Roth IRAs

The Roth IRA is a new type of retirement account with significant advantages for most investors. Unlike a traditional IRA, the money you contribute to a Roth IRA is taxable at the time you invest it.
However, the income enjoyed by your Roth IRA account is not taxed, nor is the money in the account when you withdraw and spend it after retirement. This is a huge tax break, because your $2,000 annual contribution is likely to have grown into tens of thousands of dollars by the time you retire — all of which will be yours to use, tax-free. Generally speaking, the only people for whom a traditional IRA is probably a better deal than the Roth IRA are those who are less than ten years away from retirement. For them, the immediate deductibility of this year’s contribution may be worth more than the back-end deductibility of the Roth IRA.
Your broker, banker, or mutual fund company can help you with the calculations if you’re unsure which type of account is better for you.

Individual Retirement Accounts (IRAs)

Any American whose income is below a legally specified level can save up to $2,000 per year in an IRA account tax-free. This means that you pay no income taxes on the money you invest in your IRA, and the interest, dividends, and other income enjoyed by the money continues to be tax-free for as long as you let the investment grow. When you retire and begin withdrawing the IRA money, the funds are taxed as ordinary income at your applicable tax rate — which is likely to be lower than your current tax rate, because you no longer earn a salary.
Check current tax law to find out whether you’re eligible for an IRA account. The answer will depend on your income and on whether you’re covered by your employer’s pension plan. If you’re not covered by such a plan, you’re fully eligible for the IRA tax deduction; if you are covered, the income limits kick in.
Any mutual fund company, brokerage firm, bank, or other financial company can help you set up an IRA account. You can then fund it with whatever investment you choose, including your choice of mutual fund.
When investing in an IRA or any other tax-deferred retirement plan, don’t invest in a municipal bond fund or in any other fund type that specializes in low-tax or no-tax investing. Remember, such funds generally produce a lower rate of return than similar taxable funds, and because you are not paying any taxes on the income you enjoy from the fund, you have no reason to settle for that lower rate.

Tax-Deferred Retirement Accounts

If your primary investment goal is retirement, taxes need not be a major issue. Thanks to federal laws designed to encourage retirement savings, several special kinds of investment accounts are currently available that enable you to save on current taxes as you invest for retirement. Any mutual fund investment can enjoy major tax benefits if it is placed in one of these tax-deferred retirement accounts. Every smart investor who is putting away money for a comfortable old age owes it to himself or herself to open such an account. Your money grows much faster in a tax-deferred account than in an ordinary

Municipal bond funds

A municipal bond fund is another kind of tax-advantaged mutual fund. A municipal bond fund invests in bonds issued by state, county, city, and other local government agencies. Most income from these bonds is exempt from federal income taxes (although you must report the income on your federal income tax return). If you live in a state that levies a high state income tax, such as New York, California, or Massachusetts, you may want to consider a single-state fund, which invests in municipal bonds issued only in that state. Income from such a fund is exempt from state taxes as well as federal taxes, and may even be exempt from local taxes in a city (like New York) that levies a local income tax. Over 600 such single-state funds are currently available, covering some 30 states.
Despite the tax advantages of single-state funds, they’re not for every investor. Some single-state portfolios are relatively risky. Because the fund manager is restricted to buying bonds issued in one state only, he may be forced to invest in some counties or government agencies whose credit is shaky. If the agency defaults on its obligations — that is, if it fails to make timely payment of the interest due on its bonds — the value of the portfolio may suffer significantly. Study the prospectus of any municipal bond fund you are considering buying, and make sure you understand the degree of safety or risk involved with the bond investments held in the portfolio.
If safety is especially important to you, consider a municipal bond fund that invests only in insured bonds. These are bonds guaranteed by an independent agency that promises to make timely interest payments if the issuing agency runs into financial difficulties.
The prospectus for any fund you’re considering states whether the portfolio includes insured bonds. The safety does come at a cost; generally speaking, an insured bond fund has a return that is 0.1% to 0.4% lower per year than an uninsured bond fund. You have to decide whether this lower return is a reasonable trade-off for you.
Although interest and dividends from municipal bond funds are not taxable, capital gains (if any) generally are. Be careful to distinguish the different forms of income and treat them correctly on your tax return.

