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Search Topic 13:

Mutual Funds Tutorial

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by Tom Stewart, Associate Editor

I. Overview of Topic

As I'll discuss in this mutual funds tutorial, mutual funds are one of the most successful ideas in modern-day finance. It's easy to see why. With one investment you get professional management, diversification, audited performance, low costs, and, best of all, you don't have to deal with stockbrokers posing as your "friend".

At the same time you can compare mutual funds and choose your own risk level, from low to high, and you only need a small investment to get into most funds.

Now, there have been some books written lately disparaging mutual funds as being lousy investments. The gist of all these books is that mutual funds, as a whole, don't produce very good returns, often no better than the stock market as a whole. So, they claim, you'll probably do better picking your own stocks and you don't need a mutual funds tutorial.

But doing your own stock picking is a really risky and time-consuming endeavor. Before you pick a stock you need to do some serious, in-depth research on the company. What's its product or service? What are its growth prospects? How financially sound is it? Few of us have the time for all this research or, for that matter, the skills to do it right. Sure, you can bet on a stock now and then, much as you might bet on a horse at the race track. But that's not investing, that's gambling.

Another consideration is diversity. With a good mutual fund your money is diversified into a variety of sectors and many individual stocks. Your risk is reduced accordingly. Thus, even if your return is not spectacular, at least you probably won't see your investment evaporate either.

Some funds do produce outstanding returns. The trouble is, picking those funds is as hard as picking individual stocks that will turn into high-flyers. So how do you know which funds to invest in? I'll try to provide a few important pointers below in this mutual funds tutorial and then suggest some sources for doing further mutual fund research on your own.

Mutual Fund Categories

All mutual funds are not stock funds - it's surprising how many people don't know that. You can invest in a money market fund, a bond fund, a hybrid fund, a stock fund, or an international fund, among others. There's even something called a fund of funds.

  • Money market funds - ultimate in safety, higher yields than bank savings accounts, and they offer check-writing privileges.
  • Bond funds - considered a safer investment than stock funds, each fund usually invests in bonds of similar maturity (short term funds focus on bonds maturing in 2-3 years and have the lowest returns; long term funds focus on bonds maturing in 7-10 years and have the highest returns).
  • Hybrid funds - invest in a mix of stocks and bonds and sometimes real estate. Also known as balanced or asset allocation funds because they attempt to maintain a fixed proportion of stocks and bonds in their portfolio. Hybrid funds are the ultimate in simplicity for the average investor as they invest in a wide range of professionally-selected investments to maintain a given risk profile.
  • Stock funds - Sometimes called equity funds, they are classified in various ways. By market value of the companies they invest in (capitalization), by risk (growth funds being riskier, value funds being less risky), and by geography (regional, U.S., international, etc.).
  • International/Global - Many international funds have been doing extremely well in recent months. These funds, which specialize in non-U.S. stocks or bonds, can offset to some degree the risk of investing strictly in U.S. securities. In general, funds investing mainly in industrialized countries are less risky than those investing in developing countries; however, returns can be spectacular in developing countries, as they have been in recent months in Chinese securities. But this is a bubble that is due to burst at any time. By the way, note that most domestic mutual funds also usually invest some portion of their portfolios in international securities (say 10% or so) so you don't necessarily have to buy an international fund to benefit from overseas growth.
  • Funds of funds - These are, as the name suggests, funds that pick other funds to invest in. Although this is an appealing concept, you have to be careful because operating expenses can be sky-high, as some of these funds charge 1.5 to 3 percent on top of the fees of the underlying mutual funds.
  • Specialty funds - invest in specific industries, like health care, technology, banking, energy, etc. Typically carry extremely high expense ratios and generate substandard returns, though, of course, if you pick a winner you can do extremely well.
  • Index funds - These are funds that attempt to replicate a given market index such as the S&P 500. They are computer-managed for the most part, which results in low fees. The major problem that most mutual funds have in providing good returns boils down to high operating expenses. These expenses come right off of your return, so if the fund earns 9% and its fees/expenses are 3% your return is an unexciting 6%. That's the appeal of index funds, boring as they seem to some people. With low fees they can provide solid returns. A major provider of index funds is the Vanguard Group.

Mutual Funds Tutorial: Tips For Mutual Fund Investments

There have probably been enough books written on how to compare mutual funds to fill up Kennedy Airport, but the basic principles can be written on the back of an envelope. Yet these are principles only a fraction of investors know or follow.

Principle number one is to know what this fund is really costing you. Studies have shown again and again that most investors go into a fund - often on the basis of a broker's advice - without a clue what its costs are.

