ABCs of Mutual Funds
Sound advice from the U.S. Securities and Exchange Commission
Buying and Selling Shares
You can buy some mutual fund shares by contacting the investment firm directly. Others are sold mainly through brokers, banks, financial planners, or insurance agents. All mutual funds will redeem (buy back) your shares on any business day and must send you the payment within in seven days.
You can find out the value of your shares in the financial pages of major newspapers; after the funds name, look for the column marked “NAV.”
What is NAV?
The NAV or Net Asset Value per share is the value of one share in a fund. When you buy shares, you pay the current NAV per shares, plus any sales charge (also called a sales load). When you sell your shares, the fund will pay you NAV less any other sales load. A fund's NAV goes up or down daily as its holdings change in value. For example: You invest $1,000 in a mutual fund with an NAV of $10.00. You will therefore own 100 shares of the fund. If the NAV drops to $9.00 (because the value of the fund's portfolio has dropped), you will still own 100 shares, but your investment is now worth $900.00. If the NAV goes up to $11.00, your investment is worth $1,100. (This example assumes no sales charge.)
How Funds Work and Earn Money
A mutual fund brings together money from many people and invests it in stocks, bonds, or other securities. (The combined holdings of stocks, bonds, or other securities and assets the fund owns are known as its portfolio.) Each investor owns shares, which represent a part of these holdings.
You can earn money from your investment in three ways:
First, a fund may receive income in the form of dividends and interest on the securities it owns. A fund will pay its shareholders nearly all of the income it has earned in the form of dividends.
Second, the price of the securities a fund owns may increase. When a fund sells a security that has increased in price, the fund has a capital gain. At the end of the year, most funds distribute these capital gains (minus any capital losses) to investors.
Third, if a fund does not sell but holds on to securities that have increased in price, the value of its shares (NAV) increases. The higher NAV reflects the higher value of your investment. If you sell your shares, you make a profit (this is also a capital gain).
Usually funds will give you a choice: the fund can send you payment for distributions and dividends, or you can have them reinvested in the fund to buy more shares, often without paying an additional sales load.
You still owe taxes on any distributions and dividends in the year you receive them (or reinvest them). You will also owe taxes on any capital gains you receive when you sell your shares. Keep your account statements in order to figure out your taxes at the end of the year.
If you invest in a tax-exempt fund (such as a municipal bond fund), some or all of your dividends will be exempt from federal (and sometimes state and local) income tax. You will, however, owe taxes on any capital gains.
Kinds of Mutual Funds
The three main categories of mutual funds are money market funds, bond funds, and stock funds. There are a variety of types within each category.
Money Market Funds have relatively low risks, compared to other mutual funds. They are limited by law to certain high-quality, short-term investments. Money market funds try to keep their value (NAV) at a stable $1.00 per share, but NAV may fall below $1.00 if their investments perform poorly. Investor losses have been rare, but they are possible.
Bond Funds (also called Fixed Income Funds) have higher risks than money market funds, but seek to pay higher yields. Unlike money market funds, bond funds are not restricted to high-quality or short-term investments. Because there are many different types of bonds, bond funds can vary dramatically in their risks and rewards.
Most bond funds have credit risk, which is the risk that companies or other issuers whose bonds are owned by the fund may fail to pay their debts (including the debt owed to the holder of their bonds). Some funds have little credit risk, such as those that invest in insured bonds or U.S. Treasury bonds. But be careful: nearly all bond funds have interest rate risk, which means that the market value of the bonds they hold will go down when interest rates go up. Because of this, you can lose money in any bond fund, including those that invest only in insured bonds or Treasury bonds.
Stock Funds (also called Equity Funds) generally involve more risk than money market or bond funds, but they also can offer the highest returns. A stock fund's value (NAV) can rise and fall quickly over the short term, but historically stocks have performed better over the long term than other types of investments.
Not all stock funds are the same. There are classifications based on the fund's goals. For example, growth funds focus on stocks that may not pay a regular dividend but have the potential for a large capital gain, while income funds focus on corporate bonds, which pay dividends but have lower capital appreciation. Other classifications are based on the markets in which the funds invest; for example, a fund may specialize in a particular industry such as technology stocks.
A Word About Banks and Mutual Funds
Banks now sell mutual funds, some of which carry the bank's name. But mutual funds sold in banks, including money market funds, are not bank deposits. Don't confuse a “money market fund” with a “money market deposit account.” Their names are similar, but they are completely different:
- A money market fund is a type of mutual fund. It is not guaranteed, and comes with a prospectus.
- A money market deposit account is a bank deposit. It is guaranteed, and comes with a Truth in Savings form.
- To reiterate, even if you buy a fund through a bank and the fund carries the bank name, there is no guarantee. You can lose your money.
A Word About Derivatives
Some funds may face special risks if they invest in derivatives. Derivatives are financial instruments whose performance is derived, at least in part, from the performance of an underlying asset, security, or index. Their value can be affected dramatically by even small market movements, sometimes in unpredictable ways.
There are many types of derivatives with many different uses. They do not necessarily increase risk, and may in fact reduce risk. A fund's prospectus will disclose how it may use derivatives. You may also want to call a fund and ask how it uses these instruments.