Tax-advantaged mutual funds

Tax-advantaged mutual funds are funds whose investment holdings are designed to minimize the investor’s tax liability. They may or may not be tax-managed, but their approach tends to be tax-efficient over time, resulting in overall lower tax payments by investors.
Index funds are the premier form of tax-advantaged investment. Index funds feature a passive style of investing, in which the fund manager buys and sells stocks only as needed to ensure that the fund continues to mirror the index on which it’s modeled. Because the manager of an index fund doesn’t do a lot of trading, relatively low amounts of capital gains are realized during any given year, minimizing the tax bite you must pay. Perhaps the most tax-efficient fund type available today is an index fund that is specifically managed to minimize capital gains distributions. This involves certain accounting practices that the fund manager must be careful to follow, including identifying for the Internal Revenue Service the bought and sold specific shares of a given company. By selling first all shares bought at a higher price and holding on to those bought at a lower price, a fund manager can reduce taxable distributions to investors significantly. If you’re interested in a tax-advantaged mutual fund, contact Charles Schwab and Vanguard. These two mutual fund companies are among those that offer tax-efficient index funds specifically designed to keep capital gains taxes as low as possible.

Understanding Tax-Managed Funds

Tax-managed funds are those in which tax effects are incorporated in the fund manager’s decision-making process. The manager of such a fund is guided in her buying and selling decisions, in part, by considerations of how to avoid incurring excessive capital gains taxes in any given year. For example, suppose that Jane Goodbucks is the manager of Fund T, a tax-managed fund. Jane may be contemplating selling the fund’s shares of Microsoft, the giant software company, because she and her research staff expect the value of Microsoft stock to increase at a rate of just 10% a year during the next several years — a little lower than Jane would like. Jane is considering replacing her Microsoft stock with shares of Amazon.com, the online retailer, which she expects to grow at 11% a year.
If Jane ignores tax effects, she is likely to sell the Microsoft stock and buy Amazon.com. But because Fund T is a tax managed fund, Jane first considers the cost her shareholders can expect to incur for capital gains. The taxes due will depend on the amount of the gains realized, which will depend, in turn, on how long Fund T held Microsoft and how far the stock increased during that time. Based on these considerations, Jane may or may not decide to sell Microsoft. Due to the effect of taxes, trading Microsoft for Amazon.com may result in lower returns for investors, so holding the Microsoft shares may be the better choice. You can find out whether a fund is tax-managed by reading the fund prospectus. Unless the prospectus states otherwise, assume the fund is not tax-managed. If tax considerations are important to you, consider focusing your fund choices specifically on those that are managed with tax effects in mind.

Tax on mutual funds capital gains

Capital gains — profits from an increase in the value of the securities held by the mutual fund — may be either realized or unrealized. Their tax status differs accordingly, with only realized profits being eligible for taxation. Here’s how it works.
Capital gains are realized when the fund manager sells stocks (or, less commonly, bonds) at a price greater than their purchase price. When stocks held by the fund increase in price but are still held, the capital gains are unrealized.
Capital gains are taxed only when they are realized. For example, suppose Sharon owns shares of Fund M, whose net asset value increases by 10% during the course of a year due to a 10% increase of the value of the stocks owned by the fund. If the fund manager sold no securities during the year, the investor would receive no realized gains in the current year — therefore, no taxes due on capital gains. However, suppose Sharon decides to sell her shares of Fund M. (Maybe she needs to cash in her investment in order to make a down payment on a new house.) When she does so, she is realizing (literally “making real”) the profits earned by the fund due to the increase in the value of the stocks it owns. These profits are now capital gains on which Sharon is obligated to pay taxes.
If you plan to sell your mutual fund shares, consider the tax implications of your timing. If the value of your shares has grown significantly, so that you can expect a large tax payment, consider whether you want to accelerate the transaction (making the sale by December of the current year) or to delay it (pushing it back into next January), depending on which year your income may be greater. Realizing your profits and paying taxes on them may be less painful during a year when your income is smaller and your tax rate is therefore lower.
Current tax law also distinguishes between short-term and long-term capital gains. Short-term capital gains are profits from sales of securities held by the fund for 18 months or less. The government taxes these gains at the same rate as ordinary income, just like dividends. In fact, you will actually find short-term capital gains listed in the “dividend income” box on your Form 1099-DIV because the tax rate is the same.
Long-term capital gains, on the other hand, are profits from the sale of securities held by the fund for longer than 18 months. These profits are taxed at a more favorable rate. If you are in the 15% tax bracket, the government taxes any long-term capital gains you enjoy taxed at just 10%; if you are in the 28% bracket or higher, your long-term capital gains are taxed at 20%.
As you can see by its design, federal tax law encourages investors — including fund managers — to hold on to securities for a longer time. Taxing long-term capital gains less heavily than short-term capital gains is another reason why a mutual fund with a lower turnover rate may be more beneficial for the investor than a fund that buys and sells stocks rapidly.

