, the higher the risk of loss. Although some funds are less risky than others, all funds have some level of risk -
it's never possible to diversify away all risk. This is a fact for all investments.

Each fund has a predetermined investment objective that tailors the fund's assets, regions of investments and
investment strategies. At the fundamental level, there are three varieties of mutual funds:
1) Equity funds (stocks)
2) Fixed-income funds (bonds)
3) Money market funds

All mutual funds are variations of these three asset classes. For example, while equity funds that invest in fast-
growing companies are known as growth funds, equity funds that invest only in companies of the same sector or
region are known as specialty funds.

Let's go over the many different flavors of funds. We'll start with the safest and then work through to the more risky.

Money Market Funds

The money market consists of short-term debt instruments, mostly Treasury bills. This is a safe place to park your
money. You won't get great returns, but you won't have to worry about losing your principal. A typical return is twice
the amount you would earn in a regular checking/savings account and a little less than the average certificate of
deposit (CD).

Bond/Income Funds
Income funds are named appropriately: their purpose is to provide current income on a steady basis. When referring
to mutual funds, the terms "fixed-income," "bond," and "income" are synonymous. These terms denote funds that
invest primarily in government and corporate debt. While fund holdings may appreciate in value, the primary objective
of these funds is to provide a steady cashflow to investors. As such, the audience for these funds consists of
conservative investors and retirees. (Learn more inIncome Funds 101.) 

Bond funds are likely to pay higher returns than certificates of deposit and money market investments, but bond funds
aren't without risk. Because there are many different types of bonds, bond funds can vary dramatically depending on
where they invest. For example, a fund specializing in high-yield junk bonds is much more risky than a fund that
invests in government securities. Furthermore, nearly all bond funds are subject to interest rate risk, which means
that if rates go up the value of the fund goes down.

Balanced Funds
The objective of these funds is to provide a balanced mixture of safety, income and capital appreciation. The strategy
of balanced funds is to invest in a combination of fixed income and equities. A typical balanced fund might have a
weighting of 60% equity and 40% fixed income. The weighting might also be restricted to a specified maximum or
minimum for each asset class.

A similar type of fund is known as an asset allocation fund. Objectives are similar to those of a balanced fund, but
these kinds of funds typically do not have to hold a specified percentage of any asset class. The portfolio manager is
therefore given freedom to switch the ratio of asset classes as the economy moves through the business cycle.

Equity Funds
Funds that invest in stocks represent the largest category of mutual funds. Generally, the investment objective of this
class of funds is long-term capital growth with some income. There are, however, many different types of equity funds
because there are many different types of equities. A great way to understand the universe of equity funds is to use a
style box, an example of which is below.

The idea is to classify funds based on both the size of the companies invested in and the investment style of the
manager. The term value refers to a style of investing that looks for high quality companies that are out of favor with
the market. These companies are characterized by low P/E and price-to-book ratios and high dividend yields. The
opposite of value is growth, which refers to companies that have had (and are expected to continue to have) strong
growth in earnings, sales and cash flow. A compromise between value and growth is blend, which simply refers to
companies that are neither value nor growth stocks and are classified as being somewhere in the middle.

For example, a mutual fund that invests in large-cap companies that are in strong financial shape but have recently
seen their share prices fall would be placed in the upper left quadrant of the style box (large and value). The opposite
of this would be a fund that invests in startup technology companies with excellent growth prospects. Such a mutual
fund would reside in the bottom right quadrant (small and growth). (For further reading, check out Understanding The
Mutual Fund Style Box.)

Global/International Funds
An international fund (or foreign fund) invests only outside your home country. Global funds invest anywhere around
the world, including your home country.

It's tough to classify these funds as either riskier or safer than domestic investments. They do tend to be more volatile
and have unique country and/or political risks. But, on the flip side, they can, as part of a well-balanced portfolio,
actually reduce risk by increasing diversification. Although the world's economies are becoming more inter-related, it
is likely that another economy somewhere is outperforming the economy of your home country.

