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EDUCATIONAL SERIES
MUTUAL FUND
HANDBOOK
SAMPLE CHAPTER
CHAPTER ONE
Know What You Own
With corporate pensions on the wane and Social Security’s future in doubt, people have more responsibility
for both their retirement plans and their all-around financial health. Ready or not, your future prosperity
is in your hands.
To work toward a goal of securing your financial future, you need a basic knowledge of how mutual funds
work, along with an understanding of the risks and rewards of fund investing. When you know what you
own, it’s easier to make objective decisions that help you reach your investing goals.
What Is a Mutual Fund?
When you invest in mutual funds, you pool your money with other investors, allowing a professional portfolio
manager to select and manage the investments in the fund. These other investors are people like you, who
either invest directly in a fund, or invest through a retirement, college savings or annuity plan. Most mutual
funds have thousands of shareholders.
Mutual funds invest in a variety of securities such as stocks, bonds or other instruments that investors can
own and trade on financial markets.A stock fund is a type of mutual fund that purchases shares of stocks in a
number of companies. A stock is a share in a business, issued by a company that trades on the public stock
markets. Stock funds can emphasize U.S. companies, international companies, real estate investment trusts
(REITs) or companies that operate in a specific sector, such asnatural resources, financials or technology.
A bond fund is another kind of mutual fund that purchases a number of different bonds. Bonds are debt
issued by corporations, governments or other entities. There are also mutual funds that invest in both
stocks and bonds, and other types of funds that invest in a variety of other instruments, such as commodities
or precious metals. Regardless of the type of securities held by a mutual fund, the people who own shares
of the fund are owners of all the fund’s holdings in proportion to the amount of money contributed. If
your stock fund owns 30 companies, you own part of those 30 companies. The value of your shares rises
or falls depending on the success or failure of those companies in the stock market.
Open-End and Closed-End Funds
There are three types of mutual funds: open-end, exchange-traded funds (ETFs) and closed-end. Most
funds are open-end, which means the fund continually issues new shares to anyone willing to purchase
them.
Open-end funds readily redeem shares for cash from any shareholder. Shares of open-end funds have a
value that reflects what the securities in the portfolio are worth at a given time. Open-end funds generally
can be bought and sold only at the end of the business day. Orders are placed in advance, and the buyer or
seller receives the net asset value (NAV) price calculated for that day.
In contrast, exchange-traded funds trade just like stocks, with share prices that can vary from minute to
minute. The underlying investments in the fund may be similar to or identical to a corresponding mutual
fund, or the ETF may be constructed to mirror a specific asset class or sector. Theoretically, ETFs should
trade at a price very close to their NAV, but during periods of extreme market volatility, there have been
some instances in which they have deviated. ETFs are very tax-efficient and are worth considering, particularly for investments held in taxable accounts. Many types of accounts (such as 401(k)s and 529 plans)
do not yet offer them as an investment option. Generally, you will be charged a commission to buy and sell
ETFs.
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MUTUAL FUND HANDBOOK
A closed-end fund issues a fixed number of shares and trades like a common stock on the open market.
Consequently, the shares of a closed-end fund can trade at a greater or lesser price than the actual value of
the fund’s holdings. Their popularity has faded somewhat with the rise of ETFs.
Mutual funds aren’t a new investing phenomenon. They were created in 1924 and as of 2010 there were
more than 7,500 U.S. funds. Throughout the years, they have undergone many changes.
The federal government has enacted a number of laws that have contributed to the growth of mutual
funds. These include the creation of individual retirement accounts, 401(k) retirement plans and Section
529 college savings plans.
How Funds Are Structured
Most mutual funds are structured quite differently from the set-up of traditional companies. Funds are
shell companies that have no employees — just a board of directors. The board contracts with companies
specializing in different areas of fund operations to handle different functions of the fund.
The board employs a management company or an investment adviser to manage the fund’s portfolio. The
distributor oversees the sale of fund shares, while the custodian maintains possession of the fund’s assets.
The transfer agent processes buy and sell orders of fund shares. Brokers execute portfolio buy and sell orders. An independent firm of public accountants audits a fund’s financial statements.
When you buy shares in a mutual fund, a fund manager invests your money, but the fund’s board of directors is ultimately responsible for safeguarding your interests. Because the board of directors is the only
entity that is directly affiliated with the fund, how the board conducts itself is vital to fund shareholders.
The board oversees how your money is invested and what fees you pay. There are two types of directors on
a board. Inside directors are involved with fund
management or may even be on a fund’s management team. The other board members are independent
directors who aren’t affiliated with fund management but who look out for shareholders’ interests.
Shareholders have little voice when it comes to fund policies, so they must depend on independent directors to speak on their behalf. Generally, shareholders vote only on a major change in a fund, such as a
shift in the fund’s investment objective or an increase in fund fees.
