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Nature of Mutual Funds

Why Mutual Funds?

E very smart investor should have a thorough knowledge
of mutual funds. Mutual funds are everywhere, and they’re an
important part of a successful investment plan. As a matter of fact, Mutual funds are distributed by investment
over $6 trillion is currently invested in them. So what are mutual companies, such as Vanguard or Fidelity. You
funds, exactly? aren’t actually investing in the investment
Mutual funds offer an alternative to investing in individual company—you’re investing in the mutual fund
securities. A mutual fund is a collection of shareholders’ itself. The investment company is responsible
money that is invested (by professional fund managers) in an only for marketing and managing the fund.
assortment of different securities, such as stocks or bonds.
Each shareholder then owns a small slice of the fund’s entire
investment portfolio.

Investing in mutual funds can help you reach a variety of finan-

cial goals. Each mutual fund has a specific objective, described
in its annual prospectus (document containing all vital informa-
tion about the fund). The fund’s objective is the result it is trying
Discuss reasons individuals choose to achieve through the investments it makes, and to meet that
to invest in mutual funds. objective, the fund managers will formulate a specific strategy.

Explain how to buy/sell mutual funds. Net Asset Value

The price of a mutual fund’s shares is determined by its NAV, or
net asset value. NAV is the total value of a fund’s investment
portfolio, minus its liabilities (debts or obligations), divided by
the number of its outstanding shares (the number of shares the
fund has issued). It sounds confusing, but it’s not so bad.
Let’s say you’ve invested in a mutual fund with a total invest-
ment portfolio value of $50 million. Its liabilities are $5 million,
and it has issued 9 million shares. Plug those numbers into the
NAV equation to figure the value of each share:

$50 million (total portfolio value) – $5 million (liabilities) = $5 per share

9 million (shares)

Mutual fund managers calculate NAV at the close of each

business day. Because these prices are determined only once
per day, mutual fund shares may be traded (bought or sold) only
once per day, unlike individual stocks and other securities, which
trade all day long.

Mutual Attraction LAP: QS-035 © 2007, MarkED

Four Big Advantages Types of Mutual Funds
(...And a Couple of Disadvantages) Open-End Funds and Closed-End Funds
There are several reasons mutual funds are so popular among Mutual funds are classified in a number of different ways.
today’s investors. The biggest advantage of investing in mutual The first way involves distinguishing between open-end funds
funds is diversification. Diversification means spreading out and closed-end funds. Most mutual funds are open-end funds.
your investment dollars among a number of different securities. Open-end means that there is no limit on the amount of shares
Let’s say you have $10,000 to invest. If you invested all $10,000 the fund can issue or the amount of money it can hold. An open-
in one stock, and end fund issues as many (or as few) shares as investor demand
the stock went bust, calls for.
you’d lose every- Closed-end means that the fund has a set number of shares
thing. It’s smarter it can issue, determined before it’s ever established. After all the
to invest in several shares in a closed-end fund have been sold, the only way to buy
different stocks and them is from an existing investor who is ready to sell. Open-end
other types of securi- mutual funds are preferable to closed-end because they are less
ties. But doing so expensive to operate and their shares are easier to trade.
on your own would
require a lot more Stock Funds
time, effort and money than you would probably be able to give. Also called equity funds, stock funds are the most popular type
Investing in mutual funds takes care of the problem for you, of mutual fund. As the name suggests, stock funds invest in
since mutual funds contain many different securities, often 100 stocks. As with investing in individual stocks, investing in stock
or more. funds offers both greater risk and greater return than investing in
Another advantage of investing in mutual funds is access to other types of securities. However, the risk of investing in a stock
professional money management. When you invest in a mutual fund is significantly less than investing in individual stocks.
fund, you’re handing your money over to well-trained profession- That’s because of diversification. Since a stock fund invests in
als whose full-time jobs are to make smart investment decisions many different stocks, sometimes across a variety of industries,
for you. These managers spend all day, every day, researching you won’t take as big of a hit if one of those stocks drops signifi-
and analyzing all the factors that have potential impact on your cantly in value.
money. There are several different types of stock funds, including:
Mutual funds are also very convenient. They’re fairly simple • Growth funds. Growth funds invest in stocks that are
to trade, and they also provide you with easy access to your money most likely to appreciate in value over the short term.
because you can cash out of them at any time. The ability to eas- Because the NAV of growth funds often sways drastically
ily convert your investment back into cash is known as liquidity. up and down, they are ideal for aggressive investors who
Yet another advantage of investing in mutual funds is mini- are willing to accept greater risk for greater short-term
mal risk. The United States Securities and Exchange Commission returns.
(SEC) (www.sec.gov) regulates mutual funds very carefully to • Value funds. Value funds invest in stocks that seem
make sure they’re managed properly. And because mutual funds to be undervalued or overlooked. These stocks tend to
invest in a variety of different securities, their risk of bankruptcy be “good bargains” and sell at low prices. Value fund
is virtually nonexistent. However, that doesn’t mean that certain managers choose stocks they think will appreciate in
mutual funds aren’t riskier than others. There are thousands of value over the long term. These funds are ideal for more
mutual funds to choose from, so you can decide for yourself how conservative investors who want to avoid risk.
much risk you’re willing to take with your investment dollars,
• Blend funds. Blend funds contain both growth and
and then choose the types of mutual funds that suit your goals.
value stocks.
Mutual funds have disadvantages as well. They cost money to • Sector funds. Sector funds invest in stocks from one
manage (you’ll learn more about fees later), and you also will be specific industry, such as oil.
required to pay taxes on your gains. If you do your homework,
though, you can plan smart strategies to make your mutual fund • International funds. International funds invest in
investments as tax efficient as possible. stocks from overseas companies and are often viewed
as the highest risk stock funds because of political and
currency fluctuation in foreign markets.

