Mutual Funds & How does a Mutual Fund work?
Mutual funds make it easy to diversify your assets
Most funds require moderate minimum investments, from a few hundred to a few thousand dollars. Investors can construct a diversified portfolio much more cheaply than they could on their own.
There are many kinds of stock funds divided into various categories. Some examples: growth funds, which buy shares of burgeoning companies; sector funds, which buy shares of companies in a particular sector, such as technology or health care, and index funds, which buy shares of every stock in a particular index, such as the S&P 500.
Then there are bond funds to fit every investor’s requirement. If you want safe investments, consider buying government bond funds. If you prefer higher risk investments for more capital gains, try high-yield bond funds. And if you want to keep reduce your tax bill, try municipal bond funds.
Profits are not the only consideration. Consider the risk taken to achieve your gains.
When buying a fund, look at how risky its investments are. Can you tolerate big market swings for a chance of higher returns? If not, stay with low-risk funds. To assess risk level, look at three factors: the fund’s largest quarterly loss. It will prepare you for the worst. Its beta, which measures a fund’s volatility against the S&P 500. And the standard deviation, which shows how much a fund bounces around and its average profits.
Low expenses are important when choosing a fund.
To cover their expenses, funds charge a percentage of total assets. At a few percentage points a year, expenses may not sound substantial but they create a drag on performance over time.
Taxes can take a toll on performance. If you don’t sell any of your fund shares, you could still end up stuck with a tax bill. When a fund owns dividend-paying stocks or when the fund manager sells some big winners, shareholders must pay their share of the tax on capital gains. Some funds are more tax-efficient as they avoid rapid trading (and high short-term capital gains taxes) and match winning trades with losing trades.
Mutual funds that rank very highly over one period don’t always finish on top in. When choosing a fund, look for consistent long-term results.
Index mutual funds should be a prime component of your portfolio.
Index performance funds track the performance of stock market benchmarks, such as the S&P 500. These “passive” funds offer some advantages over “active” funds: Index funds may charge smaller expenses and be more tax efficient. There’s little risk the fund manager will make sudden changes that can upset your portfolio’s allocation mix. Added to that is most active mutual funds underperform the S&P index.
The majority of mutual funds don’t beat the market most years. That means, you’re better off buying all the stocks in the S&P than paying a fund manager. There are many reasons so many funds fall short.
Consider the investment costs that fund companies incur and the cost of research, administration, managers’ salaries, etc. A fund management will have to pick a lot of great stocks to pay for those costs. Index mutual funds have much lower maintenance and servicing costs.
Be patient when switching between funds
Most funds can – and will – have an off year. You may be tempted to sell a losing fund, first check to see whether it has trailed comparable funds for more than one year. If it hasn’t, sit tight. But if earnings have been consistently below average, it could be time to switch.
The most popular ways to own stocks is to buy mutual funds. Most people are likely to own shares of companies through mutual funds held in their 401(k) or Roth IRA. Mutual funds offer many benefits through the use of a fund manager. You don’t need to choose individual stocks or research companies. The fund manager and his team of professionals do this.
Mutual funds investing are a good ways for new investors to build wealth. Whether you own them through your retirement plan, such as a 401(k) or IRA, or you buy them directly or through a bank or broker or you should understand what they are and how they work.
Stock mutual funds
Stock mutual funds come in all sorts of names and categories. They can sometimes be misleading.
These are some of the most common categories and sub-categories:
Value mutual funds
Value fund managers look for stocks that are cheap on the basis of earnings power (this means they have low price/earnings ratios) or the value of the underlying assets have relatively low price/book ratios).
Large-cap value managers typically look for battered blue chips whose shares are selling at discounted prices. These managers are patient long term investors as they can wait a long time before their stock picks reward them.
Small-cap value managers will usually look for small companies (with market value of less than $1 billion) that have been battered and beaten down by other investors.
Growth mutual funds
There are different types of growth funds. Many growth fund managers are content to buy shares in companies with above-average revenue and earnings growth. Others managers looking for high returns try to catch the fastest movers before they fall back.
Aggressive growth mutual fund managers tend to take on more risk. These funds often lead their competition over long periods of time. And over short periods when the stock market is booming. But they also can also stumble along the way.
Growth funds also invest in fast growing companies but lean toward large established names. Growth funds won’t fly as high in bull markets as their more aggressive counterparts. But they fare a bit better when the markets are going down.
Invest in them if you seek higher long-term returns and can tolerate the volatility of the market. As long-term investors, growth fund should be the core holding around which the rest of their portfolio is built.
Growth and income, equity income and balanced mutual funds
Three types of funds have a common goal. Providing steady long-term growth while simultaneously providing a reliable income stream. These funds consists of some combination of dividend-paying stocks and income-producing securities, such as bonds or convertible securities (bonds or special stocks that pay interest but can also be converted into company shares).
Growth and income funds concentrate more than the other two on growth, so they generally have the lowest yields. Balanced funds strive to keep anywhere from 50 to 60% of their holdings in stocks and the rest in interest-paying securities such as bonds and convertibles, giving them the highest yields. In the middle is the equity-income class.
These funds lag in a raging bull market but are more defensive in a down turn. These funds are for risk-averse investors who seek steady income but also wish the potential for capital growth.
Specialty and other types of mutual funds
Sector and specialty funds concentrate their assets in a defined sector, such as technology, telecom, resource or health care. It can be a good investment approach. However this year’s top sector may not lead the following year. These funds are most appropriate for investors who are interested in a particular sector from an asset allocation investment perspective.
Investors investing in US government bond mutual funds. Bond funds invest mainly in bonds issued by the U.S. Treasury or federal government agencies, which means you don’t have to worry about credit risk. Because of their level of safety is high, their yields and total returns are slightly lower than those of other bond funds.
If you can handle moderate risk fluctuations then intermediate government bond funds offer an alternative. If you plan to hold a bond fund several years and can tolerate more risk, long-term government bond funds will provide more yield.
Corporate bond funds
Bond funds in this category invest in bonds issued by corporations. When researching corporate bonds funds, check the credit quality of the company bonds they hold. Most hold highly rated bonds, AAA to A minus or A3, but some take more risk by adding small doses of high yielding junk bonds. Also look at the average maturity of the bonds. The longer the a maturity, the greater the possibilities of volatility.
High-yield bond funds
These are junk bond funds investing in debt of fledgling or small firm. Or in the bonds of large well-known companies in a weakened financial condition.
These chances of these companies defaulting on their interest payments greater than with higher quality bonds. However these fund should more than 100 issues and a default now and then won’t be catastrophic for the fund.
With more risk comes higher yields potential. Anywhere from 3 to 10 percent more than safer bond funds. These funds excel when the economy is growing but decline when the economy is shrinking
This type of fund is for investors who seek higher income and returns but can accept losses of 10% during periods of economic turbulence.
Municipal bond funds
Tax-exempt bond funds invest in the bonds issued by cities, states and other local government entities. These funds generate dividends that are exempt from federal income taxes.
Income from muni bond funds that invest in the issues of a single state is also exempt from state and local taxes for resident shareholders. When you calculate the tax benefits, municipal bond funds can offer better yields than government and corporate bond funds.
Mutual fund information is widely available from the mutual funds and ratings companies like Morningstar. www.morningstar.com
Choose for funds with lower expenses. Mutual fund expenses reduce your return. Also look for consistency. Check also past performance relative to peers
Examine a fund’s performance, look at its long-term performance versus that of its peers as well as how it has performed over shorter periods.
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