Invest Wisely: An Introduction to Mutual Funds
The following is taken from the "Beginners' Guide to Mutual Funds: Online Publications at the SEC" Office of Investor Education and Assistance:
Invest Wisely: An Introduction to Mutual Funds.
This publication explains the basics of mutual fund
investing, how mutual funds work, what factors to
consider before investing, and how to avoid common
Factors to Consider
Thinking about your long-term investment strategies and tolerance for risk can help you decide what type of fund is best suited for you. But you should also consider the effect that fees and taxes will have on your returns over time.
Degrees of Risk
All funds carry some level of risk. You may lose some or all of the money you invest - your principal - because the securities held by a mutual fund go up and down in value. Dividend or interest payments may also fluctuate as market conditions change.
Before you invest, be sure to read a mutual fund's prospectus and shareholder reports to learn about its investment strategy and the potential risks. Funds with higher rates of return may take risks that are beyond your comfort level and are inconsistent with your financial goals.
A Word About Derivatives
Derivatives are financial instruments whose performance is derived, at least in part, from the performance of an underlying asset, security, or index. Even small market movements can dramatically affect their value, sometimes in unpredictable ways.
There are many types of derivatives with many different uses. A mutual fund's prospectus will disclose whether and how it may use derivatives. You may also want to call a mutual fund and ask how it uses these instruments.
Fees and Expenses
As with any business, running a mutual fund involves costs - including shareholder transaction costs, investment advisory fees, and marketing and distribution expenses. Funds pass along these costs to investors by imposing fees and expenses. It is important that you understand these charges because they lower your returns.
Some funds impose "shareholder fees" directly on investors whenever they buy or sell shares. In addition, every fund has regular, recurring, fund-wide "operating expenses." Funds typically pay their operating expenses out of fund assets - which means that investors indirectly pay these costs.
SEC rules require funds to disclose both shareholder fees and operating expenses in a "fee table" near the front of a mutual fund's prospectus. The lists below will help you decode the fee table and understand the various fees a mutual fund may impose:
- Sales Charge (Load) on Purchases : the amount you pay when you buy shares in a mutual fund. Also known as a "front-end load," this fee typically goes to the brokers that sell the fund's shares. Front-end loads reduce the amount of your investment. For example, let's say you have $1,000 and want to invest it in a mutual fund with a 5% front-end load. The $50 sales load you must pay comes off the top, and the remaining $950 will be invested in the fund. According to NASD rules, a front-end load cannot be higher than 8.5% of your investment.
- Purchase Fee : another type of fee that some funds charge their shareholders when they buy shares. Unlike a front-end sales load, a purchase fee is paid to the fund (not to a broker) and is typically imposed to defray some of the fund's costs associated with the purchase.
- Deferred Sales Charge (Load) : a fee you pay when you sell your shares. Also known as a "back-end load," this fee typically goes to the brokers that sell the fund's shares. The most common type of back-end sales load is the "contingent deferred sales load" (also known as a "CDSC" or "CDSL"). The amount of this type of load will depend on how long the investor holds his or her shares and typically decreases to zero if the investor holds his or her shares long enough.
- Redemption Fee : another type of fee that some funds charge their shareholders when they sell or redeem shares. Unlike a deferred sales load, a redemption fee is paid to the fund (not to a broker) and is typically used to defray fund costs associated with a shareholder's redemption.
- Exchange Fee : a fee that some funds impose on shareholders if they exchange (transfer) to another fund within the same fund group or "family of funds."
- Account fee : a fee that some funds separately impose on investors in connection with the maintenance of their accounts. For example, some funds impose an account maintenance fee on accounts whose value is less than a certain dollar amount.
Annual Fund Operating Expenses
- Management Fees : fees that are paid out of fund assets to the fund's investment adviser for investment portfolio management, any other management fees payable to the fund's investment adviser or its affiliates, and administrative fees payable to the investment adviser that are not included in the "Other Expenses" category (discussed below).
- Distribution [and/or Service] Fees ("12b-1" Fees) : fees paid by the fund out of fund assets to cover the costs of marketing and selling mutual fund shares and sometimes to cover the costs of providing shareholder services. "Distribution fees" include fees to compensate brokers and others who sell mutual fund shares and to pay for advertising, the printing and mailing of prospectuses to new investors, and the printing and mailing of sales literature. "Shareholder Service Fees" are fees paid to persons to respond to investor inquiries and provide investors with information about their investments.
- Other Expenses : expenses not included under "Management Fees" or "Distribution or Service (12b-1) Fees," such as any shareholder service expenses that are not already included in the 12b-1 fees, custodial expenses, legal and accounting expenses, transfer agent expenses, and other administrative expenses.
