Mutual funds can benefit your investment portfolio, but you should understand basic concepts before choosing a mutual fund. Two important components of a mutual fund are yield and return. These terms are often used interchangeably in relation to the earnings and cost of a mutual fund, but the definitions are quite different. You must obtain a firm grasp of these two concepts to help you make the best decision when choosing a mutual fund.
The mutual fund yield is the amount of dividends paid by a mutual fund minus expenses, and is expressed as a percentage. The yield is important because it shows how investors measure the income of a mutual fund, but it does not reflect the change in price of a mutual fund. Yields are typically shown on bond and money market funds for a period of seven or 30 days. Most money market yields are lower than bond yields because money market investments are typically less risky. Yields are usually converted into an annual percentage rate to simplify the comparison of mutual fund yields to investments with similar characteristics.
Mutual Fund Return
The total return of a mutual fund includes the capital appreciation and dividends paid to investors by the fund. In most cases, capital appreciation is achieved when the fund sells some of its assets to secure profits. To calculate total returns, you must subtract the ending net asset value from beginning net asset value, and add distributions to the total. Take the new total and divide it by beginning net asset value ((ending NAV – beginning NAV) + distributions) / beginning NAV). Net asset value is the price per share of a mutual fund. Although analyzing historical returns is a common practice among investors, historical returns do not guarantee a fund's future returns.
Mutual fund yields and returns alone do not give an investor insight concerning the performance of a fund. Investors compare yields and returns to benchmarks to determine how well the fund performed. A benchmark is a point of reference to help evaluate risk and performance. According to an article presented on the website of AXA Equitable, the common benchmark used for money market funds is the IBC's Money Fund Report Averages. Bond funds are usually benchmarked against the Barclays Aggregate Bond Index and the 10-Year U.S. Treasury Bond. Investors use the S&P 500 Index, Nasdaq Index and the Morgan Stanley Capital International's Europe, Australasia, Far East (EAFE) Index as benchmarks for equity funds.
Benefits of Mutual Funds
Mutual funds offer many benefits to investors once the yield and return is understood. A primary benefit of investing in a mutual fund is diversification. Mutual funds invest in a basket of securities, which allow you to own a variety of asset classes in one fund. Diversification reduces investment risk. Another advantage of mutual fund investing is that the funds are professionally managed. This alleviates the burden of buying and selling individual investments for an investor. Mutual funds are also liquid and are easy to buy and sell within one day.
- penny into antique piggy bank image by Joyce Wilkes from Fotolia.com