Mutual Funds: Module V-I

MUTUAL FUNDS: MODULE V-I

By now you've probably heard a great deal about mutual funds. So have many investment-minded members of the public. But, while most people may be familiar with the term, they may not know much more about this financial product except that it is a good investment. They may not realize that a mutual fund encompasses much more than just one type of investment.

A mutual fund is comprised of shareholders or partners who join forces to reach a specific investment objective. Their funds are pooled together and invested by professional money managers, who attempt to achieve the stated objectives of the mutual fund.

Usually, a mutual fund belongs to a 'family.' The same company manages a group of funds, or family, so an investor can switch funds easily and quickly within that family. Each fund within that family has a different investment goal.

The investment purpose of a mutual fund can be found in its prospectus. The prospectus is the legal document, which is usually filed with the Securities and Exchange Commission (SEC), that provides important information about the mutual fund. It is required reading for investors considering any mutual fund.

The prospectus can tell the investor much more than just the investment purpose of the fund. Investors can learn about a fund's management policies, its portfolio, and any fees that are charged. Although it may seem difficult to understand at first glance, it is definitely worth reading. No money should ever change hands until the investor has been given a chance to thoroughly review the prospectus.

When clients invest in a mutual fund, they pay net asset value plus a sales charge, if any. The net asset value represents the total value of the fund's assets, less any debt, and divided by the number of shares outstanding. The net asset value changes constantly and will be calculated on a daily basis.

While most mutual funds operate in this fashion, there are also closed-ended funds. With closed-ended funds, a limited number of shares are sold to investors. Once all these shares have been sold, they can only be purchased from another investor. The price of these shares is based upon supply and demand, rather than in relation to the net asset value.

An open-ended fund will continue to issue shares to any investor who wants them. Since most funds are open-ended, the following material deals with them.

In order to become eligible to sell mutual funds, an agent must be licensed.

In most cases, there are federal and state requirements that must be met. The Securities and Exchange Act of 1934 empowered the National Association of Securities Dealers, Inc. (NASD) to set standards for licensing. The agent who wishes to sell mutual funds must obtain a Series 6 license. To obtain that license, the agent must be sponsored by a securities broker/dealer and must pass a test administered by the NASD.

In addition to the federal requirement, most states have their own securities laws, called 'blue sky' laws. More than 30 states also require an additional license to sell mutual funds, which requires passing the Series 63 Uniform Securities Agent State Law Examination.

This is not as difficult as it sounds: The NASD administers both exams and they may be taken on the same day. These exams are administered at locations across the country and use the PLATO system. Agents simply make an appointment at one of these centers and take the exams at their convenience. Unlike college boards or other exams, there is no need to go on a particular day or wait months to take the exams. And with the PLATO system, agents can get the results of their exams immediately.

Although the NASD administers both the state and federal qualification examinations, it does not offer training courses or study materials. It will, however, provide an outline of the topics covered in the exams and the relative importance of each. The NASD also supplies a list of reference materials.

Applicants can continue taking the exams until they pass them. An applicant who fails the exams can immediately apply to take the tests again. There are no training requirements for taking the exams and receiving a license. While no specific training is required to take the exams, agents should certainly be reading and taking courses on investments and financial planning in order to best serve their clients. Agents would also be well-advised to check their Errors & Omissions coverage before embarking on any such venture.

Just as there are a multitude of investment opportunities, so are there a wide variety of mutual funds. While a particular organization may offer dozens of mutual funds, there are basically four different types: money-market funds, stock funds, bond funds, and specialty funds. These categories offer investment opportunities designed to meet the goals of virtually every investor, from the most aggressive to the most conservative.

When looking at these types of mutual funds, it is important to recognize that many are difficult to classify. There is no sharp delineation between some types of funds. Within the category of stock mutual funds, there are additional distinctions, such as the difference between growth and aggressive-growth funds. Practically speaking, the portfolios of these funds may be quite similar. The managers of both funds seek stocks that will appreciate in value. In searching for long-term capital growth, there might not be a distinct difference between the funds.

Even the services that monitor mutual funds find it difficult to classify them. One particular fund may be labeled differently by each of the services since each service uses its own criteria to classify a fund.

