What is a mutual fund?

A mutual fund is a collective investment vehicle owned by the investors who purchase shares of the fund. Each fund is registered as an investment company with the Securities and Exchange Commission,* with a Board of Directors or Trustees that selects the manager who oversees daily operations. The manager uses the investors' pooled money to purchase securities—which may include stocks, bonds, money market instruments, or other assets—in accordance with the objectives and limitations outlined in the fund's prospectus.

What are the benefits of mutual funds?
  • Professional management: A portfolio manager or management team, who often work closely with a group of research analysts, is responsible for deciding which securities to buy and sell.
  • Diversification: Most mutual funds own dozens, if not hundreds, of different securities, providing a level of diversification that is impractical for many investors to achieve on their own. As the number and variety of holdings increase, poor performance from a single security should have a reduced impact on the portfolio's performance and volatility. Of course, diversification cannot assure a profit or protect against loss in a declining market.
  • Liquidity: It's easy to sell shares if you need cash or decide to change your investment. Before the U.S. stock market closes on a given business day, you can sell your shares at that day's closing price. Keep in mind that the price at which you sell your shares may be higher or lower than your purchase price. Also, some funds may charge redemption fees or sales charges that will reduce sale proceeds.
  • Services: Many major fund companies offer investors a variety of convenient services. These may include automatic dividend reinvestment, recordkeeping for tax purposes, systematic investments and withdrawals, electronic and telephone account access, detailed statements, and regular reports on fund performance and holdings.
How can an investor purchase a mutual fund?

Mutual funds can be purchased directly or through financial intermediaries such as brokers, financial planners, insurance agents, or banks. Funds that are bought directly from a mutual fund company are often "no load," meaning that they have no sales charges. Funds sold by intermediaries usually involve payment of a sales charge (load) in addition to the fund expense.

What type of expenses will an investor pay?

Fund investors pay two types of expenses: a management fee, paid to the investment advisor for managing the portfolio, and a fee to cover various administrative costs. Some funds also charge a 12b-1 fee to help pay for sales and marketing costs. The expenses are deducted each day when the fund's price is calculated. The fund's annual expenses are expressed as a percentage of fund assets and can be found in the fund's prospectus, which details the types of fees that investors can expect to pay.

How is a fund's price calculated?

The fund's share price, also known as the net asset value (NAV), is calculated each business day by adding up the value of the fund's investment assets, deducting daily expenses, and dividing the result by the number of shares outstanding.

How can funds provide capital growth and income?
  • Share price appreciation: If the value of a fund's securities increases and its NAV rises, it could result in a gain that will be realized when you sell your shares. Of course, if a fund's securities lose value and its NAV decreases, you could lose money when you sell your shares.
  • Income distributions: Most bond and money funds distribute dividend income monthly, while stock funds pay dividends quarterly or annually.
  • Capital gain distributions: If profits from a fund's sales of securities exceed losses during the year, the fund may pay investors a capital gain, usually near the end of the calendar year. If a fund's losses exceed profits in a given year, the losses may be used to offset future gains.

Reinvesting these income and capital gain distributions in additional fund shares can result in faster growth of capital through the power of compounding—generating earnings from previous earnings as well as from your initial investment.

What type of risks do mutual fund investors face?

Market risk is your willingness to accept declines in the value of your investment. Stock prices fluctuate in daily trading due to competing factors that include company or industry developments, overall economic outlook, and shifts in investor sentiment. Bond prices regularly fluctuate due to changes in interest rates; as interest rates rise, the prices for existing bonds fall. The impact of these interest rate movements is greater for bonds with a longer time to maturity. Bond prices also react to changes to the issuer's financial condition that could affect its ability to make interest and principal payments, as well as supply and demand factors.

Inflation risk is the erosion in purchasing power caused by rising prices throughout the economy. If your investments do not earn a rate of return that exceeds the inflation rate, your money will buy less in the future than it does today—even if your total return is positive.

What factors should investors consider when choosing a mutual fund?

Before selecting a fund, you should first define your financial goals by determining your purpose for saving and when you will need the money. Taking your goals and time horizon into consideration, you should then examine your tolerance for risk. Finally, you should become familiar with the different types of mutual funds and select those that match your objectives.

What are some of the different classes of mutual funds?

Although there is a broad spectrum of funds available to investors, they can be broadly classified into three categories aligned with different investor goals:

  • Stability: If your goal is stability of principal, money funds that hold very short-term, high-quality securities may be a good choice. An investment in a money fund is not insured or guaranteed by the FDIC or any other government agency. Although these funds seek to preserve the value of your investment at $1.00 per share, it is possible to lose money by investing in them.
  • Income: If your goal is regular income, you should consider bond funds. Bonds represent loans to governments or corporations in exchange for interest payments and payback of the loan at a specified maturity date. Generally, bonds that pay higher income have greater potential for price fluctuations. If you have lower risk tolerance, select a bond fund with a lower weighted average maturity and higher overall credit quality. If you are willing to accept more risk, a fund focusing on longer-term or lower-quality bonds may be more appropriate. Bond funds have higher market risk than money funds but may provide returns that are more competitive with inflation over the long term.
  • Growth: For investors who seek to build capital over a long-term horizon and are willing to accept frequent and potentially substantial price fluctuations, stocks, which represent ownership in a company, offer higher growth potential and lower inflation risk. Stock funds are not appropriate as short-term investments due to their higher market risk. Among stock funds (also known as equity funds), there are a wide variety of options, from more conservative funds that buy shares of established, dividend-paying corporations to higher-risk funds that invest in small, fast-growing companies or focus on specific sectors. Funds that invest in developed and emerging overseas markets provide potential diversification benefits but also have additional risks, such as currency, liquidity, and political risks.
When is the best time to invest?

Because even experts are frequently wrong about the direction of the markets, trying to time your investment is a risky endeavor. Your best bet is to start saving as early as possible, add to your investments regularly, and reinvest your earnings. The power of compounding can result in dramatically higher growth in your investments over time.

*The Securities and Exchange Commission does not approve or disapprove securities.