Chapter 6 Mutual Funds—The Basics

“The things that come to those who wait may be the things left by those who got there first.”

Do I Need to Read This Chapter?

• Am I thinking about getting started in mutual funds? • Is there a way around price fluctuation in the mutual fund arena? • Do mutual funds have advantages over direct stock purchases? • What key factors should I examine when evaluating individual funds and families of funds?

• What are the different kinds of stock-based mutual funds?

• What are the different kinds of bond-based mutual funds?

For the past seven years in this new century,we have experienced stock market record-breaking rises and stock market plunges that today are still causing anxiety among investors.If you feel uncertain about the market but would like to take some active part,a mutual fund may be ideal.In 2006, investors added their 10 trillionth dollar to mutual funds up from 3 trillion just 10 years earlier.This country’s 80 million baby boomers are coming close to their retirement years,and mutual funds are the most popular investment for savings during retirement.

How Does the Mutual Fund Work?

It begins by having a large number of investors putting their money together in a pool that will be managed by knowledgeable investment professionals. The price of a share in the mutual fund is determined by the value of the fund’s holdings.As the value of the stocks owned by the fund increases,the share price increases,and the investors make a profit.If the value of the stocks decreases,the shares are worth less,and investors suffer a loss.The price of a share in a mutual fund (determined by dividing the net value of the fund’s assets by the number of shares outstanding) is usually announced once or twice a day.The mutual fund also earns dividends that may be paid directly to investors or reinvested to buy additional shares in the fund.

Therefore,mutual funds can make money for their investors in three distinct ways: 1.The shareholders receive dividends earned through the investment that the fund possesses. 2.If a security in the fund’s portfolio is sold at a profit,a capital gains distribution will be made by the fund to its shareholders. 3.If the value of the fund’s portfolio increases,the value of each share also increases.

Mutual funds are normally created and managed by brokerage houses.As you’ll learn,there are many kinds of mutual funds,depending on the types of stocks invested in,the degree of risk involved,the financial goals of the fund, and other factors.

A way to take care of market fluctuations in the mutual fund arena is through dollar cost averaging (DCA).The investor invests into the mutual fund the same amount of money at regular intervals (monthly,for example). This system allows the investor to purchase more shares when prices are low and fewer shares when prices are high.

What Is Dollar Cost Averaging?

DCA can limit your market risk by investing the same sum of money monthly regardless of any stock fluctuations.As prices fall,your fixed amount of money

buys more shares.If prices should rise,your amount would purchase fewer shares.But in the long run,DCA results in your buying more shares at low prices than you do at high prices.This method uses time to the best advantage, since,over time,several market cycles can occur.The best way to understand DCA is to think of it as an installment plan for the investor or as an automatic purchase plan.Arrangements can be made to have this predetermined monthly or quarterly withdrawal come directly from your checking or savings account into the investment of your choice.

Dollar cost averaging sounds ideal, doesn’t it? In most ways, it is. However, you should be aware that DCA is not without its problems. If the same amount is invested each month, its inflation-adjusted value will decrease over the years. Also, it does not guarantee that you will protect your investment from losses. If the overall economy and the market are down, you will wind up with a loss for that period of time.

Although dollar cost averaging can work with any investment, it is especially well suited to mutual funds, because funds have a diversified portfolio and can bounce back quickly from declines. Table 6.1 presents an example. For the investment shown, the average price of a share was $11.25. But the investor using the dollar cost averaging method paid only $8.89 on average. This means that the average cost per share was $2.36 less than the average price.

Table 6.1 How Dollar Cost Averaging Pays Off

Month Regular Investment Share Price Shares Acquired

January $200 $10 20 February 200 5 40 March 200 10 20 April 200 20 10 Total $800 $45 90

Average share cost: $8.89 ($800/90) Average share price: $11.25 ($45/4)

Table 6.2 Average Annual Rates of Return

Total Return 3 Years 5 Years Average Annual Rate

15.76% 27.63% 5% 19.10 33.82 6 22.50 40.26 7 25.97 46.93 8 29.50 53.86 9 33.10 61.05 10 36.76 68.51 11 40.49 76.23 12

One more point on market fluctuations:many funds advertise how high their total return was for a period of time.If you are more interested in knowing the average annual rate of gain rather than the total return,which is the compounded average annual rate,examine Table6.2.