Money-market mutual funds are particularly appealing to those investors who need quick access to cash and can't have their money tied up for a long period. Money-market funds are also an excellent short-term investment vehicle.

People often leave their money parked in a passbook savings account at their local bank or savings and loan. These accounts pay low interest, but customers are free to withdraw their money whenever they need it. Money-market mutual funds offer the same feature, but pay a much better rate.

These money-market mutual funds should not be confused with a money-market deposit account that a bank or thrift might offer. Although a deposit account will pay more than a passbook savings account, the rate probably won't be as high as a money-market fund.

Money-market funds can also be used in conjunction with other mutual funds that we will discuss later. Money can be profitably stored in a money-market fund while the investor considers other investment opportunities. In times of economic uncertainty or to take advantage of high interest rates, investors can use the money-market fund as a place to put their nest egg until other investment vehicles become more attractive.

Money-market fund managers invest in Treasury or other government securities, short-term bank deposits, or commercial paper. Investors might get a better rate of return at a bank or savings and loan by buying a certificate of deposit, but they would not be able to withdraw their money at any time, as they can with money-market funds. Money-market funds let investors get the certificate of deposit rates they want without losing immediate access to their money.

Although money-market funds aren't federally insured, they are considered quite safe. The prospectus can tell investors a lot about how safe their money will be. If the money-market fund invests primarily in securities issued or is guaranteed by the U.S. government, there is almost no risk. A fund that puts a large percentage of its assets into commercial paper might be slightly riskier. Commercial paper includes short-term, unsecured promissory notes from corporations to finance short-term credit needs. Once investors are satisfied with the safety of the fund, they will likely look at more mundane criteria to determine their choice. For example, if they are going to use the fund as a checking account, they will want to know how many checks they are allowed to write per month and the charge for each check.

A money-market fund is a good place to keep a family's emergency fund. Most financial planners recommend that investors put aside a nest egg of three to six months' salary to meet emergency expenses. And, since with a money-market fund the net asset value is always $1, the interest earned simply buys more shares in the fund.

Some investors want to do more than earn interest on their cash. There are stock mutual funds for investors who wants to put money in the stock market without taking inordinate risks. Unless investors possess a great deal of knowledge about individual stocks and are willing to closely monitor their holdings, they are usually better off in a stock fund, which will give them a professionally managed, diversified portfolio.

When playing the stock market, investors have to choose their course of action. Do they want solid blue chip stocks or do they prefer to speculate on volatile issues with greater potential for growth? Are they looking for a stock with a high dividend payout, or one that will use its earnings to finance future expansion? When choosing a stock fund, investors are faced with similar decisions. There are four different types of stock funds:

Equity Income Funds-The manager of the equity income fund is concerned with generating a steady income for investors. He or she will select a portfolio composed primarily of stocks that pay high dividends. The manager of the fund is on the lookout for stocks with high yields and is less concerned about whether those stocks will appreciate in value. Part of the portfolio is invested in bonds.

There may be a reference simply to income funds. An equity income fund emphasizes income from stock dividends, while a bond fund is an income fund in which the portfolio consists primarily of bonds.

Growth Funds-While the manager of an equity income fund is determined to pick stocks with high yields, the manager of a growth fund is seeking capital appreciation. The portfolio of a growth fund consists of stocks with a potential for capital gains. Current earnings are not as important, as long as the future prospects of the stock are bright.

Growth-and-Income Funds-In addition to growth-and-income funds, there are hybrid categories. Some stock funds shoot for a mixture of both growth and income. The growth-and-income fund manager selects a portfolio of stocks with the potential for growth, without sacrificing current dividends. Investors in such a fund expect some current income, but also count on a longterm appreciation of their capital.

Once again, it is important to note that some funds are difficult to classify. You may hear 'balanced funds' mentioned. In some cases, a balanced fund is very similar to a growth-and-income fund. Its portfolio is a balanced mixture of both stocks and bonds. Although the goal of a balanced fund is to preserve the principal while paying current income, it also seeks long-term growth of the principal. There will be times when a balanced fund and a growth-and-income fund have the same mixture of securities in their portfolios.

