Mutual Fund-amentals

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The World of Mutual Funds

Today, any “little guy” can diversify like a millionaire, hire top money managers, have access to his assets at all times, choose how his funds are invested, and maintain the freedom and flexibility to change investment vehicles as his financial goals change. What are these popular investments, how do they work, and are they right for you?

Specifically, a mutual fund is a large pool of money from investors seeking similar investment objectives. For as little as $50 per month or for an initial investment of $1,000, investors can choose what types of securities to buy. Some mutual funds invest solely in U.S. government securities, while others may invest totally in stocks or even one type of stock market, such as technology. Most mutual funds invest in a combination of markets.

Investors pool their assets and hire professional money managers to choose the spe- cific securities and manage the general business of each fund. There are thousands of mutual funds to choose from.

Shareholders sell their shares back to the fund, not to other investors like stocks and bonds. At all times, fund companies must be ready to redeem a shareholder’s mutual fund shares for their current value. If your mutual fund has a good year, so do you. If your mutual fund has a losing year, you share those lumps as well.

The fund’s investment policy and how it intends to meet those goals is described in the prospectus. Some funds have a lead manager while others hire a team. The manager is paid by the fund company whether you make money or not. Mutual funds have made it possible for ordinary folks to invest in the same instruments as the rich and famous.

A Mutual Understanding

After you deposit money into a bank, the bank owns the money. You are a customer of the banking institution. If the bank has a good year, the bank’s owners (the shareholders) not the customers, receive the profits. When you purchase an insurance product and the company has a banner year, the stockholders get bigger profits, not you, the customer.

But when you purchase a mutual fund, you are the shareholder. You own the mutual fund and the profits (and the losses as well), not the fund management company.

If you and I pooled our money together to purchase more securities than we could afford individually (the fund), we would share proportionally (depending on how much each of us invested) in all profits (growth and income), all distributions, all daily ex- penses, and any losses of investment capital. We could buy many types of securities and diversify our money. The value of the total investment pool would be its total asset value.

The price per share of the fund would be its net asset value. The value of our account would be called our account value.

Every shareholder, no matter how much each had invested, would be equally entitled to the basic privileges of ownership. We would have the right to fire our money manager as well as vote on any proposed fundamental change of investment strategy. We would

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need similar investment philosophies and objectives to buy into the same investment pool. If you wanted to purchase gold or other precious metals, for example, while I was intent on buying only U.S. government bonds, our financial partnership would not work very well. Therefore, shareholders in each mutual fund tend to share similar financial goals and objectives.

You could choose to reinvest your distributions back into our fund and purchase additional new shares, while I could request the dividends or capital gains in cash and either spend the money or reinvest it into another investment.

Eventually, we might be investing alongside working folks, retirees, parents saving for college, high school and college graduates investing for the first time, and young married folks building a nest egg to buy a home.

Are Mutual Funds Safe?

We would need to understand that any type of investment carries risk of loss of prin- cipal as well as the hope of future profits. So, we would learn the inherent risks and limitations of the funds we choose. Various phases of the business cycle, the direction of interest rates, the general health of the economy, political forces, and international issues all affect the faces of investing. Hem lines, picket lines, gas lines, utility lines, and grocery lines affect our financial bottom line. Putting our investment eggs into many investment baskets would be vital to our future financial wealth. The more we understand about risk and reward, the better our chances for success.

The major advantage of purchasing mutual funds is to diversify your assets. The purpose of diversification is to reduce the risk to your investment capital. When folks caught the tech bug in 1999, they piled their money into lottery ticket stocks and mutual funds that contained mainly technology stocks and failed to diversify into different market sectors. Owning a bunch of technology companies will increase your risk, not reduce it.

When that market crashed, their hard-earned profits (and principal) went south as well.

When folks lose lots of money in a mutual fund, it’s generally because the securities inside their funds are similar and tend to decline at the same time. The tech wreck in 2000 was a horrific example of that. When one technology company got sick, they all caught the flu.

Remember the old camp song: “99 Bottles of Beer on the Wall?” If one of those bottles should happen to fall, 98 bottles are still on the wall. Mutual funds were created with a similar concept in mind. If a single company inside a diversified mutual fund portfolio defaults or otherwise disappears, you own other securities to balance out that risk. If you learn how to properly diversify, your portfolio should weather all kinds of stock market weather. Consider mutual funds as a method of prudently managing your money, not as a way to get rich quick.

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Mutual funds are ideal underlying investments for a variety of tax-advantaged plans such as retirement IRAs, SEPs, SIMPLEs, KEOGHs, profit-sharing plans, and 401(k) retirement plans. They can also be utilized as custodial accounts for minors (UTMAs), for college fund savings and Coverdell savings accounts (formerly known as Education IRAs), and for nonprofit institution tax-deferred annuity 403(b)(7) programs. They are also ideal for long-term taxable accounts with no specific future investment goal in mind.

Mutual Benefits

As you become more familiar with this system of diversifying your investment as- sets, you will discover the many benefits mutual funds can offer the average financial consumer. Service and customer benefits include professional money management, econo- mies of scale for cost efficiency, diversification of investment capital, a wide range of investment choices, and public newspaper/media reporting.

