Navigating the World of Mutual Funds

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Since the 1920s, mutual funds have helped Americans achieve their financial goals. Today they are one of the most popular investments. According to the Mutual Fund Education Alliance, more than 80 million investors in the United States own mutual funds.

But if you’re like most investors, you may have questions about different fund types, class shares, expenses and how to select the funds most suitable to your investment needs. You’ll find answers to these questions in this five-part series of articles about the world of mutual funds.

What is a mutual fund?

Mutual funds are often referred to as open-end funds. This means there is no limit to the number of shares investors can buy and sell. You might also hear about closed-end funds, which are investment companies that sell a fixed number of shares traded only on the stock market.

The money you invest in a mutual fund is pooled along with that of other shareholders with similar financial goals. Most mutual funds are part of a larger investment company or family of funds. Each fund is managed by a team of professional money managers who monitor the fund’s performance and, based on thorough research, choose investments they believe will help the fund reach the investment objectives stated in the prospectus (for example, current income or capital growth).

Because a mutual fund is essentially a collection of different investments, investors use them to reduce investment risk without having to purchase individual stocks and/or bonds. Diversification, while recommended, does not guarantee a profit or ensure against a market loss.

Another advantage of investing in mutual funds is liquidity. Generally, you can redeem or sell your shares any day the stock market is open. However, you should keep in mind that investment values will fluctuate and there is no assurance that the objective of any fund will be achieved. Mutual fund shares are redeemable at the current net asset value, which could be more or less than their original cost. Fund annual operating expenses apply as well as plan administration charges. These are described in the prospectus.

Stock mutual funds

If you’re considering investing in a mutual fund, you’ll need to know about the types of funds that are available. You can select a stock or equity fund, bond fund, balanced fund (a combination of stock and bond funds), lifestyle fund or money market fund. In Part Two of this series, we’ll take a look at stock funds.

Generally, stock or equity mutual funds are best suited for investors who:

o Seek capital growth over extended periods of time
o Are willing to tolerate share-price volatility
o Have an investment horizon of five or more years

Stock funds can have different investment objectives and target companies in various industry sectors and market capitalization (the gauge of a company’s size or value). Funds invest in companies within one of the three market capitalization categories: large-cap funds (more than $11.7 billion), mid-cap funds ($2.9 billion to $11.7 billion) and small-cap funds (up to $2.9 billion).

The following are the different types of stock funds, ranked in order of the highest to lowest investment risk:

Aggressive growth funds-Seek rapid growth of capital, often through investment in smaller companies and with investment techniques involving high-risk, short-selling, leveraging and frequent trading.

Growth funds-Seek capital appreciation by investing in equity securities of companies with earnings that are expected to grow at an above-average rate. Current income, if considered at all, is a secondary objective.

Growth and income funds-Seek capital appreciation and current income equally by investing in equity securities that have above-average yields and some potential for appreciation.

Income funds-Seek income rather than capital appreciation by investing primarily in equity securities of companies offering good dividends.

International stock funds-Invest at least two-thirds of their portfolios in equity securities of companies located outside the U.S. (global stocks). Domestic (U.S.) stocks may or may not be held.

Specialty funds-Seek capital appreciation by investing at least 65% of assets in equities of a single industry or sector, such as financial services, healthcare, natural resources, precious metals, real estate or utilities.

Lifestyle Funds-Invest in other funds and are optimized to reflect levels of risk and return suitable to specific times of an investor’s life.

Bond funds

As the name suggests, bond funds are mutual funds investing in various types of bonds. Bond funds may be appropriate for investors who:

o Value relatively steady income over growth
o Seek yields that are potentially higher than money market rates
o Want to diversify investments
o Can accept modest fluctuations in the share price

Bond funds aren’t the same as bonds. There’s no fixed yield nor contractual obligation to repay investors their principal at a future date, as is the case with bonds. Bond fund managers continually trade their positions, so the risk-return characteristics of a bond fund investment is always changing, just as with other mutual fund investments.

The main types of bond funds include:

Corporate bond funds-Seek a high level of income by investing two-thirds or more of their portfolios in corporate bonds.

Global bond funds-Invest in worldwide debt securities. Up to 25% of their portfolio’s securities (not including cash) may be invested in companies located in the United States.

Government bond funds-Invest at least two-thirds of their portfolios in U.S. government securities and have no stated average maturity. Bonds issued by Uncle Sam are backed by the full faith and credit of the U.S. government.

High-yield bond funds-Seek a high level of current income by investing at least two-thirds of their portfolios in lower-rated corporate bonds (Baa or lower by Moody’s and BBB or lower by Standard and Poor’s rating services).

Mortgage-backed funds-Invest at least two-thirds of their portfolios in pooled mortgage-backed securities.

National municipal bond funds-Invest predominantly in municipal bonds. The funds’ bonds are usually exempt from federal income tax but may be taxed under state and local laws.

Other world bond funds-Invest at least two-thirds of their portfolios in a combination of foreign government and corporate debt. Some funds in this category invest primarily in debt securities of emerging markets.

State municipal bond funds-Invest primarily in municipal bonds of a single state. The funds’ bonds are exempt from federal and state income taxes for residents of that state.

Strategic income funds-Invest in a combination of domestic fixed-income securities to provide high current income.

Other mutual fund investments

In addition to the stock and bond funds described in previous articles, mutual fund investing offers other choices that might be appropriate to your circumstances and goals. These choices include:

Balanced funds

These funds, also known as hybrid funds, are a combination of stock and bond funds. Balanced funds seek high total return by investing in a mix of equities, fixed-income securities and money market instruments. Unlike flexible portfolio funds, these funds are required to strictly maintain a precise weighting in asset classes.

Money market funds

Money market funds typically invest in short-term government and company loans, which, while lower-yielding, are generally less risky than many other types of funds. Money market funds can be appropriate for investors who:

o Need access to their money in the near future
o Are looking for a current short-term rate of interest
o Are very conservative in their investment approach

An investment in a money market fund is not insured or guaranteed by the Federal Deposit Insurance Corporation (FDIC) or any other government agency. Therefore, while the fund seeks to preserve the value of your investment at $1 per share, it is possible to lose money while investing in the fund.