A mutual fund is a business enterprise that combines the money of many different
people and invests it in stocks, bonds, or other securities. The fund's manager
chooses investments that best match the fund's objectives as described in the
fund's prospectus. Each share of the fund represents proportionate ownership
in all the fund's underlying securities.
Most funds are "open-end," which means they can continue to sell their shares
for as long as they want to (and as long as there are investors who want to buy).
Occasionally, open-end funds grow so large that they "hold" the maximum amount
their managers feel they can effectively invest. These funds may then be closed
to new buyers.
Other funds are "closed-end," which means that they only sell shares when they're
formed. The money is then invested, and the proceeds that come from sales or
interest and dividends are reinvested. The only way to buy a closed end fund
after its original offering is to purchase shares from other investors-usually
through a stock exchange.
The share price of an open-ended fund is known as its NAV (Net Asset Value).
When you buy, you pay the current NAV for each share plus a sales charge (load),
if applicable. When you sell, you receive the then-current NAV less any sales
Mutual Funds Benefits
Diversification: Mutual funds spread
out (diversify) their investments to help you reduce
risk or efficiently target particular industries, such
as high-technology, biotechnology, and other sectors.
With mutual funds, even investors with relatively small
amounts of money can achieve broad diversification.
Convenience: Many funds offer automatic reinvestment
of distributions and telephone redemptions and transfers.
Oversight: Federal regulators of mutual funds
monitor their investing activities, and assure full
disclosure of their practices and management.
Mutual Fund Profitability
If your fund's stocks and/or bonds increase in value, the NAV increases proportionally. Mutual funds can also make money for investors when the fund sells investments at a profit.
The capital gain (less any capital loss) is distributed. The fund also distributes dividend and interest income.
Mutual Fund Distributions
Earnings on your account may be distributed to you in cash, reinvested in additional shares, or a combination.
Mutual Fund Risks
The FDIC does not federally insure mutual funds, as it does bank savings accounts and CDs.
Mutual Fund Prospectus
There's a wealth of information available directly from every mutual fund, in its prospectus. All funds must provide you with a prospectus before you invest with them. It spells
out the past performance, fees and expenses, investment objectives, and information about its management.
Funds also provide semi-annual and annual reports. These reports include the portfolio of securities a fund is invested in, along with financial statements related to the operation
of the fund.
Selecting Mutual Funds There are more than 10,000 mutual funds. While some may overlap, you still have many choices - almost too many for the average consumer to properly
Money-market funds have the lowest risk since they only invest in high quality, short-term assets. Although their risk is lower, money-market funds aren't risk free as they are not
Bond funds invest in bonds of many different durations and types. But because bonds have risks (see Bonds), the value of a bond fund can fluctuate much more than a money market fund.
Stock funds (also known as equity funds) are generally riskier than other funds. But with higher risk comes the chance for greater returns.
Within each of these categories, funds are further divided up by their objective. For example, stock mutual funds may have different emphases or objectives, such as growth, balue,
a blend of the two, and income. Funds are also divided into the categories of Load (the sales charge you pay when you buy and/or sell), and No-load, where there are no sales charges
or commissions to pay.
Some stock mutual funds invest in only certain sized companies, such as large -, mid-, or small-capitalization (total market value) companies. Others may invest overseas, in international
stocks. Other funds look for a blend of all sizes and types of companies.
Still other types of stock mutual funds are Sector funds (investing in specific industries), and Index funds (which match, as closely as possible, a specific index, such as the S&P
500 Stock Index).
Bond Funds Bond mutual funds have specialized portfolios as well. They're designed to produce a regular income for you by earning interest from government and corporate bonds.
The major difference between purchasing individual bonds and investing in a bond fund is that with an individual bond, there's a maturity date. There are no maturity dates with bond
funds. For a more detailed discussion of bonds, see
Bonds and Taxation
Besides specializing in the type of issuer (corporations, governments, or foreign), bonds can be Taxable or Tax-exempt.
Interest on some municipal bonds (issued by state and local governments) may be exempt from federal, state, and local income taxes. In turn, their yields tend to be lower. Interest
on federal bonds is exempt from state and local income tax.
Comparing Mutual Funds
The primary factors when considering mutual funds include: consistency of performance; superior performance relative to funds with similar objectives and investment styles; tenure
of the fund manager; quality of the other funds within the mutual fund's family of funds; risks; and costs.
When you sell a fund that's not part of a tax-deferred retirement plan or IRA, any gain you receive may be taxed at ordinary income tax rates or long-term capital gains tax rates.The
difference between the two rates can be nearly 20% on the federal level alone.