Aggressive-Growth Fund-Another hybrid category is the aggressive-growth fund. Stock funds of this type are designed for risk-takers who can afford to speculate on the market. Investors in this type of fund should be prepared to lose some of their investment. In exchange for this risk, they might receive an outstanding return on their investment. Aggressive-growth funds are not for conservative investors who can't deal with significant fluctuations in the value of their investment.

This type of fund is sometimes called a maximum capital gains fund, or a capital appreciation fund. No matter what it's called, the fund manager can be expected to pursue a more risky trading strategy than usual. The portfolio will be turned over frequently to meet this investment objective.

The aggressive-growth fund manager is searching for stocks that have the potential for rapid growth, and he or she will take aggressive steps to increase the value of these stocks. Because these stocks can be volatile, there is far more risk than with the growth fund.

Because of this risk, the investor should pay particular attention to the prospectus sent by the fund. It will clearly state the fund's objectives and will outline the types of stocks that have been and will be purchased. The goals of the fund should be compatible with the investor's reasons for investing.

Investors who are dissatisfied with the yield on money-market funds might view bond funds as an attractive alternative. Unlike money-market funds, however, the net asset value of bond funds can fluctuate. Although bond fund investors are striving for current income and safety, the principal is at risk due to possible changes in the interest rate.

Equity income funds rely primarily on stock dividends to generate income. Bond funds, as the name implies, emphasize bonds in their portfolios to provide income to investors. The risk associated with bond funds varies, depending on the types of bonds utilized in the portfolio.

The prospectus will warn investors of a potential problem. It might say that the fund invests in lower-quality bonds that are subject to greater risk. This could mean that the fund will invest in 'junk bonds,' which are extremely risky.

To understand mutual funds of this kind, it is helpful to understand the distinction between taxable bond funds and tax-free bond funds.

Taxable Bond Funds-This type of bond fund invests in corporate bonds and other fixed-income securities. A corporate bond is a security that represents a debt owed by the corporation. The interest rate will be dependent upon the size and financial strength of that corporation, among other factors. Riskier bonds will pay a higher interest rate. The value of the bond fund's portfolio depends on where interest rates are headed, the maturity dates of the bonds, and how risky those bonds are in view of current economic conditions.

Government bond funds also fit into this category. Although these funds only invest in securities issued by the U.S. government and its agencies, they can still be risky. The value of the shares in a government bond fund can rise or fall in relation to fluctuations in interest rates.

Investors can even buy shares in a bond fund that only invests in securities issued by the Government National Mortgage Association, or Ginnie Mae, as the federal agency is often called. As is the case with other government bonds, fluctuations in the interest rate can cause a decline in the investor's principal.

The interest on government bond funds is subject to federal taxation. In general, however, it will be free of state and local taxes.

Tax-Free Bond Funds-The tax-free bond fund invests in municipal bonds issued by cities, states, and other governmental entities. The income from these funds will be free from federal income taxes. As a general rule, only individuals in a high tax bracket would benefit from a tax-free bond fund, since the tax savings on this income offsets the lower interest rate that is usually paid.

Within a family of funds, there might be more than one kind of tax-free bond fund. One type will utilize only high-quality municipal bonds; another might use only insured municipal bonds. While insurance will guarantee payment of the interest and principal, the value of the bonds in the portfolio can still fluctuate.

There are even some tax-free bond funds that are geared to investors from one particular state. The portfolio is arranged so that the income is also free from state and local taxes.

A tax-free bond fund can eliminate some of the risk associated with buying municipal bonds. The manager of the fund can weed out risky new issues that might default. In addition, the diversity of municipal bonds found in a tax-exempt fund reduces the risk from default.

Depending upon their tax bracket, investors might be attracted to a municipal bond fund as the income from these bonds is not included in an investor's taxable income.

There would seem to be a mutual fund to cover any and all investment objectives. Specialty funds have been created to exploit specific investment opportunities and to achieve certain financial objectives. Obviously, there are unique risks associated with these specialty funds. These funds require sophistication and financial expertise to truly understand the dangers they present.

Gold Funds-This type of fund invests in gold mining stocks, gold coins, or bullion. Some of these gold funds are even more specific in their objectives. For example, they might only invest in stocks from a particular geographic area, such as Canada or Australia.