What Are the Advantages of Mutual Fund Ownership?

Mutual funds offer seven important benefits to prospective stock market investors:

1. Diversification and risk control.Money invested in a mutual fund is used to buy shares in many different stock issues.This reduces your investment risk since the failure of one or two companies out of many will not have a devastating effect on your portfolio.It would be impossible for an individual investor to achieve a comparable degree of diversification without having a very large sum to invest in a variety of stocks.Also,with a small investment amount,you will find that by “doing it yourself”your transaction costs (commissions) will be very high because you will be transacting in small dollar amounts.Remember that diversification takes both time and a great deal of knowledge. 2. Professional management.Few investors have the time,energy,or expertise to keep track of all the many factors affecting the stock market,including changes in interest rates and the money supply,new developments in technology,

legal and political developments,and foreign competition.Mutual fund companies have the resources to monitor these developments,for they employ staffs of researchers whose sole task is to keep track of business and economic trends that may affect the performance of securities in the fund’s portfolio.This expertise works to your benefit when you invest in the fund.

And one more point on management and decisions regarding the terms value and growth.A value approach by fund managers is based on the theory of finding corporations whose underlying values are underappreciated,or in other words,their value is less than what they believe it should be.

Sometimes they may purchase bankrupt companies or those in serious financial difficulty if they determine the firm has the potential to gain solvency.

They seek to earn their profit if and when the market learns of the new, higher value of the company.

Growth fund managers are interested in revenue and earnings,seeking out those companies that outpace other corporations similar in nature.They want companies that have a potential for large increases in earnings.

3. Fund-swapping option.Many investment firms sponsor more than one type of mutual fund.The firms usually allow their investors to move money from one fund to another by means of letters or phone calls.This is a convenient way to take advantage of changing investment conditions.You enjoy definite advantage by investing in a fund that is part of a family of funds.

Literally,hundreds of fund families are offered today;entire books,magazines,and newsletters (available at any public library) are devoted to identifying and ranking them. • Determine which fund families interest you;then ask for their literature and study their offerings. • Pay special attention to the types of stocks each fund invests in,the degree of risk involved,and the financial goals of the fund.

All fund families have the same basic structure:Each is a group of mutual funds with differing investment objectives,managed by the same company. Each allows you to move your money from one fund to another (by written notification,by telephone,or,in some cases,even by Internet access),thus offering you maximum flexibility with a minimum of paperwork and lost time. 4. Moderate cost.Many mutual funds require only a small initial investment, with management fees averaging 1/2 percent of your investment annually.

By buying or selling in large blocks,the mutual fund pays a brokerage

commission that is but a fraction of what you,the small investor,might have to pay.Also,certain types of securities should be bought only in large amounts.For example,Treasury bonds produce the best prices on trades of $1 million or higher—far more than most of us can afford—but such trades are no problem for the mutual fund.For more information,see the discussion of load and no-load funds in Chapter 7. 5. Automatic deposits and reinvestments.You can usually arrange for automatic investments to be made in your mutual fund account by specifying a dollar amount to be withdrawn from your bank account on a regular basis.

This provides a painless way of building your investment portfolio month by month.Also,you can have all dividends,interest,and capital gains earned by your investment automatically reinvested in additional shares in the fund, another painless way of keeping your investment growing.

Some funds may charge a high fee for reinvesting dividends. Make certain that your monthly statement says that the offer is at “net asset value” and not that the reinvestment of the dividend was at the “offering price.”

6. Ease of withdrawal.You can withdraw your funds by means of a letter authorizing the redemption of shares.You’ll normally receive your money within seven days. 7. Reduction of record keeping.The fund handles all stock transactions for you, records any changes in your holdings,and provides periodic statements showing all transactions,dividend distributions,reinvestments,and capital gains.

