You may already know that mutual funds are vehicles that invest pools of cash contributed by investors who purchase shares of the fund. What you may not know, and what your financial adviser may never have taken the time to explain to you, are some of the fundamental aspects of a mutual fund that help to define it and differentiate it from its competitors.
It is worth the effort to educate yourself about mutual funds; they are one of the most prevalent investment vehicles in the United States. According to the Investment Company Institute's 2015 Investment Company Fact Book, mutual funds held $15.9 trillion in total net assets at the end of 2014, and 43.3% of all U.S. households were invested in them.
In fact, if you participate in your company's retirement plan, such as a 401(k) or 403(b) plan, even if you don't know what a mutual fund is, you likely own at least one. For this reason, it pays for every investor to know the basics of this important investment vehicle. Before you invest in a mutual fund, you should be able to answer the following seven questions about it.
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(Please note that this article only discusses open-end mutual funds. Closed-end funds are different in their structure, but represent only a small minority of mutual funds in existence.)
1. What's the name of the fund?
By law, the name of a mutual fund must be consistent with its investment objective. Additionally, because most funds include the name of their management company in their titles, the name of a mutual fund is typically somewhat descriptive. For example, a common structure for a fund name is something like "XYZ Company Large-Cap Growth Fund." In this example, an investor is informed of one of the companies the fund is associated with and what it primarily invests in—large-cap growth stocks. Fund names, nevertheless, do not provide nearly enough information from which to make an investment decision.
2. What's the price of the fund?
A mutual fund's price is defined by its net asset value (NAV), plus adjustments for commissions in some cases. The NAV represents the value of the fund's total assets, which is calculated on a per-share basis through a process referred to as fund accounting. The NAV is required by law to be calculated at the close of each trading day. Thus, unlike stocks and bonds, which are exchanged throughout the trading day and priced according to the laws of supply and demand, mutual fund shares can only be purchased or redeemed at the end of the trading day at the share's NAV.
3. Is it an index fund or an actively managed fund?
If you were researching mutual funds, it wouldn't be long before you stumbled across the term index fund. Index funds are mutual funds that employ an investment strategy that attempts to replicate the performance of an index, which is a particular group of investments that reflect a market or segment of a market. For example, one of the oldest stock market indices is the Dow Jones industrial average. This index includes the stocks of 30 large U.S. companies in an attempt to reflect the performance of the U.S. stock market as a whole.
Unlike index funds, actively managed funds attempt to beat the performance of a market by actively choosing which investments to buy and when. Because of their investment approach, index funds tend to have lower costs and be more tax efficient than their actively managed counterparts. Knowing the investment strategy pursued by a mutual fund is one of the most critical aspects of investing in a fund since it will influence its cost to investors and its investment performance.
4. Who runs the fund?
One reason individuals invest in mutual funds is to receive professional investment management services. Therefore, the professionals responsible for investing the mutual fund's assets are one of the most important aspects of the mutual fund. The investment professionals who do so are all part of the fund's investment adviser, which is hired by the mutual fund. These investment professionals typically include one or more portfolio managers and supporting research staff, whose collective job it is to design and pursue an investment strategy that is consistent with the stated investment objectives and strategy of the mutual fund as defined in its prospectus. A fund's investment adviser is often related to the management company that formed the mutual fund, but that is not always the case.
5. How much are the fund's fees?
Operating a mutual fund requires a wide range of services, including investment management, fund administration and promoting and distributing the fund, among many others. To help pay for these services, mutual funds charge investors an annual expense ratio, which is a percentage of the fund's total assets. Because fund expenses can vary considerably and introduce a significant drag on the growth of your money, it is important that you consider these fees as part of the fund selection process.
6. Does the fund charge a commission?
In addition to the expense ratio, if you buy a mutual fund through a commission-based financial professional, you may have to pay an additional charge, known as a load, that may be imposed either upon buying, selling or indirectly while owning the fund. It is very important to know whether a fund you're interested in carries a load because it can be a potentially significant cost to you as an investor. If you purchase fund shares directly from the fund company itself, or you invest in them through the services of a registered investment adviser, you likely will not pay these commissions.
7. Is the fund tax efficient?
Like sales commissions and operating expenses, taxes imposed on income generated by a mutual fund may have a significant long-term impact on the growth of your investment. (That is, of course, unless the funds are inside an individual retirement account or employer-sponsored retirement plan, in which case you won't pay taxes on fund distributions or realized gains anyway.) Depending upon the types of investments the fund owns, and its investment strategy, the taxable income generated by a mutual fund may be greater or less than that of competing funds, and it is one of the primary factors that should be considered as part of the evaluation process. Although mutual funds do not report this kind of information themselves, you can access data on a fund's tax efficiency through research firms such as Morningstar and Lipper.
Michael Rose, CFP, is president of Forthright Investments, LLC. He holds a B.S. in Finance and a M.S. in Taxation from Bentley University.