Specialty Funds
This classification of mutual funds is more of an all-encompassing category that consists of funds that have proved to
be popular but don't necessarily belong to the categories we've described so far. This type of mutual fund forgoes
broad diversification to concentrate on a certain segment of the economy.

Sector funds are targeted at specific sectors of the economy such as financial, technology, health, etc. Sector funds
are extremely volatile. There is a greater possibility of big gains, but you have to accept that your sector may tank.

Regional funds make it easier to focus on a specific area of the world. This may mean focusing on a region (say Latin
America) or an individual country (for example, only Brazil). An advantage of these funds is that they make it easier to
buy stock in foreign countries, which is otherwise difficult and expensive. Just like for sector funds, you have to
accept the high risk of loss, which occurs if the region goes into a bad recession.

Socially-responsible funds (or ethical funds) invest only in companies that meet the criteria of certain guidelines or
beliefs. Most socially responsible funds don't invest in industries such as tobacco, alcoholic beverages, weapons or
nuclear power. The idea is to get a competitive performance while still maintaining a healthy conscience.

Index Funds
The last but certainly not the least important are index funds. This type of mutual fund replicates the performance of a
broad market index such as the S&P 500 or Dow Jones Industrial Average (DJIA). An investor in an index fund
figures that most managers can't beat the market. An index fund merely replicates the market return and benefits
investors in the form of low fees. (For more on index funds, check out our Index Investing Tutorial.)

Mutual Funds: Picking A Mutual Fund

Buying

You can buy some mutual funds (no-load) by contacting fund companies directly. Other funds are sold
through brokers, banks, financial planners, or insurance agents. If you buy through a third party, you may
pay a sales charge (load).

That said, funds can be purchased through no-transaction fee programs that offer funds from many companies.
Sometimes referred to as "fund supermarkets," these programs let you buy funds from many different companies.
They also provide consolidated recording that includes all purchases made through the supermarket, even if they are
from different fund families. Popular examples are Schwab's OneSource, Vanguard's FundAccess, and Fidelity's
FundsNetwork. Many large brokerages have similar offerings.

What to Know Before You Shop

Net asset value (NAV), which is a fund's assets minus liabilities, is the value of a mutual fund. NAV per share is the
value of one share in the mutual fund, and it is the number that is quoted in newspapers. You can basically just think
of NAV per share as the price of a mutual fund. It fluctuates everyday as fund holdings and shares outstanding
change.

When you buy shares, you pay the current NAV per share plus any sales front-end load. When you sell your shares,
the fund will pay you NAV less any back-end load.

Finding Funds
Nearly every fund company in the country also has its own website. Simply type the name of the fund or fund
company that you wish to learn more about into a search engine and hit “search.” If you don’t have a specific fund
company already in mind, you can run a search for terms like “no-load small cap fund” or large-cap value fund.”

For a more organized search, there are a variety of other resources available online. Two notable ones include:

The Mutual Fund Education Alliance is the not-for-profit trade association of the no-load mutual fund industry. They
have a tool for searching for no-load funds.

Morningstar is an investment research firm that is particularly well known for its fund information.
 
Identifying Goals and Risk Tolerance
Before acquiring shares in any fund, you need to think about why you are investing. What is your goal? Are long-term
capital gains desired, or is a current income preferred? Will the money be used to pay for college expenses, or to
supplement a retirement that is decades away? Identifying a goal is important because it will help you hone in on the
right fund for the task.

For really short-term goals, money market funds may be the right choice, For goals that are few years in the future,
bond funds may be appropriate. For long-term goals, stocks funds may be the way to go.

Of course, you must also consider the issue of risk tolerance. Can you afford and accept dramatic swings in portfolio
value? If so, you may prefer stock funds over bond funds. Or is a more conservative investment warranted? In that
case, bond funds may be the way to go. (To learn more, read Analyzing Mutual Fund Risk.)