Tax on mutual funds dividends

Unless you invest your money in a tax-deferred retirement account (as explained later in this chapter), dividends you receive in the form of a distribution are generally treated as taxable income. Currently, the government taxes dividends at the ordinary federal income tax rate of 15% to 39.6%, depending on your overall taxable income. You generally have a choice (selected when you open your mutual fund account) of receiving dividend distributions in the form of a payment by check or reinvesting them in the purchase of additional shares of the fund. Don’t fall for the myth that if you reinvest the dividends you receive, the dividends are not taxable.
Unfortunately, that wishful thinking is not true. Although you never actually see the dividends in the form of cash, the dividends reinvested on your behalf during the year appear on your 1099-DIV form, and the IRS expects payment of all taxes due on these dividends.
If you want to avoid paying taxes on dividend income, you can opt to invest in a growth fund or a small cap fund. Such funds generally pay lower dividends than large cap funds or income funds, because they invest in small companies that use their profits to finance business expansion rather than paying dividends to investors. As a result, you’re likely to receive lower dividends while enjoying greater profits in the form of net asset value growth.
However, the positive tax effect of lower dividends may be spoiled if the fund’s rate of turnover is unusually high. If the fund manager buys and sells stocks frequently, the fund is likely to experience greater than average capital gains, on which the individual investor must also pay taxes. So, if you choose a fund partly to avoid heavy tax payments, make sure to check its turnover rate before investing. You can also delay or avoid some tax liabilities for dividend income by choosing a tax exempt municipal bond fund or by putting your mutual fund investments in a tax-deferred account, such as an IRA or 401(k).

Tax Consequences of Mutual Fund Profits

You can profit in three ways when you own a mutual fund: through any increase in the net asset value (NAV) of the fund shares; through dividends; and through capital gains. Each of these kinds of profit has a potential impact on the taxes you have to pay. For most investors, tax considerations are not worthy of top ranking on the list of concerns that may affect decisions about buying or selling a mutual fund. Most people are wise to buy and sell mutual funds based on their changing financial goals and their perceptions of the investment markets and the overall economy rather than worrying too much about the relatively small tax consequences of their decisions. However, if you’re in a higher tax bracket (31% to 39.6%), you may want to take the tax implications of your mutual fund investment decisions more seriously. Here are the things you need to know.
At least annually, a mutual fund must distribute to investors the dividends and capital gains that the fund’s portfolio has generated over the course of the year. As Dividends are a portion of the profits generated by a company and shared with those who own stock in the company, and capital gains represent the difference between the price at which you purchased a security and the higher price at which you sold it — the profits.
Bond funds usually distribute the income received from their investments in the form of a monthly dividend. Stock (equity) funds and balanced funds, which hold both stocks and bonds, may distribute dividends quarterly, annually, or semiannually. Capital gains are distributed once a year. Around the end of the calendar year, the mutual fund company sends you a 1099-DIV form detailing the taxable distributions that you received during the year. You use this information when preparing your income tax return for submission by the following April 15.

