Invest Wisely: Mutual Funds
Advice From The U.S. Securities and Exchange Commission
A Mutual Fund Checklist
 Mutual funds are NOT
guaranteed or insured by any bank or government agency. Even if you buy through a bank and the
fund carries the bank's name, there is no guarantee. You can lose money. (See A Word About Banks and Mutual Funds).
Mutual funds ALWAYS carry
investment risks. Some types carry more risk than others. (See Kinds Of Mutual Funds).
Understand that a higher rate of
return typically involves a higher risk of loss. (See Kinds of Mutual Funds).
Past performance is not a reliable
indicator of future performance. Beware of dazzling performance
claims. (See Comparing Different Funds).
ALL mutual funds have costs
that lower your investment returns.
(See Comparing
Costs).
You can buy some mutual funds by
contacting them directly. Others are sold mainly through brokers,
banks, financial planners, or insurance agents. If you buy through
these financial professionals, you generally will pay an extra
sales charge for the benefit of their advice.
Shop around. Compare a mutual fund with others of the same type before you buy.
Why Mutual Funds?
Mutual funds can be a good way for people to invest in stocks,
bonds, and other securities. Why?
- Mutual funds are managed by professional money managers.
- By owning shares in a mutual fund instead of buying individual
stocks or bonds directly, your investment risk is spread out.
- Because your mutual fund buys and sells large amounts of
securities at a time, its costs are often lower than what you
would pay on your own.
This document explains the basics of mutual fund investing — how
a mutual fund works, what factors to consider before investing,
and how to avoid common pitfalls.
There are sources of information that you should consult before
you invest in mutual funds. The most important of these is the
prospectus of any fund you are considering. The prospectus
is the fund's selling document and contains information about
costs, risks, past performance, and the fund's investment goals.
Request a prospectus from a fund, or from a financial
professional if you are using one. Read the prospectus before
you invest.
Before you buy a mutual fund, make sure it is right for
you.
How Mutual Funds Work
A mutual fund is a company that 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.
How To Buy and Sell Shares
You can buy some mutual funds by contacting them 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 seven days.
You can find out the value of your shares in the financial pages
of major newspapers; after the fund's name, look for the column
marked "NAV."
TERMS TO KNOW
Net Asset Value per share (NAV): NAV is the value of one
share in a fund.
When you buy shares, you pay the current NAV per share, 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.
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. If the NAV goes up to $11.00, your investment is
worth $1,100. (This example assumes no sales charge.)
How Funds Can Earn You Money
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 also is 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.
TAXES
You will 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
You take risks when you invest in any mutual fund. You may lose
some or all of the money you invest (your principal), because the
securities held by a fund go up and down in value. What you earn
on your investment also may go up or down.
Each kind of mutual fund has different risks and rewards.
Generally, the higher the potential return, the higher the risk
of loss.
Before you invest, decide whether the goals and risks of any fund
you are considering are a good fit for you. To make this
decision, you may need the help of a financial adviser. There
are also investment books and services to guide you.
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.
1. 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.
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." The 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.
2. 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 holders 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.
Long-term bond funds invest in bonds with longer
maturities (length of time until the final payout). The
values (NAVs) of long-term bond funds can go up or down more
rapidly than those of shorter-term bond funds.
3. 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. For example, growth funds
focus on stocks that may not pay a regular dividend but have the
potential for large capital gains. Others specialize in a
particular industry segment such as technology stocks.
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.
Comparing Different Funds
Once you identify the types of funds that interest you, it is
time to look at particular funds in those categories.
Viewing Past Performance
A fund's past performance is not as important as you might think.
Advertisements, rankings, and ratings tell you how well a fund
has performed in the past. But studies show that the future is
often different. This year's "number one" fund can easily become
next year's below average fund. (NOTE: Although past performance
is not a reliable indicator of future performance, volatility of
past returns is a good indicator of a fund's future volatility.)
Tips For Comparing Performance
- Check the fund's total return. You will find it in the
Financial Highlights, near the front of the prospectus.
Total return measures increases and decreases in the value
of your investment over time, after subtracting costs.
- See how total return has varied over the years. The
Financial Highlights in the prospectus show yearly total
return for the most recent 10-year period. An impressive
10-year total return may be based on one spectacular year
followed by many average years. Looking at year-to-year
changes in total return is a good way to see how stable
the fund's returns have been.
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