CARL WATTS & ASSOCIATES

September 6, 2010


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Securities -- Part 4
Mutual Funds
TOP
So what is a mutual fund and how does it work? It is defined as a collective investment scheme, or, if you prefer, a company that pools money from many investors and invests it in different kinds of securities. The investors money is placed under professional investment management; the combined holdings the mutual fund owns (stocks, bonds and other assets) are called its portfolio. Each investor owns shares which represent a part of the fund’s holdings.
Mutual funds must comply with a strict set of rules that are monitored by the Securities and Exchange Commission. The SEC monitors the fund’s compliance with the Investment Company Act of 1940, as well as its adherence to other federal rules and regulations. Since their development, the regulation of mutual funds has provided investors with confidence in terms of the investment structure.
The beauty of mutual funds is that you can invest a few thousand dollars in one fund and obtain instant access to a diversified portfolio. Otherwise, in order to diversify your portfolio, you might have to buy individual securities, which exposes you to more risk and difficulty.


There are many types and styles of mutual funds. There are stock funds, bond funds, sector funds, money market funds and balanced funds. Mutual funds allow you to invest in the market whether you believe in active portfolio management (actively managed funds) or you prefer to buy a segment of the market with no interference from a manager (passive funds and index funds). The availability of different types of funds allows you to build a diversified portfolio at low cost and without much difficulty.
Money Market Funds or as they are called the fixed-income funds, invest in treasury bills, certificates of deposit and other stable short-term investments. They are suitable for short-term financial goals because of their fixed, modest return over a short period of time.

Bond Funds, as their name states, invest primarily in many categories of bonds. They present higher risks than money market funds, aimed at producing higher yields. Because of the great diversity of bonds, bond funds can vary dramatically in their risks and rewards.

Stock Funds, or Equity Funds consist of course mainly of stock investment and are the most common type of mutual funds. The objective of an equity fund is long-term growth through capital gains. Stock funds may have a specific style, like value or growth; investment in securities from one country or several countries; focus on some size of company that is small-cap or large-cap, and so on; may involve some component of stock picking - named actively managed; or mirror specific stock market indices like index funds do.

- Value Funds invest in value stocks, which are usually associates with older, established businesses that pay dividends.
- Sector Funds invest in one area of industry, like gold mining, technology and utility funds. They may offer high appreciation potential but also higher risks to investors.

- Index Funds buy and sell securities in a manner that mirrors the composition of the selected index (such as Standard & Poor’s 500 index).

- Growth Funds invest in the stock of companies with rapid growth, focusing mainly on generating capital gains rather than income.

- Aggressive Growth Funds are designed to fetch the highest capital gains by investing in instruments that plough back quick and big returns, suitable for not risk-adverse investors willing to accept a high risk-return trade-off.

- Equity Income Funds stress current income over growth, while Option Income Funds seek to increase total return by adding income generated by the options to appreciation on the securities held in the portfolio.

- Asset Allocation Funds split investments between growth stocks, income stocks and money market instruments.

- A Fund of Funds implies that the assets of the fund are other funds.

- Hedge Funds are legal structures that trade stocks or invest in anything else depending on the fund, mainly to reduce the risk of investment in stocks.

- International Mutual Funds obviously invest in non-domestic securities markets throughout the world, thus providing greater portfolio diversification and letting you capitalize on some of the world’s best opportunities. The risk here is mainly the currency exchange fluctuations. Some specialists consider that the best policy for investment is to have a 70% domestic and a 30% international diversified funds investment.

A Family of Funds is a group of mutual funds that share administrative and distribution systems. It offers a selection of mutual funds for investors to choose from. The constituent funds generally cover a wide range of fund categories and investment objectives.
When you decide to buy shares with a mutual fund the price you pay for your shares is the fund’s per share net asset value (NAV) plus any shareholder fees that the fund imposes at the time of purchase (such as sales load). NAV is the current market value of a fund’s holdings, minus the funds liabilities.

No-Load Funds do not charge any type of sales load but may charge purchase fees, redemption fees, exchange fees and account fees, along with operating expenses.

Mutual Funds typically offer more than one class of shares which differ in shareholder services and/or distribution arrangements with different fees and expenses:
- Class A Shares impose a front-end sales load and tend to have a lower 12b-1 fee (distribution and/or service fees).
- Class B Shares don’t usually have a front-end sales load but may impose a contingent deferred sales load and a 12b-1 fee, plus other annual expenses.
- Class C Shares may have a 12b-1 fee, annual expenses and either a front- or back-end sales load which usually tend to be lower than for Class A or Class B shares.

The front-end load is actually the sales charge (load) on purchases (5% on average) which reduces the amount of your investment. Say if pay $1,000 for your shares, only $950 will be invested in the fund.

The back-end load is the deferred sales charge (the fee you pay when you sell your shares, depending on how long you hold your shares).

Advantages & Disadvantages of investing in mutual funds:

  • Professional Management who constantly researches, selects and monitors the performance of the securities the fund purchases.

  • Diversification, which we can sum up as “Don’t put all your eggs in one basket”. Spreading your investments across a wide range of companies and industry sectors can help lower your risk if a company or sector fails.

  • Affordability, some mutual funds accommodate investors who don't have a lot of money to invest by setting relatively low dollar amounts for initial purchases, subsequent monthly purchases, or both.

  • Liquidity — Mutual fund investors can readily redeem their shares at the current NAV — plus any fees and charges assessed on redemption — at any time.

  • Costs Despite Negative Returns — Investors must pay sales charges, annual fees, and other expenses regardless of how the fund performs.

  • Lack of Control — Investors typically cannot ascertain the exact make-up of a fund's portfolio at any given time, nor can they directly influence which securities the fund manager buys and sells or the timing of those trades.

  • Price Uncertainty, the price at which you purchase or redeem shares depends on the fund's NAV, which the fund might not calculate until many hours after you've placed your order. In general, mutual funds must calculate their NAV at least once every business day, typically after the major U.S. exchanges close.


You can earn money from your investment in mutual funds in three ways:

  1. Dividend Payments — A fund may earn income in the form of dividends and interest on the securities in its portfolio. The fund then pays its shareholders nearly all of the income (minus disclosed expenses) it has earned in the form of dividends.



  2. Capital Gains Distributions — 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.
  3. Increased NAV — If the market value of a fund's portfolio increases after deduction of expenses and liabilities, then the value (NAV) of the fund and its shares increases. The higher NAV reflects the higher value of your investment.