- Total Annual Fund Operating Expenses ("Expense Ratio") : the line of the fee table that represents the total of all of a mutual fund's annual fund operating expenses, expressed as a percentage of the fund's average net assets. Looking at the expense ratio can help you make comparisons among funds.
A Word About "No-Load" Funds
Some funds call themselves "no-load." As the name implies, this means that the fund does not charge any type of sales load. But, as discussed above, not every type of shareholder fee is a "sales load." A no-load fund may charge fees that are not sales loads, such as purchase fees, redemption fees, exchange fees, and account fees. No-load funds will also have operating expenses.
Be sure to review carefully the fee tables of any funds you're considering, including no-load funds. Even small differences in fees can translate into large differences in returns over time. For example, if you invested $10,000 in a mutual fund that produced a 10% annual return before expenses and had annual operating expenses of 1.5%, then after 20 years you would have roughly $49,725. But if the fund had expenses of only 0.5%, then you would end up with $60,858 - an 18% difference.
A mutual fund cost calculator can help you understand the impact that many types of fees and expenses can have over time. It takes only minutes to compare the costs of different mutual funds.
A Word About Breakpoints
Some mutual funds that charge front-end sales loads will charge lower sales loads for larger investments. The investment levels required to obtain a reduced sales load are commonly referred to as "breakpoints."
The SEC does not require a mutual fund to offer breakpoints in the fund's sales load. But, if breakpoints exist, the fund must disclose them. In addition, a NASD member brokerage firm should not sell you shares of a mutual fund in an amount that is "just below" the fund's sales load breakpoint simply to earn a higher commission.
Each fund company establishes its own formula for how they will calculate whether an investor is entitled to receive a breakpoint. For that reason, it is important to seek out breakpoint information from your financial advisor or the fund itself. You'll need to ask how a particular fund establishes eligibility for breakpoint discounts, as well as what the fund's breakpoint amounts are. NASD's Mutual Fund Breakpoint Search Tool can help you determine whether you're entitled to breakpoint discounts.
Classes of Funds
Many mutual funds offer more than one class of shares. For example, you may have seen a mutual fund that offers "Class A" and "Class B" shares. Each class will invest in the same "pool" (or investment portfolio) of securities and will have the same investment objectives and policies. But each class will have different shareholder services and/or distribution arrangements with different fees and expenses. As a result, each class will likely have different performance results.
A multi-class structure offers investors the ability to select a fee and expense structure that is most appropriate for their investment goals (including the time that they expect to remain invested in the fund). Here are some key characteristics of the most common mutual fund share classes offered to individual investors:
- Class A Shares : Class A shares typically impose a front-end sales load. They also tend to have a lower 12b-1 fee and lower annual expenses than other mutual fund share classes. Be aware that some mutual funds reduce the front-end load as the size of your investment increases. If you're considering Class A shares, be sure to inquire about breakpoints.
- Class B Shares : Class B shares typically do not have a front-end sales load. Instead, they may impose a contingent deferred sales load and a 12b-1 fee (along with other annual expenses). Class B shares also might convert automatically to a class with a lower 12b-1 fee if the investor holds the shares long enough.
- Class C Shares : Class C shares might have a 12b-1 fee, other annual expenses, and either a front- or back-end sales load. But the front- or back-end load for Class C shares tends to be lower than for Class A or Class B shares, respectively. Unlike Class B shares, Class C shares generally do not convert to another class. Class C shares tend to have higher annual expenses than either Class A or Class B shares.
When you buy and hold an individual stock or bond, you must pay income tax each year on the dividends or interest you receive. But you won't have to pay any capital gains tax until you actually sell and unless you make a profit.
Mutual funds are different. When you buy and hold mutual fund shares, you will owe income tax on any ordinary dividends in the year you receive or reinvest them. And, in addition to owing taxes on any personal capital gains when you sell your shares, you may also have to pay taxes each year on the fund's capital gains. That's because the law requires mutual funds to distribute capital gains to shareholders if they sell securities for a profit that can't be offset by a loss.
Tax Exempt Funds
If you invest in a tax-exempt fund - such as a municipal bond fund - some or all of your dividends will be exempt from federal (and sometimes state and local) income tax. You will, however, owe taxes on any capital gains.
Bear in mind that if you receive a capital gains distribution, you will likely owe taxes - even if the fund has had a negative return from the point during the year when you purchased your shares. For this reason, you should call the fund to find out when it makes distributions so you won't pay more than your fair share of taxes. Some funds post that information on their websites.
SEC rules require mutual funds to disclose in their prospectuses after-tax returns. In calculating after-tax returns, mutual funds must use standardized formulas similar to the ones used to calculate before-tax average annual total returns. You'll find a mutual fund's after-tax returns in the "Risk/Return Summary" section of the prospectus. When comparing funds, be sure to take taxes into account.