Direct wire transfers to and from your local savings institution or checking account and 24-hour telephone and Internet access to account information and pricing data make access and visibility to your money easy. Check-writing privileges, convenient transfers (exchanges) between funds in the same mutual fund family, monthly income checks au- tomatically sent to your home or bank, and account linkups with the banking institution or the brokerage of your choice are easy to add to most accounts. Detailed and understand- able account statements and timely earnings updates, prompt distribution of dividends, interest and capital gains, automatic free reinvesting and systematic withdrawal plans, and reduced sales charges for larger investors should be automatically offered.

They are ideal as the underlying investment for IRAs and other tax-sheltered retire- ment programs, tax-advantaged college savings programs such as custodial accounts and ESAs, automatic monthly investment programs, and payroll deduction plan options. Most mutual fund companies, upon request, will provide record-keeping and tax information statements for simplified tax preparation, and every investor, no matter how small, enjoys full investor privileges regardless of account value, optional Certificates of Ownership like those issued for stocks, and simple and convenient investing methods. Prompt tele- phone liquidation of account funds; a ready buyer when you want to sell your shares;

joint, trust, and custodial ownership registrations; and reader-friendly periodic statements and reports complete the list of benefits.

You could soak in your tub, relax by the pool, or drive in your car, while receiving up- to-the-minute status reports on your investments. In today’s fast-paced society, conve- niences and services save time. But select conveniences only after you have chosen a high-quality mutual fund portfolio. Today’s mutual funds are truly service-oriented.

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31-Plus Flavors to Choose From

The last thing the world needs is another mutual fund. A better way to choose one, however, would be helpful. There are nearly as many categories of mutual funds as there are types of investors. They can be grouped according to their investment strategies and goals and the securities they purchase:

Higher Risk All-Stock Mutual Funds

Aggressive growth funds seek maximum capital gains and invest in higher- risk companies that aim for higher returns than the stock market in general.

(Not for investment wimps.)

Small company growth types are comprised primarily of stocks of com- panies worth less than $500 million. (Here today, gone tomorrow types.) Growth funds mainly include medium-sized company stocks expected to

grow faster than average. (Many of these were previously identified as the tech wreck of 2000.)

Midcap growth funds usually focus on one sector: technology or other fast startup companies with a high attrition (death) rate.

Large capitalization funds major in large “blue chip” stocks of major U.S.

corporations that have consistently increased profits over the years and usu- ally pay consistent dividends. (There is no such thing as a “safe” stock.) Defensive stock funds usually include utility and other companies that tend

to hold up well in price during downturns in the economy until higher inter- est rates drive them down. (That theory didn’t hold water—or money—

during the latest bear stock market.)

International funds specialize in stocks of companies outside the United States. Though only 65 percent of their assets must be invested abroad, they seek aggressive returns and may take large stock positions in one or two countries at a time. (You can reduce your risk to foreign economies and currency by purchasing funds that don’t focus on single countries.)

Precious metals funds buy stocks of gold, silver, or platinum mining com- panies and trade like stocks, not metals. (They don’t have to hold metals as core investments.)

Asset allocation funds may change investment mixes on a dime, moving between stocks, bonds, cash, and even gold. Their composition may change depending on the manager’s outlook of market conditions. There’s no tell- ing what these funds may buy tomorrow.

Sector funds focus on single industries or a certain market niche, attempt- ing to enhance returns by leveraging profits through investing heavily into

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Social awareness funds invest in socially responsible companies and are generally invested in stocks. The thought of green money is attractive, but I doubt there is a company out there that doesn’t put hamsters into experimen- tal cages; pollute the environment; buy, sell, or make weapons; in a nonunion or sweat shop somewhere, in a naughty politically incorrect country.

A stock mutual fund is typically geared for long-term growth and higher risk. Conser- vation of principal and current income are generally not investment objectives. Your re- turn is primarily dependent on appreciation (or growth) if the stock prices go up. Current income is rarely an objective. Most investors I know have had all the risk in the last three years they care to take. I recommend that you find a more conservative menu than funds totally invested in stocks with similar characteristics.

Medium-Risk Stock Mutual Funds

Balanced funds generally have several objectives, such as growth without undue risk, conservation of investment principal, or paying out current in- come. They aim to achieve multiple goals through common and preferred stocks, bonds, and some cash, typically 60 percent stocks and 35 percent bonds.

Growth and income funds are made up of high dividend, mature stock companies, some technology or higher-risk upstarts, a few bonds, and some cash.

Equity income funds invest primarily in stocks with high dividend payouts for current income. They claim to be less risky than other types of growth stocks. Equity income funds generally contain stocks from many industries, a few U.S. bonds, corporate bonds, and cash equivalents.

Global stock funds tend to diversify among more countries than interna- tional types, betting less on the fortunes of a single foreign economic or currency market. They are generally under less pressure to produce stellar short-term returns and often don’t spend fund assets to hedge currencies because they own so many within the pool. Portfolios vary a lot. (Global funds, like international or foreign funds, can purchase domestic American securities as well.)

High-Risk Bond Funds

High-yield (junk) corporate funds tend to invest in lower-quality credit corporations.

High-yield (junk) municipal funds hold lower-rated municipal bonds is- sued by cities, states, counties, and revenue or public projects with impaired credit ratings.

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