Dollar Cost Averaging

Dollar cost averaging is a technique whereby an investor puts a fixed amount of money into the same investment vehicle at regular intervals. For example, if Ian invests $500 a month into a mutual fund every month, he is dollar cost averaging. Dollar cost averaging offers a number of benefits. For many investors, the habit of investing regularly is a difficult one to develop and maintain. Setting aside the same amount of money from each paycheck is a good way to develop this discipline. Many mutual fund companies can arrange automatic deductions from your checking or savings account which make it even easier to invest regularly. You’ll soon find that you hardly miss the money which is going to build a steadily increasing investment nest egg.
Dollar cost averaging also increases the rate of return on your investment dollar. Here’s how it works. Suppose Ian invests his $500 a month into a mutual fund whose net asset value per share varies between $20 and $40. During months when the NAV is lower, Ian’s $500 will enable him to buy more shares; when the NAV is higher, he’ll buy fewer shares. The beauty of dollar cost averaging is that, over time, by investing the same amount each month, Ian will buy more shares at a relatively lower price. Therefore, his average price per share will be lower, meaning that his investment profits will be greater.
See Table 8-2 for an illustration of how this works. Over the year shown, with the NAV of Ian’s Fund F varying between $20 and $40 per share, the average NAV is $30.08 per share (calculated simply by adding the average monthly NAV — $20 in January, $24 in February, and so on — and then dividing the sum by 12). But Ian has been able to buy a total of more than 208 shares for $6,000. Thus, the average per share price Ian has actually paid is just $28.83 — more than a dollar less than the average NAV for the period.
Dollar cost averaging always works this way: By buying more shares when the price goes down, you reduce your per-share purchase price and so stretch your investing dollar. Dollar cost averaging enables the investor to regard a decline in NAV not as a loss of value but rather an opportunity to buy more fund shares at a discount price. I strongly recommend it to all new investors — and to experienced ones who’ve never enjoyed its benefits.

Deciphering Differences in Share Classes

If you buy a mutual fund from a broker, financial planner, or banker rather than directly from the mutual fund company, you may run into a confusing variety of share classes. These different classes of shares have varying fee structures, and choosing among them can be tricky. You can avoid this complication by sticking to a no-load fund and buying direct. But if buying a load fund from a broker, planner, or banker interests you, you may need to know the differences in class shares:

• Class A shares: These usually involve paying a sales charge (load) up front. The typical front-end load is in the neighborhood of 5.75%, but it may be higher or lower.
• Class B shares: You don’t have a front-end sales charge on these shares, but you do have a 12b-1 fee, which is usually 1% a year. In addition, expect a declining back-end charge (sometimes called a redemption fee). For example, if you sell between one and two years after buying, you may be charged 4%; between years three and four, 3%, and so on. Typically, after year six, you may have no charge.
• Class C shares: These involve a so-called level load, which means they may charge a front-end charge of 1% plus a 1% annual 12b-1 fee.

Which class of shares offers the best deal? No single right answer exists. Although the high front-end load of the Class A shares sounds scary, paying the 5% once may be cheaper than paying 1% annually over (say) a 10-year investment period.
To further complicate matters, in many cases, a B share or C share automatically converts to Class A after a period of time. The quicker B shares convert to A, the better, because this conversion eliminates the annual 1% fee. Unfortunately, share classes are not regulated and may vary from one fund company to another. Sometimes, only specific groups of investors are able to invest in special share classes.
For example, a certain share class may be designed for those who participate in 401(k) retirement plans. When buying a mutual fund through a broker, financial planner, or banker, be sure to ask about share classes and make certain you know what fees you will be charged.
If you want to avoid the confusing share classes, opt for a noload fund. No-load funds have no front-end sales charges or other loads to figure out.

Deciding When to Buy

Be careful about buying shares in a mutual fund during the last quarter of the year (that is, during the months of October, November, and December). Most funds announce their dividends, capital gains, and other such profits for the year during this quarter. The actual payment of these profits to shareholders (called the distribution) usually doesn’t take place until January.
However, according to Internal Revenue Service rules, these profits are considered paid on December 31, and anyone who is a shareholder as of that date must pay taxes on them. Thus, you’re probably better off waiting until after the January distribution to invest. You can receive the benefits of the profits, but you won’t have to pay a tax bill on them because you were not a shareholder as of December 31.

What are Fund Supermarkets?

