LESSON 5: Investing in Mutual Funds

What Is a Mutual Fund?

A mutual fund is an investment cooperative managed by an investment company. As

in other cooperatives, (such as credit unions), mutual fund investors pool their assets
together and employ an investment company with investment professionals and
administrators who conduct the day-to-day business of managing the fund. Each
mutual fund is distinguished by an investment objective. For example, the Vanguard
500 Index fund invests only in stocks comprising the Standard & Poor 500 index.

The popularity of mutual funds exploded in the 1980s and 1990s, mainly because they
offer more benefits to individual investors than individual stocks do. They reduce
investment costs and provide professional investment management while enabling
individual investors to diversify portfolios very easily.

Reduced Costs & Diversification

Brokers charge commissions on individual security prices that can quickly add up in a
well-diversified portfolio, eating into your returns. Most Internet discount brokers
charge $20 to $50 commissions to buy and sell one round lot (100 shares). Full-
service brokers, who also provide investment advice, charge much more. If you owned
20 stocks, their round-trip discount commission could total approximately $1,000.
Since investors pool all their money into mutual funds, they enjoy economies of scale
in management and transaction fees, which usually lowers the cost of broker fees.

Mutual funds also enable investors with small- and medium-sized portfolios to
diversify in an efficient manner. You could create a minimally diversified portfolio on
your own with $50,000, but some experts say that you'd need to invest $100,000 to do
the job right. In contrast, a mutual fund will allow you to invest in all 500 stocks
comprising the S&P 500 Index with only $1,000.

The Impact of Fees and Loads

Mutual fund investors still need to pay attention to fees and loads despite the
economies of scale they enjoy. The cost of mutual funds assumes two forms: periodic
fees and transaction fees.

Periodic fees, which are also known as management fees, are assessed at least
annually as a percentage of the value of your investment. The percentage varies
significantly from one investment company to another, depending on whether the fund
invests in stocks or bonds and whether it tracks an index or is actively managed to
beat an index.
Fixed-income funds and index funds charge the lowest fees. Fees exceeding 1 percent
are common, though you can find funds charging less than 0.25 percent. Actively
managed stock funds charge the highest periodic fees, often exceeding 2.75 percent
per year.

Transaction fees, known as loads, are also expressed as a percent of investment value.
The charge applies when you buy and/or sell the investment. Most loads are less than
5 percent. No-load mutual funds charge periodic fees and, as the name implies, don't
charge any transaction fees. These periodic fees, however, are often higher than load
fund fees, so you need to be careful.

Culling Useful Information From the Prospectus

Investment companies are required to offer a prospectus when offering mutual fund
shares for sale. The prospectus details everything about the fund. Though the
prospectus is filled with legalese and technical terms, a novice can cull the vast
majority of essential information by following these five simple steps:

1. Select a prospectus from one of the widely known investment companies.

2. Read the investment objective on the first page. The objective states whether the
mutual fund invests in fixed income, equity or both, giving clues about how risky the
fund is. Be on the lookout for an elaboration of the objective deeper in the prospectus.

3. Identify the cost of the mutual fund. Loads are usually stated on the inside cover.
Periodic fees are reported in a table, which is usually found in the first few pages.
Look for a tabled column or row entitled "Ratio of expenses to average net assets."
Data are grouped to report annual results. While you're here, also find the turnover
rate, the percent of the portfolio replaced each year. A 100 percent turnover rate
means everything in the portfolio at the beginning of the year was sold and replaced
once during the year. Higher turnover increases costs and may indicate excessive
turnover due to bad investment decisions. You should favor income stock funds and
fixed income funds with turnover rates less than about 100 percent. As you approach
more risky investments such as small growth stock funds, 150 percent is not
uncommon.

4. Examine historic investment returns. Usually you can find a table or chart
illustrating returns. If you can't find this, go to the table you examined in step 3 and
find either the two columns or rows (depending on the table's format) with these
headings: net asset value at end of year and total from investment operations. To
calculate annual return, divide one year's total from investment operations by the
immediately previous year's net asset value at the end of the year. Compare annual
returns with an appropriate mutual fund index to evaluate how well the fund has
performed in relation to its peers.

5. Find a section with the word "risk" in the title. Risk discussions are usually
straightforward, and lay out worst-case scenarios.

There's more in the prospectus, but these steps will be more than enough to get you
started. The investment policy section is usually technical, but with time, practice and
more experience you'll catch on. Be sure to keep the prospectus whenever you decide
to buy a fund.

Mutual Fund Categories: What Do They Mean?

In Investing 101, Kathy Kristof identifies the major mutual fund investment categories
and offers concise summaries distinguishing them. When organizing your mutual fund
investing plan, use these categories so that your portfolio incorporates a broad range
of investment categories.

Unless you've stockpiled a lot of cash, you won't be able to invest in all of these
categories at one time. When you're just starting out, pick broadly diversified mutual
funds such as balanced funds, global funds and growth and income funds. As your
portfolio grows, you can begin to apply some precision to your strategy by selecting
narrowly focused funds such as sector funds, which limit investments to targeted
industries, and junk bond funds.

These categories aid planning, but, since investment companies and the media apply
these terms very loosely, use care when you see them in the objective section on the
first page of the prospectus. Two mutual funds subsumed under the same category
may be invested in very different types of investments. And you definitely don't want
to make a mistake and pick a fund that is incompatible with your plan.

Use the prospectus to make individual mutual fund choices. The discussion of and
elaboration on the fund's objectives, which occurs throughout the prospectus, helps to
clarify the objective. Discussions of risk and investment methods also aid the process.
Mutual funds also publish quarterly reports listing specific investments by corporate
name or government. These lists help identify the kinds of investments the fund uses
to achieve its objective.

Taxes and Mutual Funds

Mutual funds have one major drawback: unlike taxes on individual investments, the
federal income tax applies to all mutual fund earnings, even if you don't sell your
shares.
And it doesn't take a CPA to imagine how painful this can be to an investor. Let's say
you buy a growth fund and hold it for at least two years. In the first year, it earns 10
percent, and in the second year it earns 15 percent. You dutifully pay tax on your
earnings without a second thought. But, since you could have reinvested this money,
you should consider the taxes you pay for mutual funds as lost income.

The solution to the mutual fund tax drawback lies in tax-favored accounts such as
IRAs and 401(k) plans offered by your employer. If your mutual funds are invested in
tax-favored accounts, you'll only have to pay taxes when you start drawing on your
account.

Adopt a Consistent Mutual Fund Selection Process

With 10,000 mutual funds available, how are you going to find the best funds to
achieve your goals? By the time you're finished researching all of them, you'll already
be retired!

The best advice is to find a good book and use it until the pages get worn. The NEW
Commonsense Guide to Mutual Funds by Mary Rowland delivers sound guidance and
practical advice on selecting and managing mutual funds. Her list of 75 "Dos and
Don'ts" lays the groundwork for a sensible approach to mutual funds.

Chaos characterizes the retail financial products industry. Every firm has a story to
tell. While some tell it with colorful charts, others pummel us with performance data
and index comparisons. Investors familiar with mutual fund advertisements would
probably agree that it seems like most mutual funds are well aware of these two
strategies and readily bombard us with them.

The investor's only defense is a written plan. A plan that identifies specifics and a firm
strategy cuts through the blitz of advertisements and all the smooth sales pitches. A
written plan leads to consistently applied mutual fund selection criteria. Get a book
and write your plan.