For investors without much experience or time to devote to building a portfolio, mutual funds offer advantages that simply aren't available anywhere else.
How funds work
Mutual funds pool your money with that of other investors to buy stocks, bonds or a combination of financial instruments.
Most funds offer shares to the public continuously, either directly or through stockbrokers and other dealers. Funds that sell directly to the public may or may not charge a load, or sales charge. Funds sold through brokers almost always charge a load.
Here's how funds operate:
Professional managers choose the investments. Although individual managers tend to get all the publicity, mutual funds are actually run by management companies that administer their day-to-day operations, choose their staffs and select the fund's investments. Many funds are managed by brokerage firms or investment counselors who also serve other clients. Some management companies administer a family of funds offering a variety of investment styles.
Investment objectives are clear. Portfolios are assembled to meet specific objectives: safety of capital, high income, moderate capital appreciation or fast growth, for example. A fund's investment policies are spelled out in its prospectus, which is available on request and must be given to each prospective buyer.
Shares are priced daily. The value of a fund share is expressed in terms of its net asset value, which is the fund's total net assets (the value of its portfolio minus any money the fund owes) divided by the number of shares outstanding. Because net asset value rises and falls with the market prices of a fund's holdings, the funds calculate a new price at the end of each day. The price at which you buy shares or sell them back to the fund is based on the next calculated net asset value following receipt of your order.
Shareholders get the profits. A fund makes money from dividends and interest on the securities it owns and from capital gains made on the sale of those securities or other investments. If its portfolio selections are bad or the market turns sour, the fund will probably lose money. Virtually all income left after payment of management fees and other expenses is distributed to shareholders.
Funds also offer a combination of shareholder services that is hard to beat.
Manageable minimums. You can buy into a lot of funds for an initial investment of $500 to $1,000. Minimums lower than $500 are rare. And regardless of their initial purchase requirements, most funds will take smaller amounts once you become a shareholder, and many will permit you to start smaller if you open an individual retirement account (IRA), or set up a program of automatic periodic investments.
Instant diversification. A share in a mutual fund gives you partial ownership of a professionally managed portfolio of dozens of stocks, bonds and other securities. Diversification doesn't insulate you against market movements, but it helps soften the impact of wide price swings that may affect individual securities.
Easy liquidity. Mutual funds are constantly issuing new shares and redeeming old ones. When you want to sell your shares, the fund is required to buy them back. Transactions can be accomplished through the mail, by telephone or online.
Automatic reinvestment plans. Virtually all funds automatically reinvest dividends and capital gains earned by your account. Reinvesting like this boosts the pace at which your money grows.
Automatic income plans. Most funds will arrange automatic periodic payouts for shareholders who want regular income from their account.
How funds pay you
Funds earn money for their investors in several ways. The stocks or bonds a fund owns pay dividends or interest, and the fund distributes this money to you as dividends. You pay taxes on that income at a 5% or 15% rate, depending on your ordinary income-tax rate.
You'll also get a share of the fund's capital gains from the sale of stocks or bonds. Under the tax code, short-term capital gains are taxed at your ordinary income-tax rate. Long-term capital gains are taxed at a 5% or 15% rate.
You also benefit when the stocks or bonds a fund buys increase in value and the fund's manager holds on to them. When this happens, the fund's net asset value increases. You don't pay any taxes on your gains in this instance until you sell the fund. Then you pay taxes based on how long you held the shares.