A relatively new phenomenon in the mutual fund world are so-called fund supermarkets. These allow you to buy funds from several fund families for no or low transaction costs and to manage all your money in a single account. It’s a convenient way to get access to literally thousands of mutual funds from a single source.
The fund supermarkets are managed by some of the leading discount brokerage firms — financial companies that specialize in no-frills investment buying and selling services for individual investors. Such firms as Charles Schwab, Muriel Siebert, Jack White, and National Discount Brokers are among those running fund supermarkets. If you open an account with one of these firms, you’ll be able to buy and sell shares from a wide range of fund families; switch from one fund to another with ease, even if the funds are in different families; and receive information about all your accounts in a single statement.

Knowing Where to Buy Mutual Funds

Investors use a wide range of channels to purchase mutual funds, but buying directly from the fund is the most popular, Buying directly from a fund company is the cheapest and most convenient way to buy for most investors. Just telephone the company of your choice and ask for an application. Complete the application form and send in your initial investment in the form of a check, and you’re an investor —it’s that simple.
(If you participate in a 401(k) plan or other employer-sponsored investment program, you may have the opportunity to buy shares from a fund company indirectly, through your company’s investment plan. The paperwork and procedures are quite similar.) Only a couple of the questions on the typical mutual fund application are likely to cause you any confusion. Expect to state how you want any capital gains and dividends handled. You can have these profits paid to you in cash, or have them automatically reinvested in your account, buying more mutual fund shares. I recommend that you reinvest profits from capital gains and dividends so that your investment portfolio can benefit from the power of compounding. The mutual fund application may also ask whether you want to participate in an automatic monthly investment plan. This kind of plan automatically transfers a specified amount of money each month from your checking account into the mutual fund of your choice.
If you’re starting out with an investment program, I strongly recommend that you choose this option. After a few months, you won’t even notice the money “missing” from your budget, but you can look forward to the satisfaction —excitement even — of the steady growth of your investment portfolio, as reflected in your monthly or quarterly statements. Not all investors choose to buy mutual fund shares directly from fund companies. Some prefer to invest through full service brokers, financial planners, or their bank or credit union. Investing in this way has one significant advantage and one major disadvantage. The advantage is the availability of investment advice and guidance. A good broker, planner, or banker should be willing to spend time analyzing your personal financial situation and be capable of offering unbiased, thoughtful suggestions concerning the best investment options for you. He or she should also have printed materials to share with you giving information about funds, investment strategies, economic forecasts, and other useful data. If you want this kind of help, consider consulting one of these financial professionals. The disadvantage is the cost associated with this professional help. Full-service brokers, financial planners, and banks generally sell load funds rather than no-load funds. Load funds charge sales fees, often significant ones, whenever you buy shares. These fees can have a real impact on your investment profits. Show that the investment performance of load funds is no better than that of no-load funds.
Therefore, the sales fees you pay buy the services of your broker, planner, or banker, but not an improvement in investment profits. It’s up to you to decide whether the professional’s advice is worth the expense.
If you invest through a broker, planner, or bank, you may also have to deal with the confusing phenomenon of share classes.

Reading the Fund Prospectus

The fund prospectus is a legal document that must contain specific information about a mutual fund. The prospectus informs potential investors about the fund’s goals, fees, and expenses, and its investment objectives and degree of risk, as well as information on how to buy and sell shares. You can obtain a prospectus directly from the fund company or from a broker, financial planner, or other financial professional. After you narrow your fund choices to a handful of possibilities (three to five funds), request prospectuses for each and devote an evening to comparing them. A prospectus is usually not fun to read. The document contains a certain amount of jargon and some legal terms (despite recent rules by the Securities and Exchange Commission that encourage the use of plain English in the prospectus). But if you know what to look for, you’re likely to find that the prospectus contains a wealth of information that can help you decide whether the fund is right for you.
Information contained in the standard prospectus includes

• The investment objective of the fund
• Investments the fund manager is allowed to make, even if they may not fit the stated objective
• The financial history of the fund for the past ten years, or, if the fund is younger than ten years, for the life of the fund
• The minimum amount of money required to invest
• The sales charges (loads) associated with investing, and when they are payable — at the front end (on purchasing shares), at the back end (when selling), or both
• The fund’s operating expenses, including management charges, administrative expenses, and 12b-1 fees
• How to buy and sell shares and a description of shareholder services provided