Fund companies send shareholders regular statements and reports. Statements include the number of
shares you own, the fund’s share price as of a certain date, the total value of your holdings and any dividends, interest or capital gains distributions.
Types of Funds
The largest fund families offer many different types of funds that make it possible to construct a portfolio
of funds having virtually any investing objective. As we have seen, the two basic types of mutual funds are
stock and bond.
Within these broad categories are many different types of stock and bond funds. Although some place
money market funds in a separate category, they really fall into the broad category of bond funds because
money market funds invest in fixed-income securities.
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CHAPTER ONE: KNOW WHAT YOU OWN
Stock Funds
Each stock fund has an investment style. The investment style is a broad philosophical umbrella under
which the fund manager invests.
There are three investment styles: growth, value and blend. Managers of growth funds seek to invest in
companies with rising sales and earnings. On the other hand, managers of value funds look for companies
that are trading in the market at a discount. Managers of blend funds invest in both growth and value
companies.
Beyond style and size issues, funds can be further broken down based on their investment objective.
While many funds fit into the categories that we’ve already laid out — such as a large-cap value fund or a
small-cap growth fund — many don’t.
These include international funds, sector funds and socially responsible funds. There are also many balanced funds, which invest in both stocks and bonds.
Finally, it is very important to know whether the fund manager pursues an active or passive investing
strategy. Active managers use their judgment to seek and select what they hope will be the best stocks for
the type of fund they are managing. Managers who follow a passive strategy select their portfolio based
on an index, such as the Standard & Poor’s 500 or the MSCI EAFE (Europe, Australasia and Far East),
and simply attempt to replicate the holdings and performance of that index. Passively managed funds
usually have much lower management costs than do actively managed funds.
For active managers, you will want to understand whether the fund manager pursues a short-term
strategy or is a long-term investor. Look for more in Chapter 5.
Bond Funds
A bond is a promissory note between two parties. An investor agrees to loan money to a corporation or
government. In exchange for the use of these funds, the investor expects interest payments and the eventual return of the original investment.
When you buy a bond, you lend money to a governmental body or corporation. This is different from owning shares of stock, where you are in effect part owner in a company.
Bond funds invest in many different bonds. Bond funds might purchase U.S. government or corporate
bonds or even bonds from foreign governments or companies.
There are two main types of bonds and bond funds: taxable and non-taxable. Taxable bond funds purchase bonds issued by the federal government, companies or both. The interest and any capital gain generated by these bonds are subject to federal, state and local taxes.
State and local governments issue tax-exempt bonds, which are also known as municipal bonds. The interest and any principal gain generated by these bonds is not subject to federal tax and in some cases is
exempt from state taxes.
Although bond funds are considered less risky than stock funds, in some cases they are more risky. This is
because the value of the individual bonds in the fund portfolio can fluctuate owing to outside factors such
as rising and falling interest rates. Also, ETF bond funds have sometimes varied more from their NAVs
than stock ETFs have. Bonds are not traded on a public exchange, and the market for the underlying
bonds is much more inefficient than that of stocks
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Look for more detail on bond funds in chapters 15 to 19.
Fund Families
Many fund companies are organized as fund families, offering a wide variety of funds and accounts to
investors. When you invest within a fund family, you can easily move your money from one fund to
another and may also receive consolidated statements, cutting down on paperwork.
If you are interested in purchasing shares in a number of funds, investigate the offerings of a particular
family. Although some large families such as Fidelity and Vanguard offer many different funds, other
smaller families might manage only a few funds. Also, although some fund families impose strict controls
on their fund managers, others allow considerable latitude.
Check into the services that a fund family offers. Common services include automatic investing and reinvesting, telephone or Internet redemption of shares and the ability to easily check net asset values and account balances. Before investing, make sure the fund family has a strong reputation for customer service.
If your investment objectives change and you are considering switching from one fund to another, make
sure you can change without cost. Moving your assets into a new fund from another is a sale of shares and
you may have to pay taxes on any gain you made in the original fund.
If you are interested in investing in ETFs, these are held in a brokerage account, which may also be offered
by the large mutual fund companies, and at discount brokerages such as Scottrade, Charles Schwab and
TD Ameritrade. Your account can contain a mix of mutual funds and ETFs, as well as stocks.
Although a fund company may offer hundreds of funds, a number of these funds may have similar investment objectives and portfolios with many of the same companies. Before investing in two funds in the
same family, make sure that the funds are different enough to diversify your portfolio.
Understanding Net Asset Value
Stock prices are strongly influenced by supply and demand, but mutual fund share prices are calculated
by a strict formula. This calculation takes into account the value of the securities in the fund’s portfolio,
the number of fund shares outstanding, fund expenses charged to shareholders and any outstanding fund
liabilities.