Convertible Funds-This fund invests predominantly in convertible bonds and convertible preferred shares of stock.

Foreign Funds-Funds of this variety only invest in foreign stocks.

Index Funds-An index fund's portfolio will consist of the stocks in a major market indicator, such as the Dow Jones Industrial Average or Standard & Poor's 500. In this way, it keeps pace with the direction of the market. The investor in an index fund will usually profit when there is a bull market.

Option-Income Funds-The managers of this fund write covered options on a majority of the portfolio.

Sector Funds-These funds invest in a single industry or market sector.

There is less diversity and more risk with this type of fund.

Social-Action Funds-These funds are for people who want their investments to be consistent with their political beliefs. Funds of this kind will refrain from certain investments for political or social reasons.

PROS

Mutual funds offer many advantages, especially to the small investor. There are funds that can help investors achieve either their short-term or long-term financial goals and, ultimately, financial security.

Even if they had the expertise, most people are too busy to research and investigate all of the investment opportunities available. The manager of a mutual fund performs this service on a fulltime basis. That manager and the employees of the fund have access to data that is unavailable to the individual investor.

The concept of diversification is touted by almost every financial planner and every consumer magazine. For a small investor, buying 100 shares of a $50 stock is an expensive proposition. The creation of a diversified portfolio with several quality stocks would take more investment capital than most people can afford. A mutual fund lets the investor diversify without spending too much money. The purchaser of mutual fund shares buys a truly diversified portfolio, selected by a trained specialist operating within the parameters set forth in the prospectus. Some experts have advised that unless you have $100,000 to invest, you should stick with a mutual fund. Some funds hold over 1,000 different stocks and most have at least 100.

Investors in mutual funds will have easy and quick access to their money. Many funds offer check-writing privileges and let investors switch funds at will. The open-ended fund will redeem shares at any time and will pay the net asset value of the shares.

Investors can use the flexibility and convenience of mutual funds to their advantage. As their investment objectives change, they can select a different fund with an investment portfolio that more closely matches their new goals. Changing economic conditions might also prompt a change in someone's portfolio. Mutual funds allow investors to react quickly to those changes. When stock fund investors believe a bull market is coming to an end, they can transfer their money to a different investment vehicle.

Mutual funds can be an excellent investment vehicle for both large and small investors. The minimum amount that must be invested varies from fund to fund, but can be as low as $50. After the initial deposit, investors can then use a periodic investment strategy to reduce their risk and increase their chances of building a sizable nest egg.

This investment strategy is recommended by many experts and works extremely well with mutual fund purchases. With dollar-cost averaging, an investor can accumulate shares in a mutual fund without the risk of buying shares at their highest price. The same amount of money is invested at regular intervals. The investment buys more shares when the price is low and fewer shares when the price is high. It is a systematic investment program.

The investor who utilizes this strategy will buy shares at an average price, which is less than the average market price. Because the investor is committing the same amount at fixed intervals, he or she will not purchase too many shares when the price is high.

Dollar-cost averaging helps the mutual fund investor avoid buying shares at the wrong time. It is a long-term investment strategy requiring that shares be bought at regular intervals on a continuing basis. An automatic transfer from a checking account to the fund can be arranged to implement this dollar-cost averaging strategy.

Mutual funds can remove some of the hassles of investing. For instance, participants in a money-market fund need not worry about certificates of deposit due dates. Similarly, stock mutual fund investors would get one statement rather than having to keep track of individual securities. Mutual funds also make it easy to reinvest dividends and capital gains.

The primary drawback to some mutual funds is the load, or sales charge. It is normally a frontended charge of 8 1/2% or less. Although the sales commission on the fund might seem unappealing, it is not much different from a typical purchase, or stock sale where a broker's fee is paid.

Some funds are classified as 'low-load' or 'no-load.' The low-load fund will usually have a sales charge of 2% to 4%. The no-load fund has no front-ended sales charge. The shares are purchased directly from the management of the fund.

Even the so-called no-load funds may charge other fees. The mutual fund may have a backended load, which is charged when the shares are cashed in. No-load simply means there is no initial sales charge.

Every fund will charge a management fee of some kind. There might also be a charge for accounting fees and marketing costs, whic