Some funds have policies that allow the fund manager to invest in virtually anything — stocks, bonds, derivative securities, real estate, and what-have-you. I recommend that you avoid such funds, sticking instead with those that have clearly defined investment objectives.
The more prospectuses you read, the more familiar you can become with the terminology they use. By comparing prospectuses from several funds, you develop a sense of each fund’s different personality. You probably find that one fund feels more comfortable to you than the others, which may be a sign that you’ve found a good prospect for your first investment experience.

Evaluating Fund Management

By studying the track records of funds in the categories you’re interested in, you can identify a handful of strong candidates to focus on even more closely. The next step is to examine the management of those funds, looking for signs of strength and weakness that may guide an investment decision. Several firms, including Morningstar, Value Line, Lipper Analytical, and Wiesenberger, specialize in monitoring and tracking mutual funds and publishing reports on their findings. Most public libraries subscribe to at least one of the information services offered by these firms, and with the help of a librarian you can locate a wealth of information on the management styles and strengths of most mutual funds. Below are some of the questions to ask about any fund that you are seriously considering buying. Information services like those provided by Morningstar, Value Line, and so on can provide the answers.
Who is the fund manager? How long has he or she managed the fund? How does the growth record of the fund under his or her management compare to that of other funds? In general, you want the manager to have a record of at least five years with the fund company, preferably ten or more. If the manager has only been with the firm for two years, his track record is too short to be truly meaningful; any success the fund is currently enjoying may be due more to the efforts of his predecessor.
Information about fund managers often is readily available in the financial press. A few superstar fund managers, such as Mark Mobius, the international investment guru of the Templeton Funds, are almost as widely covered in the media as top basketball players or movie stars. Check online or in any index of newspapers and magazines (available at your local library) for articles about or interviews with the managers of the funds you are considering. You may be able to locate one or more profiles in which the fund manager offers his investment philosophy, explains his successes and failures, and indicates some of his strategies for the months and years to come.
Do the investments currently held by the fund match the fund’s stated objectives?
Fund management may not exactly match an advertised description. Some funds touted in advertising as low-risk or conservative investments actually include derivatives and other risky holdings in their portfolios.

Finding High-Performing Funds

After you decide which categories of funds are likely to be best for you, you can begin to narrow your choices still further. One way to start is by looking at the track record of a wide selection of funds in a particular category. Sources abound for this information.
Magazines that deal with personal finance and investing topics, such as Money, Smart Money, and Kiplinger’s Personal Finance Magazine, run periodic special reports showing comparative investment results for hundreds of mutual funds. The publications usually group the funds by categories, so you can quickly zero in on growth funds, index funds, municipal bond funds, or any other fund type of interest to you. Similar reports appear periodically in business magazines like Business Week and Forbes, in The Wall Street Journal, and in the business sections of many local newspapers. Visit your local library and ask a librarian to help you locate the most recent mutual fund issues of your favorite financial periodical or check out the publication online. The data you need ought to be easy to find.

Be sure to compare the one-year, three-year, five-year, and ten-year annualized returns for funds in the specific type or types of funds you are considering. Look for consistently strong results. The fund that amassed huge profits over the past 12 months may have done poorly in previous years, suggesting that next year’s performance may lag again.
A better bet is a fund that shows an above-average performance year-in and year-out for the past five years or more.

Matching Goals with Fund Categories

The following checklist contains some specific suggestions that can help you decide which types of funds may best suit your personal situation and goals:

• If your investment goals are mainly long-term, consider stock (equity) funds.
• If your investment goals are mainly short-term, consider bond (fixed income) funds, especially money-market funds.
• If you feel able to tolerate a relatively high degree of risk, consider growth funds, aggressive growth funds, emerging market funds, or mid cap and small cap funds.
• If minimizing risk is important to you, consider bond funds (including corporate bond funds), balanced funds, growth and income funds, or large cap funds.
• If you want to target specific regions or industries you think will grow, consider international or sector funds.
• If you want to minimize the costs of investing, consider index funds.
• If you want to minimize the taxes on your investment profits, consider municipal bond funds.