The example in Figure 2.4 shows the formula that fund companies use to calculate your fund’s net asset value
(NAV).
Unlike stock prices, ETFs and closed-end funds, which change during trading hours, traditional open-end
mutual funds calculate their net asset value once a day, at the close of regular hours of trading. So, if you
direct the fund to sell your shares in the morning, you will get the net asset value figured at the end of that
trading day. If the open-end mutual fund has a corresponding ETF, you can get an estimate of whether the
fund might be up or down based on the ETF’s performance on the same day.
However, the actual price at which you purchase or sell fund shares may differ from the actual net asset
value if you purchased fund shares with certain sales charges. You pay sales charges when you buy a fund
through a broker, some financial advisers,or insurance agents.
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CHAPTER ONE: KNOW WHAT YOU OWN
The varying types of loads and sales charges are fully detailed in Chapter 11. If you sell a no-load fund — a
fund without any sales charges — you will get the fund’s exact net asset value.
Fund Distributions & NAV
Any assessment of a fund’s long-term track record is complicated by dividends, interest and capital gains
distributions. For example, if a fund’s net asset value was $10 a share on Jan. 1, 2007, and $20 a share on
Jan. 1, 2012, you might think your total return had doubled. You’d be wrong.
Fund managers must distribute any income gained from dividends, interest and any profit gained from
selling shares of fund securities to fund shareholders. The amount of the distribution is subtracted from
fund shares, but investor holdings are worth the same because investors have the fund shares plus the distribution, which they can take in cash or reinvest in additional fund shares. So the NAV is only part of the
total return equation.
Funds offer shareholders the option to either reinvest their distributions in fund shares or receive the distribution as a cash payment. In either case, shareholders face a tax liability if they own fund shares in a
taxable account. Shareholders owning shares in tax-deferred vehicles such as IRAs or 401(k) plans don’t
owe taxes immediately on distributions.
Risk and Reward
Virtually every type of investing entails some potential risks as well as potential rewards. Mutual funds are
no different. In investing, risk involves the possibility that you will lose part or all of your investment.
Reward is the potential for profit on your investment.
It’s frightening to think that you could lose some or part of your money by investing in mutual funds. But
the fact is that without risk, there is no potential for reward. And the potential reward far outweighs the
potential risk.
For example, say you invest $2,000 and plan to keep that amount in a stock mutual fund for 20 years to
help meet your retirement savings goals. If the worst happens, and the fund you invest in loses every dime
of your money — a very remote possibility given the diversification funds practice — the most you will lose
is $2,000.
But if you pick a quality mutual fund using the approach described in this handbook, it’s very unlikely that
your fund will lose money over the long term. Many funds do experience bad years from time to time, but
a solid, well-managed fund will get back on track. Most funds do not experience extreme volatility, and
while you may not score as big a win with a mutual fund as with an individual stock, you also are less
likely to experience extreme losses.
To have a better chance of meeting your financial goals, you must invest. And if you have an employeesponsored retirement plan such as a 401(k), 403(b) or 457 plan you probably will invest in mutual funds,
which are included in the menu of investments offered in your plan.
You can either invest wisely or rashly. The goal of the BetterInvesting mutual fund program is to help you
invest intelligently so that you can select superior funds with solid portfolios, experienced management
and low costs.
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MUTUAL FUND HANDBOOK
The Risks of Inflation
Potential for loss is only one of the risks investors encounter. Inflation is another risk that all investor
face. Inflation is the general bias in the economy toward rising prices for goods and services.
Although burying your money in a coffee can in the back yard will eliminate the risk that you will lose any
of your money in a bad investment, these savings remain exposed to the ravages of inflation. Every year,
inflation of even 1, 2 or 3 percent will chip away at the value of that money in the coffee can. This means
that over a long period this money will buy much less than it did when you buried it. $2,000 buried in
1980 will not purchase the same $2,000 worth of goods or services in 2010.
Figure 2.5 illustrates how inflation erodes monetary value.
How do you avoid the risk posed by inflation? Again, by investing your money. Because of inflation, a low
potential rate of return — although posing less risk of loss — will reap far less in the long term than other
higher-yielding investments that carry more risk.
Let’s look at money market funds, which have little potential risk. These funds historically have maintained a net asset value of $1 a share and strive to offer a competitive interest rate.
When inflation is low, interest rates are usually low, too, meaning that a money market fund will pay only
a small percentage above the prevailing interest rates. When interest rates are high, money market funds
will pay more interest, but since inflation is high, too, you won’t actually realize much of that gain.