The next question to consider include “are you more concerned about trying to outperform your fund’s benchmark
index or are you more concerned about the cost of your investments?” If the answer is “cost,” index funds are likely
the right choice for you.

Additional questions, to consider include how much money you have to invest, whether you should invest in a lump
sum or a little bit over time and whether taxes are a concern for you. (Learn how to invest with a small amount of
cash in How To Invest On A Shoestring Budget.)

Mutual Funds: Evaluating Performance

Let's look at a real example from a large mutual fund's performance:

1 year 3 year 5 year

53% 20% 11%

Last year, the fund had excellent performance at 53%. But, in the past three years, the average annual return was
20%. What did it do in years 1 and 2 to bring the average return down to 20%? Some simple math shows us that the
fund made an average return of 3.5% over those first two years: 20% = (53% + 3.5% + 3.5%)/3. Because that is only
an average, it is very possible that the fund lost money in one of those years.

It gets worse when we look at the five-year performance. We know that in the last year the fund returned 53% and in
years 2 and 3 we are guessing it returned around 3.5%. So what happened in years 4 and 5 to bring the average
return down to 11%? Again, by doing some simple calculations we find that the fund must have lost money, an
average of -2.5% each year of those two years: 11% = (53% + 3.5% + 3.5% - 2.5% - 2.5%)/5. Now the fund's
performance doesn't look so good!

It should be mentioned that, for the sake of simplicity, this example, besides making some big assumptions, doesn't
include calculating compound interest. Still, the point wasn't to be technically accurate but to demonstrate the
importance of taking a closer look at performance numbers. A fund that loses money for a few years can bump the
average up significantly with one or two strong years.

It's All Relative

Of course, knowing how a fund performed is only one third of the battle. Performance is a relative issue, literally. If
the fund we looked at above is judged against its appropriate benchmark index, a whole new layer of information is
added to the evaluation. If the index returned 75% for the 1 year time period, that 53% from the fund doesn't look
quite so good. On the other hand, if the index delivered results of 25%, 5%, and -5% for the respective one, three,
and five-year periods, then the fund’s results look rather fine indeed.

To add another layer of information to the evaluation, one can consider a fund’s performance against its
peer group as well as against its index. If other funds that invest with a similar mandate had similar
performance, this data point tells us that the fund is in line with its peers. If the fund bested its peers and
its benchmark, its results would be quite impressive indeed.

Looking at any one piece of information in isolation only tells a small portion of the story. Consider the
comparison of a fund against its peers. If the fund sits in the top slot over each of the comparison periods,
it is likely to be a solid performer. If it sits at the bottom, it may be even worse than perceived, as peer
group comparisons only capture the results from existing funds. Many fund companies are in the habit of
closing their worst performers. When the "losers" are purged from their respective categories, their
statistical records are no longer included in the category performance data. This makes the category
averages creep higher than they would have if the losers were still in the mix. This is better known as
survivorship bias. (Learn more about survivorship bias in The Truth Behind Mutual Fund Returns.)

To develop the best possible picture of fund's performance results, consider as many data points as you
can. Long-term investors should focus on long-term results, keeping in mind that even the best
performing funds have bad years from time to time. (Dig into the numbers in Mutual Fund Ratings: Are
They Decieving?)

Let's recap what we've learned in this tutorial:

 A mutual fund brings together a group of people and invests their money in stocks, bonds, and other
securities.
 The advantages of mutuals are professional management, diversification, economies of scale, simplicity and
liquidity.
 The disadvantages of mutuals are high costs, over-diversification, possible tax consequences, and the
inability of management to guarantee a superior return.
 There are many, many types of mutual funds. You can classify funds based on asset class, investing
strategy, region, etc.
 Mutual funds have lots of costs.
 Costs can be broken down into ongoing fees (represented by the expense ratio) and transaction fees
(loads).
 The biggest problems with mutual funds are their costs and fees.
 Mutual funds are easy to buy and sell. You can either buy them directly from the fund company or through a
third party.
 Mutual fund ads can be very deceiving.