Obviously, overlap exists among these various personal goals. A single investor — call him Matthew for the sake of illustration — may have two or three different yet complementary investment preferences.
For example, say he wants to invest for the long-term goal of retirement, minimize risk, and minimize the tax bite on his investment profits. In light of these three preferences, Matthew may want to consider more than one category of funds, looking for the fund type that offers a comfortable balance among different factors. So zeroing in on one category of fund isn’t necessarily an obvious or easy process. The checklist can help you begin the process of sorting out the possibilities.

The cost of turnover in investing

Another cost of investing that doesn’t show up in the expense ratio of a fund is the cost of turnover. Turnover is the rate at which a fund buys and sells investments. A turnover rate of 100% means that, on average, the fund manager buys and sells stocks or bonds with a value equivalent to that of the entire investment portfolio each year. Every time the fund manager buys or sells a stock or bond, she incurs expenses — brokerage commissions and other administrative costs. The higher the turnover rate, the more frequent trading of securities the manager is engaged in, and the higher the trading costs. Over time, high turnover can be a significant drag on the profits of a fund.
You can find the fund’s turnover rate in the prospectus. The least actively managed funds, such as an index fund, may have a very low turnover rate of just 5% to 10%. A very actively managed fund may have a turnover rate of 500% or more, meaning that each security in the fund is held, on average, for just about one-fifth of a year — 10 weeks or so — before being sold.
In general, turnover rates of less than 30% are considered low; 30% to 100% is average; over 100% is high. If every other comparative point is equal, choose a fund with a lower turnover rate because more efficient fund management is likely to earn you greater profits in the long run.

Understanding 12b-1 fees

A 12b-1 fee, also known as a marketing or distribution fee, is an alternative way to pay the salesperson who sells the fund’s shares and who may provide assistance and advice to the investor. 12b-1 fees may also defray advertising and other marketing expenses of the mutual fund company. Any fund can establish a 12b-1 fee, although not all do. When 12b-1 fees exist, they generally range between 0.25% and 1.0% annually. By law, the fee can be no higher than 1 percentage point of the fund’s average net assets per year. A mutual fund that charges no sales load and charges 12b-1 fees of 0.25% or less is considered a no-load fund. However, if the 12b-1 fee is greater than 0.25%, the fund qualifies as a load fund.
Naturally, the lower the 12b-1 fees charged by a fund, the better. In general, no-load funds are a better bargain than load funds. However, you may find that, in some instances, a load fund may actually be a better buy than a fund with a heavy 12b-1 fee.
Suppose you’re considering a fund with a modest front-end load (say, less than 5%). Because the front-end load is a onetime payment, while 12b-1 fees are an ongoing annual charge, the front-end load may end up costing you less, especially if you plan to keep your investment for a long time. In effect, the existence of 12b-1 fees gives the investor a choice of whether to pay sales expenses later or up-front. Look closely at 12b-1 fees before making an investment decision — they may influence you to choose one fund over another.

The expense ratio of mutual fund

One handy way to measure the relative cost of investing in a particular fund is by looking at its expense ratio. This figure, which appears in the fee table section of the fund’s prospectus , is the amount that each investor can expect to pay for fund expenses each year, stated as a percentage of the money invested.
The expense ratio includes administrative costs and management fees but not sales charges (loads) or 12b-1 fees, which I explain in the following sections. Thus, the expense ratio provides you with a useful, though partial, picture of the costs involved in investing in a fund.
The average stock fund has an expense ratio of about 1.4%; for bond funds, the average is under 1.0%. A ratio higher than this may or may not be justifiable, depending on the kind of fund you are considering.