Please note that I said “reduction of record keeping,”not elimination of it. Yes,mutual fund ownership requires some paperwork on your part.If you do not identify the specific shares you are selling,the rule of “first in,first out” applies,meaning that the basis of the shares you are turning in will be considered to be the ones that you own for the longest period of time.This can be a major drawback since the early shares are often the lowest priced.Thus your taxable profit will be higher.Therefore,always keep a detailed record of how many shares you buy,the date of each purchase,and the cost per share. This also includes any dividend reinvestment.

What Are the Different Types of Mutual Funds?

Depending on your financial circumstances and your investment objectives,there are many types of mutual funds from which to choose.Let’s consider the features of the most common types of funds:common-stock funds and bond funds.

Common-Stock Funds

Many funds invest in common stocks issued by corporations.Stock funds are often classified as either growth funds (holding riskier stocks that may pay low or no dividends but are expected to rise in value rapidly) or income funds (holding low-risk stocks that pay higher dividends but rise in value slowly). Different types include: • Aggressive growth.Small-company growth funds,sector funds,precious metal funds,and others that seek maximum capital appreciation. • Long-term growth.Funds whose main objective is long-term growth of capital;income is secondary. • Global/international.Funds that invest worldwide,outside the United

States only,and single-country funds.It is important to understand the difference between international funds and global funds.International funds invest only in securities of foreign countries,whereas global funds may invest in both foreign countries and the United States.Remember also that all investments involve risk,but to invest in foreign countries adds additional problems.For example,currency fluctuation is a risk in international and global funds that is not felt by other funds.Global and international funds investments are denominated in foreign currencies, and thus the value of the holdings depends on the relative strength of the dollar.A weakening dollar will boost the returns of these funds,while a strengthening dollar will reduce them.Other risks to be considered are political situations,economic instability,less liquidity, and a decreased availability of investment information.

Bond Funds

Bond funds invest in corporate or government bonds.These funds fall into several categories.High-grade bond funds deal in top-rated bonds with a high

degree of safety and modest yields.Speculative bond funds deal in somewhat riskier bonds (with ratings in the high B’s) that often pay higher yields.Junk bond funds carry both the greatest degree of risk and the greatest potential yield.And municipal bond funds invest in tax-free bonds issued by state and local governments.

Just as “turnover rate”can tell you a lot about a stock mutual fund,“duration” is a key factor when evaluating a bond mutual fund. Duration measures the sensitivity of a fund to interest rate abuses.It is stated in years and forecasts the up or down movement of the market value of the fund resulting from a 1 percent shift in interest rates.Naturally,the shorter the duration,the less volatile the fund’s value.

For example, in a short-term fund, the duration may be 2 years, which would mean that a 1 percent rise in interest rates would cut the market value of the mutual fund by 2 percent (1 percent × 2 years).A long-term fund with a duration of 10 years would lose 10 percent in value if rates rose by 1 percent.

The concept is to think of duration as a multiplier rather than a time frame. In the long-term example,it would take 10 years for the added income to make up for the lost capital.Ask the company or your broker for the duration of its bond fund portfolio.

And on the topic of time,time does not go.Time stays.We go.

It’s a Wrap

• Mutual funds may be ideal for investors who want the action of the stock and bond markets without having to choose and monitor individual stocks and bonds themselves. • With mutual funds,your money has the chance to grow in three ways: through dividends,capital gains,and increase in share value. • Investments made regularly,known as dollar cost averaging,help you ride out fluctuations in the markets. • Mutual funds offer an easy way to diversify your money,control risk,and benefit from professional money management at a reasonable cost.

• Computing taxes owed on earnings from mutual funds can be complicated.Always keep detailed records of your purchases. • There are as many types of stock mutual funds and bond mutual funds as there are stocks and bonds.

“Be careful of the toes you step on today because they may be attached to the backside you may have to kiss tomorrow.”

This page intentionally left blank