There are two kinds of costs, loads and operating expenses.

Loads are the commissions you pay your broker when he/she sells you a mutual fund. These can be horrendous, like 5% or more, and your broker may well "forget" to mention the load at all - or may even tell you it's a "no-load fund" when in fact it carries a big sales charge if you sell within some given number of years. How do you determine for sure if a fund has a load? Read the prospectus before you invest. Or hire a financial advisor on a fee-for-service (not a commission) basis. You should always invest in no-load funds, which historically have performed just as well as load funds (in fact, better, when the load is factored in).

Second, be aware of the operating expenses of your fund. This means marketing expenses, salaries, overhead, etc. involved in managing the fund, as well as profit to the fund developers. Again, you have to read the fund's prospectus to find out what the expenses really are. Look in the expenses section for "Operating Expenses."

Principle number two in making mutual fund investments is to not rely entirely on what nearly everybody relies on in making fund choices, namely historic rate of return. Just looking at a list of funds' historic performances for the past few years is a terrible way to pick funds. Too many things can affect those performances, and they are too easily manipulated by fund managements. You should always review rates of return - together with volatility - over eight to ten years or more. Assess these rates of return and riskiness (volatility) in light of your own investment goals. And always read at least the first few pages of the fund's prospectus before investing (no need, however, to wade through the whole thing, say most experts).

Principle number three, and last, is to become familiarized with the tax-friendliness of a fund before forking over your money. What does this mean exactly? Some funds produce far more taxable distributions, namely capital gains and dividends, than others. If the fund manager is extremely aggressive about timing the market he/she will buy/sell more actively, resulting in more capital gains distributions for you to pay taxes on each year. Another consideration is dividends. If the funds pays high dividends, higher-tax-bracket investors may be subject to higher taxes.

According to some experts December is the month in which most mutual funds make capital gains distributions, so it's often best to delay purchases until after the first of the year.

How do you research all these points? Again, use the prospectus. You might also try calling the fund's 800 number and discussing them with a representative.

For general research of mutual funds, the best sources are Value Line and Morningstar, both available through larger public libraries. However, be wary of their rankings, as both of these reference sources ignore fund operating expenses (which can have major effects on returns). And they are not very useful in detecting which funds are load funds and which aren't.

A final word: After a few months or so, how do you determine your mutual fund's performance? Can you simply compare its present share price with the share price you paid for the fund?

The answer is no, because distributions of dividends and capital gains will often skew downward the share-price results. Better, say most experts, to compare the total value of your present holdings in the fund versus the total dollar amount you invested. So if you originally invested $20,000 and it's now worth $25,000, your gain is $5,000. Simple as that. Then you can calculate your total return by dividing your gain (or loss) by your original investment.

That's it - our ten minutes are up! (OK, maybe twelve or thirteen). Below is a listing of Web resources to help you continue your research on this topic, "mutual funds tutorial."

II. For Additional Research

This Section provides reviews and recommendations of Web sites and other online resources


If you plan to take an active role in managing your mutual fund investments - and even moreso if you plan to do some trading in individual stocks, bonds or options - you should consider signing up with a good online brokerage service (as suggested above in our mutual fund tutorial). You're probably familiar with most of the better-known ones, but the service recommended by Barrons is lesser-known, and much less expensive, namely TradeKing. This is a basic but reputable online investment service for those looking to pay as little as possible for trades but still get fast, reliable service. TradeKing is a nationally licensed online broker offering low flat fees ($4.95 per trade and $0.65 per option contract) with no hidden costs or account minimums. The TradeKing Web-based platform features powerful online equity, options and fixed-income trading tools including real-time portfolio information, advanced order entry, customized charting and alerts, free research and integrated news, stock, option and mutual fund screeners, volatility charts, a pricing probability calculator, enhanced option chains and interactive educational information. TradeKing also features community networking capabilities to help connect like-minded traders for enhanced strategy development and information sharing.


If you're planning on making a serious effort to compare mutual funds before investing it's a good idea to subscribe to a couple of good investment-advice letters. One of the best is put out by ValueLine - the ValueLine Investment Survey. On their website, the company claims the publication is highly recommended by none other than Warren Buffet. They also claim that their recommendations have vastly outperformed the Dow for many years. These claims have to be given some credibility coming from ValueLine, which is of course highly reputable. You may not follow all or any of the advice in their letter but it's always valuable to have available the insights and forecasts of top-notch investment analysts. The cost of the weekly ValueLine Investment Survey is $75 for the first 13 weeks.

Recommended Reading


III.Discussion Group


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