Mutual Funds Tutorial

by Cynthia Myers

Mutual funds give you one alternative to investing in individual company stocks or bonds. With a mutual fund, an investment company pools the money from a number of investors and builds a portfolio of stocks, bonds, money market funds and other investments. Instead of owning individual shares of stocks, when you invest in a mutual fund you own shares in the mutual fund. The first mutual fund was created in Boston in 1924. The concept experienced tremendous growth in the 1980s and 1990s, a trend that made stock market investing available to a wide range of investors.

Types of Funds

Mutual funds primarily invest in three types of assets: stocks (equities), bonds (fixed-income) and money market instruments (cash equivalents). Different mixes of these assets create different opportunities for fund growth and varying degrees of risk. Some funds identify themselves by their investment objectives. A growth fund invests with an eye towards maximizing growth, or an increase in the fund’s value. An income fund purchases investments that pay dividends, in order to derive an income from the investments. An index fund purchases an assortment of stocks, with the goal of achieving the same rate of return as a published stock market index, such as the Standard and Poor’s 500 Index. An index fund may invest in all the companies listed in an index, or a representative sample of these companies. Some funds specialize in a single asset class -- bond funds invest only in bonds. Other funds focus on certain industries or types of investments; a fund may invest only in technology stocks, while another invests only in foreign bonds, and still another focuses on environmentally friendly, or “green” investments.

Investing

When you invest in a mutual fund, you’ll open an account with the company that manages the fund. Large investment firms, banks and online investment companies offer mutual funds. You’ll be able to study a list of the mutual funds available and read a prospectus that explains the investments in the fund, how long the fund has existed, what type of fund it is and the past performance of the fund. Funds establish a minimum amount you must invest, which can range from $100 to several hundred dollars. The fund may also set a minimum for subsequent investments. You write a check or arrange a bank transfer of your funds to the mutual fund and the fund manager purchases shares in the fund, minus any fees. When you want to sell your shares in a fund, you instruct the manager to do so and the manager sends you a check, or invests the money as you instruct her to do.

Fees

The companies that manage mutual funds collect fees to cover expenses associated with managing the fund, from paying the fund manager to broker’s fees. Some fees charge a “load” or “front-end load” whenever you purchase shares. The load is expressed as a percentage. If a fund has a 6 percent load, six dollars of every one hundred dollars you invest goes to pay the fund. You may also pay a fee when you sell your shares, known as a “back-end load.” Other fees include purchase fees, redemption fees and account maintenance fees. You may see a fund advertised as “no load.” These funds don’t charge a percentage to purchase or sell shares, but you’ll still often pay maintenance fees to cover the fund's expenses. The fund must reveal all fees in the fund prospectus.

Value

The value of a mutual fund at the end of any market day is expressed as the Net Asset Value, or NAV. The NAV is a company’s assets minus its liabilities. Federal law requires mutual funds to calculate their NAV at least once a day. To calculate the NAV of a single share in a mutual fund, the fund divides the NAV of the total fund by the number of shares in the fund. To learn a fund’s NAV you can call the fund or look at the fund's website.

Risk

The money in a mutual fund is not guaranteed or insured. If the fund loses value, you lose your investment. How the fund performed in the past is no guarantee of how the fund will perform in the future. Different funds carry different degrees of risk. Funds that make riskier investments may potentially have larger yields, but also may experience greater losses.

Taxes

If your mutual fund is part of your 401(k), IRA or other retirement savings, you defer taxes on any earnings until you begin to withdraw from the fund upon your retirement. If you invest in a mutual fund outside of a retirement fund, you’ll owe taxes on any dividends the fund pays you during the year. If you realize a profit, you’ll also owe capital gains when you sell shares in the fund. Even if you don’t sell shares of the fund during the year, you’ll owe capital gains tax on capital gains the fund itself realized during the year. At the end of the year, the fund will send you a 1099 form showing the amount of capital gains, if any, for which you are responsible.

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