Advising Clients since 1980
Mutual Fund Investing
A mutual fund is a business enterprise that combines the money of many different people and invests it in stocks, bonds, or other securities. The fund’s manager chooses investments that best match the fund’s objectives as described in the fund’s prospectus. Each share of the fund represents proportionate ownership in all the fund’s underlying securities.
Benefits of Mutual Funds
Diversification: Mutual funds spread out (diversify) their investments to help you reduce risk or efficiently target particular industries, such as high-technology, biotechnology, and other sectors. With mutual funds, even investors with relatively small amounts of money can achieve broad diversification.
Convenience: Many funds offer automatic reinvestment of distributions and telephone redemptions and transfers.
Oversight: Federal regulators of mutual funds monitor their investing activities, and assure full disclosure of their practices and management.
Types of Mutual Funds
Most funds are “open-end,” which means they can continue to sell their shares for as long as they want to (and as long as there are investors who want to buy). Occasionally, open-end funds grow so large that they “hold” the maximum amount their managers feel they can effectively invest. These funds may then be closed to new buyers.
Other funds are “closed-end,” which means that they only sell shares when they’re formed. The money is then invested, and the proceeds that come from sales or interest and dividends are reinvested. The only way to buy a closed end fund after its original offering is to purchase shares from other investors-usually through a stock exchange.
The share price of an open-ended fund is known as its NAV (Net Asset Value). When you buy, you pay the current NAV for each share plus a sales charge (load), if applicable. When you sell, you receive the then-current NAV less any sales charge.
Mutual Fund Profitability
If your fund’s stocks and/or bonds increase in value, the NAV increases proportionally. Mutual funds can also make money for investors when the fund sells investments at a profit. The capital gain (less any capital loss) is distributed. The fund also distributes dividend and interest income.
Mutual Fund Distributions
Earnings on your account may be distributed to you in cash, reinvested in additional shares, or a combination.
Mutual Fund Risks
The FDIC does not federally insure mutual funds, as it does bank savings accounts and CDs.
Mutual Fund Prospectus
There’s a wealth of information available directly from every mutual fund, in its prospectus. All funds must provide you with a prospectus before you invest with them. It spells out the past performance, fees and expenses, investment objectives, and information about its management.
Funds also provide semi-annual and annual reports. These reports include the portfolio of securities a fund is invested in, along with financial statements related to the operation of the fund.
Selecting Mutual Funds
There are more than 10,000 mutual funds. While some may overlap, you still have many choices - almost too many for the average consumer to properly consider.
Money-market funds have the lowest risk since they only invest in high quality, short-term assets. Although their risk is lower, money-market funds aren’t risk free as they are not federally insured.
Bond funds invest in bonds of many different durations and types. But because bonds have risks, the value of a bond fund can fluctuate much more than a money market fund.
Stock funds (also known as equity funds) are generally riskier than other funds. But with higher risk comes the chance for greater returns.
Within each of these categories, funds are further divided up by their objective. For example, stock mutual funds may have different emphases or objectives, such as growth, value, a blend of the two, and income. Funds are also divided into the categories of Load (the sales charge you pay when you buy and/or sell), and No-load, where there are no sales charges or commissions to pay.
Stock Funds
Some stock mutual funds invest in only certain sized companies, such as large -, mid-, or small-capitalization (total market value) companies. Others may invest overseas, in international stocks. Other funds look for a blend of all sizes and types of companies.
Still other types of stock mutual funds are Sector funds (investing in specific industries), and Index funds (which match, as closely as possible, a specific index, such as the S&P 500 Stock Index).
Bond Funds
Besides specializing in the type of issuer (corporations, governments, or foreign), bonds can be Taxable or Tax-exempt.
Interest on some municipal bonds (issued by state and local governments) may be exempt from federal, state, and local income taxes. In turn, their yields tend to be lower. Interest on federal bonds is exempt from state and local income tax.
Bonds & Taxation
Besides specializing in the type of issuer (corporations, governments, or foreign), bonds can be Taxable or Tax-exempt.
Interest on some municipal bonds (issued by state and local governments) may be exempt from federal, state, and local income taxes. In turn, their yields tend to be lower. Interest on federal bonds is exempt from state and local income tax.
Comparing Mutual Funds
The primary factors when considering mutual funds include: consistency of performance; superior performance relative to funds with similar objectives and investment styles; tenure of the fund manager; quality of the other funds within the mutual fund’s family of funds; risks; and costs.
Income Taxes
When you sell a fund that’s not part of a tax-deferred retirement plan or IRA, any gain you receive may be taxed at ordinary income tax rates or long-term capital gains tax rates. The difference between the two rates can be nearly 20% on the federal level alone.
When you own a non-tax-deferred fund for more than 12 months, profits are federally taxed as long-term capital gains (with a tax rate ranging from 10% to 20%) as compared to the ordinary income tax rate (which ranges from 15% to 39.6%).
The general tax rules discussed above are the federal income tax rules as of January 1, 2002 and may be subject to exceptions. State and local taxes may also be due. Income tax rules for retirement plans and IRAs are different.(See Distributions and taxation of retirement benefits).
Since tax laws are subject to change, always consult with the IRS or check with your tax advisor before making major decisions regarding your investments and your retirement plans and accounts.
Mutual funds distribute capital gains to shareholders each year. These gains are taxable. If you’re not careful, you might purchase shares just before the distribution date and be saddled with a year’s worth of gains, even though you’ve only owned the fund for a short time.
And second, watch the dates in fund advertising. If an ad appears after a fall in the market, see whether percentage returns include the market decline.
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Charles M. Bloom, Registered Principal offers securities and advisory services through Centaurus Financial, Inc. - Member FINRA and SIPC - 775 Avenida Pequena, CA, 93111 (mailing address: 3905 State Street Suite 7173, Santa Barbara, CA, 93105) - CA Life Insurance License No. 0A52786 - Centaurus Financial, Inc. and Shoreline Wealth & Investment Management are not affiliated companies.
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