LAP: QS-035 © 2007, MarkED Mutual Attraction

 There is another way to categorize stock funds as well. Many Index Funds
times, these funds are grouped according to the stock market Index funds are a unique type of stock mutual fund that copy
value of the companies they invest in, or cap size. Large-cap the performance of a particular stock market index, such as the
funds invest in companies with market values of greater than $8 Standard and Poor’s 500 (S&P 500) or the Nasdaq 100. The index
billion; mid-cap funds, companies with market values of $1 bil- fund purchases all the stocks listed on that particular index, in
lion to $8 billion; and small-cap funds, companies with market the same percentages as the index. Sector index funds invest in
values of under $1 billion. stocks across a certain industrial sector and are designed to copy
Bond Funds the performance of that industry’s segment of the stock market.
Researching and investing in a variety of individual bonds takes One advantage of index funds is that they’re much cheaper to
lots of time and effort. That’s why bond funds are a great way to manage than other types of mutual funds. It takes a much smaller
invest in bonds—in exchange for a fee, investors in bond funds staff to manage an index fund because the fund copies a stock
get access to the expertise and buying power of a professional market index instead of researching and choosing individual
fund manager. Bond funds work the same way stock mutual stocks. A computer can do most of this work.
funds do, except that shareholders’ money is pooled to invest in Another advantage of index funds is the reliable performance
a variety of different bonds rather than stocks. Investing in bond of most stock market indices. Results show that, over the long
funds can provide a steady stream of income for the investor. term, the S&P 500 gets better returns than 80 percent of actively
The most important variables in bond funds are the rate at managed funds. Index funds are perfect for investors who want to
which your money grows, the average maturity of the bonds sit back, relax, and watch their money grow without making a lot
in the fund, and the credibility ratings of the bonds in the of aggressive investing moves.
fund. Shares in a bond fund are purchased with principal, earn
Exchange-Traded Funds
income over time from the interest or coupon rate, and then give
principal back. Since it has invested in dozens and dozens of Exchange-traded funds, or ETFs, are “cousins” of mutual funds
bonds, the fund continuously has bonds maturing. These returns that trade like individual stocks. When you invest in an ETF, you
are typically reinvested in even more bonds. buy shares in an entire stock portfolio, like a stock fund; however,
you can trade those shares just as you would individual stocks.
The three general maturity categories for bond funds are Like stocks, the prices of ETFs depend on supply and demand
short-term (mature within one year), intermediate-term (mature rather than NAV.
in 1–10 years), and long-term (mature in 10–30 years). Bond
funds also differ according to issuer, such as government, ETFs have many similarities to index funds and are another
municipal, and corporate bonds. way that investors can match the performance of a particular
group of stocks. One popular ETF is a Standard and Poor’s
Balanced Funds Depository Receipt, also known as a SPDR, or “spider.” “Spiders”
Balanced mutual funds, also called hybrid funds, invest in both represent ownership in the S&P 500. Another ETF, the Nasdaq
stocks and bonds. The advantage of investing in balanced funds 100 Trust, is known as “cubes,” after its ticker symbol, QQQ.
is the combination of stock growth and bond income in one “Cubes” trades over 70 million shares per day.
mutual fund. While balanced funds may not offer the same high ETFs have many advantages over traditional mutual funds that
rates of return as stock funds, most people consider them to be make them attractive to investors. Like index funds, ETFs are
somewhat “safer.” Be sure to keep in mind that, even though cheaper to manage than most mutual funds because they are
they’re called “balanced,” these funds do not necessarily invest passively managed rather than
in 50 percent stocks and 50 percent bonds. actively managed. And ETFs
trade all day long, whereas
Money Market Funds
mutual funds only trade once
Some people consider money market funds (also called money per day. But there is one big
funds) to be among the most conservative investments you can disadvantage to ETFs as well.
make. Unlike other mutual funds, shares in money market funds You pay commissions to your
do not fluctuate in value. Money market funds invest in a variety broker every time you trade ETF
of different securities that provide relatively higher rates of return shares, just like you do when
over the short term. Money market funds are ideal for investors you trade individual stocks.
with short-term savings goals or who are near retirement and
can’t afford much risk.