A money market fund is a fairly safe investment, but not one to use for long-term growth when saving for
your retirement or other big-ticket items. On the other hand, money market funds are a preferable
alternative to stock funds if you need access to your money in the next few years.
Like money market funds, bond funds are subject to risks from swings in interest rates. Generally speaking,
bonds return far less than stocks over the long term. The value of bonds fluctuates depending upon which
direction interest rates are headed. But in a bond fund, as the value of the bond drops, the yield
increases. Bond fund managers are more able to take advantage of these changes than are individuals who
may hold a limited number of individual bonds.
A portfolio with a sizable percentage of stocks and stock funds is more likely to meet your long-term
investing goals than a portfolio with that same percentage invested in money market and bonds or
bond funds. The volatility of stock prices is the risk you incur for increased rewards.
Before you invest, think about how much risk you can accept on the way to your financial goals. The
further away those objectives are, the more risk you can assume. If, for example, you are saving for retirement
and have 20 or 30 years to go, you can comfortably select more aggressive investments with potential high
returns over the long term. Investors with long-term goals who stick to their investing plans will benefit
from the market bias towards growth over time.
Pros and Cons of Mutual Fund Investing
Mutual funds offer many advantages to investors. But for every advantage, there is a disadvantage.
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CHAPTER ONE: KNOW WHAT YOU OWN
Advantages
For either the novice or experienced investor, mutual funds offer many advantages. Even an investor with
$50 in mutual fund shares benefits from diversification. Any fund, whether it invests in 30 companies or
3,000 companies, offers instant diversification.
You gain from diversification in several ways. It protects you against fluctuations in one area of the market. Also, you get the power of instant diversification for the fraction of the sum you’d pay for investing individually in a large number of companies.
Highly trained managers are in charge of your money when you purchase mutual fund shares. These managers can devote many more hours a week to investing than you could on your own. Funds employ analysts and researchers who assist fund managers in researching and selecting stocks for purchase.
Investing in funds is very convenient. You can purchase fund shares via the fund family’s website, your
brokerage website,or by mail or phone. Fund companies offer many benefits to shareholders, including
automatic payment and withdrawal plans as well as free reinvestment of dividends and distributions.
Many fund families not only allow investors to move their money from one fund to another without fees,
but also offer many different types of funds. Funds are a highly liquid investment. Shares can be purchased or sold on any day that the market is open.
Reports, prospectuses and other information on a particular fund are widely available. To obtain information about a fund, you can download many fund reports from the Internet, or call or write the fund company.
The Securities and Exchange Commission regulates mutual funds and fund transactions stringently. The
commission requires that funds meet certain standards of operation, monitors them for fraudulent representation in advertising and other communications and enforces strict disclosure rules.
Disadvantages
The savvy investor realizes that no investment is perfect. Investing in funds has a downside. Keep the
following disadvantages in mind.
Diversification is both a disadvantage and an advantage in fund investing. Although investing in a large
number of stocks insulates you from taking a huge loss, it also limits the potential upside you might experience with a smaller, more concentrated portfolio of individual stocks.
The government doesn’t guarantee your investment in mutual fund shares. As noted earlier, investments
in mutual funds are risky. You could lose some or indeed all your money. You also stand to gain if you pick
superior funds and stick with a diversified investment strategy.
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Professional management is another aspect of fund investing that can be a disadvantage. The quality and
experience of fund managers not only vary, this quality and experience also comes at a cost. You pay for
fund management, and costs can eat up more than 2 percent of your fund’s profits. And despite their education and experience, relatively few fund managers outperform the market indexes that track portions of
the stock and bond markets. In June 2012 Lipper reported that through December 2011, 34.9 percent of
actively managed mutual funds had outperformed their market benchmarks over the past 10 years.
Sales charges, ongoing expenses, brokerage fees and distribution fees can dramatically impact your returns. Every dollar you pay in fund fees is one dollar less you can invest.
If you hold fund shares in taxable accounts you may owe considerable amounts in state and federal taxes.
Because fund managers are required to pass on all gains, you may receive taxable distributions.
Fund investors have no control over their fund’s tax distributions, and on some occasions will receive
large distributions with little or no warning, wreaking havoc on their tax planning. Unless your money is
invested in an account that is sheltered from taxes such as an IRA or 401(k) plan, your fund will likely increase your tax bill.
ETFs are much more tax-efficient because fund managers are not forced to sell investments to meet redemption requests, thereby (perhaps) generating capital gains. Thus, the individual investor can control
the realization of capital gains by making the choice to hold or sell shares. Some experts, however, feel
that ETFs tend to encourage frequent trading rather than long-term investment strategies.
Despite the disadvantages involved in investing in mutual funds, they are widely popular. With careful
fund selection, you can avoid some of the problems involved in fund ownership and use funds to build a
secure financial future.
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