When you own a non-tax-deferred fund for more than 12 months, profits are federally taxed as long-term capital gains (with a tax rate ranging from 10% to 20%) as compared to the
ordinary income tax rate (which ranges from 15% to 39.6%).
The general tax rules discussed above are the federal income tax rules as of January 1, 2002 and may be subject to exceptions. State and local taxes may also be due. Income tax rules
for retirement plans and IRAs are different.(See Distributions and taxation of retirement benefits).
Since tax laws are subject to change, always consult with the IRS or check with your tax advisor before making major decisions regarding your investments and your retirement plans
Mutual funds distribute capital gains to shareholders each year. These gains are taxable. If you're not careful, you might purchase shares just before the distribution date and be
saddled with a year's worth of gains, even though you've only owned the fund for a short time.
And second, watch the dates in fund advertising. If an ad appears after a fall in the market, see whether percentage returns include the market decline.
The Current Mutual Fund Scandals Explained
Paul Krugman, Princeton economics professor and New York Times columnist explained the scandal, below, for readers on 18 November 2003 in a New York Time editorial.
"[Suppose] you're selling your house, and your real estate agent claims that he's representing your interests. But he sells the property at less than fair value to a friend, who
resells it at a substantial profit, on which the agent receives a kickback. You complain to the county attorney. But he gets big campaign contributions from the agent, so he pays
"That, in essence, is the story of the growing mutual fund scandal. On any given day, the losses to each individual investor were small - which is why the scandal took so long to
become visible. But if you steal a little bit of money every day from 95 million investors, the sums add up. Arthur Levitt, the former Securities and Exchange Commission chairman,
calls the mutual fund story "the worst scandal we've seen in 50 years" - and no, he's not excluding Enron and WorldCom. Meanwhile, federal regulators, having allowed the scandal
to fester, are doing their best to let the villains get off lightly.
"Unlike the cheating real estate agent, mutual funds can't set prices arbitrarily. Once a day, just after U.S. markets close, they must set the prices of their shares based on the
market prices of the stocks they own. But this, it turns out, still leaves plenty of room for cheating.
"One method is the illegal practice of late trading: managers let favored clients buy shares after hours. The trick is that on some days, late-breaking news clearly points to higher
share prices tomorrow. Someone who is allowed to buy on that news, at prices set earlier in the day, is pretty much assured of a profit. This profit comes at the expense of ordinary
investors, who have in effect had part of their assets sold off at bargain prices.
"Another practice takes advantage of "stale prices" on foreign stocks. Suppose that a mutual fund owns Japanese stocks. When it values its own shares at 4 p.m., it uses the closing
prices from Tokyo, 14 hours earlier. Yet a lot may have happened since then. If the news is favorable for Japanese stocks, a mutual fund that holds a lot of those stocks will be
underpriced, offering a quick profit opportunity for someone who buys shares in the fund today and unloads those shares tomorrow. This isn't illegal, but a mutual fund that cared
about protecting its investors would have rules against such rapid-fire deals. Indeed, many funds do have such rules - but they have been enforced only for the little people.
"In some cases fund managers traded for their own personal gain. In other cases hedge funds, which represent small numbers of wealthy investors, were allowed to enrich themselves.
In return, it seems, they found ways to reward the managers. You make us rich, we'll make you rich, and the middle-class investors who trusted us with their money will never know
"And there's probably more. During last year's corporate scandals, each major company that came under the spotlight turned out to have engaged in some original scams. By analogy,
it's a good guess that the mutual fund industry was cheating its clients in other ways that haven't yet come to light. Stay tuned.
"The S.E.C. ignored warnings about mutual fund abuses, and had to be forced into action by Eliot Spitzer, the New York attorney general. Having finally brought a fraud suit against
Putnam Investments, the S.E.C. was in a position to set a standard for future prosecutions; sure enough, it quickly settled on terms that amount to a gentle slap on the wrist. William
Galvin, secretary of the commonwealth of Massachusetts - who is investigating Putnam, which is based in Boston - summed it up: 'They're not interested in exposing wrongdoing; they're
interested in giving comfort to the industry'."
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Charles M. Bloom, Registered Principal offers securities
and advisory services through Centaurus Financial, Inc. - Member FINRA and SIPC - 775 Avenida Pequena, CA, 93111 (mailing address: 3905 State Street Suite 7173, Santa Barbara, CA, 93105) - CA Life Insurance License No. 0A52786 - Centaurus Financial, Inc. and Shoreline Wealth & Investment Management are not affiliated companies.
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