Mutual Attraction LAP: QS-035 © 2007, MarkED

 How to Trade Mutual Funds

Where to Trade
When deciding whether or not a certain mutual fund is right Do your homework. Just because mutual
for you, consider the investment company that distributes the
fund. Choose a company with a good reputation and a reliable
funds are professionally managed doesn’t
track record. You can’t go wrong with established organizations mean you shouldn’t carefully consider
such as Fidelity, T. Rowe Price, or Vanguard. It’s even better if which ones you choose to invest in. You
you choose a few good investment companies among whom to
should approach trading mutual funds just
diversify your portfolio.
as you would individual stocks or bonds.
Where Not to Trade
There are many places you can trade mutual funds, but that
doesn’t necessarily mean that you should. Avoid trading mutual Buying and Selling Direct
funds through bank representatives, insurance agents, or finan-
There are a number of ways that you can trade mutual fund shares
cial planners. Oftentimes, these employees are instructed
directly and avoid “load” fees. First, you can do so over the
to “push” certain funds, regardless of your individual needs.
phone and through the mail. By looking in the financial section
And all of these places will charge you commission, called
of your local newspaper, you can find toll-free numbers for the
“load,” of up to 5.5 percent for trading mutual fund shares.
funds you’re interested in. When you call, fund representatives
Despite these warnings, many people still choose to invest will be available to help you and answer your questions. You can
in mutual funds through a broker. Doing so eliminates the in- request a copy of the fund’s prospectus and an application to open
vestor’s responsibility for the research and paperwork involved an account. When you receive your application, fill it out, write a
in the process. And many brokerage firms also offer “perks” check, and send it back. The fund opens an account for you and
for trading with them, such as checks and debit cards attached sends you periodic statements in the mail. It’s as simple as that.
to your account, so you can draw on your money with greater
You can also trade mutual fund shares online with invest-
convenience.
ment companies. Click on the company’s web site, such as
www.troweprice.com, and find the link to register for a new
Costs account. At T. Rowe Price’s mutual fund account page, you
Remember that mutual funds are managed by a full-time staff. can download each fund’s prospectus as well as all relevant
And that staff doesn’t work for free! All funds charge managerial forms for your account. Trading mutual funds is so easy, you
fees, covered by shareholders. Your objective is to find mutual have no excuse not to make it a regular part of your personal
funds with the lowest costs possible. First, you can avoid investment plan!
paying “load” or commission fees by eliminating the mid-
dleman and purchasing “no-load” mutual funds directly
from the investment company. Second, you can look for
funds with low managerial fees (also called operating
expenses). A fund’s expense ratio, the percentage of
assets used to pay for expenses, is required in its prospectus.
Look for funds with expense ratios of less than 1.5 percent.

LAP: QS-035 © 2007, MarkED Mutual Attraction