Administrative costs of mutual funds

Administrative costs may include a variety of expenses. Shareholder service fees, sometimes referred to as transfer agent service fees, are typical administrative costs. The transfer agent maintains records of your ownership of the fund’s shares. When you open an account, the transfer agent records that transaction. If you transfer money into or out of the fund, the agent records this activity. The agent also handles your redemption requests when you want to cash in all or part of your investment. And if the fund company distributes dividends or capital gains to investors, the transfer agent records that transaction.
Mutual fund companies offer other shareholder services, the cost of which is included in the same set of fees. When you call the fund company to set up an account, you talk to a representative; similarly, when you request information about a fund or receive an annual report in the mail, a fund employee must handle these services. Such expenses also come out of shareholder service fees.
Custodial fees are another type of fee included in the annual operating expenses listed in a fund’s prospectus. When you invest in a mutual fund, you’re buying stocks or bonds that must be handled by a third party — a custodian. The custodian holds the stock for you, provides ownership records to the mutual fund company, and handles various kinds of internal paperwork.
The custodian also tracks the action if a particular stock splits — that is, if the company issuing the stock decides to convert (say) 100 shares trading at $120 per share into 200 shares trading at $60 per share. (Companies sometimes do this in order to keep their per-share price fairly low and affordable.) The custodian handles the administrative work caused by stock splits.
For most domestic funds, custodial fees are usually not high. For funds that invest in foreign stocks, custodial fees can be substantial because of the complications of investing in foreign countries.

Management Fees of Mutual Funds

Management fees cover the fund company’s management expenses — the work of lawyers and accountants, the cost of maintaining books and records, money spent complying with government regulations and disclosure rules, research expenses, and the salary of the fund manager, among other costs. The amount varies from fund to fund and from one type of fund to another.
Management fees are usually lower on money market mutual funds and other bond funds and higher on most types of equity funds because of the greater complexity of the investment decisions.
Management fees are usually the single largest portion of a fund’s annual expenses, averaging between 0.5% and 1.0% of the fund’s assets.

Annual Operating Expenses of Mutual Funds

Of course, (almost) no good thing is free. All mutual funds have associated expenses — even no-load funds. Before choosing any fund, learn about the costs you can expect to pay for the investment expertise and services the fund provides.
You can find the annual operating expenses of any fund described and estimated in the fund’s prospectus. These expenses may include management fees, administrative costs, and 12b-1 fees, all of which I explain in this chapter. These fees are generally deducted automatically from your account and shown when you receive your regular account statement in the mail, so you don’t have to worry about sending in a check.
Some funds are naturally more expensive to operate than others.
A fund that invests in international stocks or small company stocks tends to be more expensive than average, because research costs are likely to be higher in these areas. By contrast, an index fund that simply tracks the performance of a preselected bundle of stocks generally has lower expenses and therefore can save you money when you invest. However, the fact that a particular fund has relatively higher expenses need not deter you from investing in it. A high investment return may more than make up for the annual expenses charged.

Understanding no-load funds

A no-load fund charges no sales commission. Typically, the mutual fund firm that sponsors the fund is the investor’s source for this kind of fund. These firms often sponsor entire families of no-load funds, each with a different investment objective, philosophy, and style.
Some of the better-known mutual fund families, including T. Rowe Price, Fidelity, Janus, and Vanguard, offer a wide array of no-load funds, one of which is likely to be an appropriate and attractive investment for you.
When you invest in a no-load fund, you skip the middleman — the sales agent — and therefore save the money that would otherwise go to pay his commission. You don’t have to meet with or speak to a broker or salesperson; instead, you call the mutual fund company, ask for an application and informational brochures about their funds, and then send in a completed application form with your check. If you invest $1,000, the entire amount begins working for you, with no deduction for any load or commission.
Is there any significant downside to choosing a no-load fund? Not really. Some investors prefer load funds because they like having an ongoing relationship with a broker or other financial professional who can advise them from time to time. By contrast, with a no-load fund, the investor is on her own; she can call the fund company to make transactions or to request publications, but she can count on speaking to a different representative every time she calls. The investment performance of load and no-load funds is the subject of many research studies. In virtually every study, no significant difference is apparent. In other words, investors who paid sales commissions of 5% or more for load funds did not enjoy noticeably better investment results. Because you can invest your money with equal profit in either a load or a no-load fund, why not save some of your hardearned cash by considering only no-load funds for your portfolio?

Understanding redemption fees

Instead of up-front sales charges, some load funds charge a redemption fee. With this kind of load, you pay a fee when you cash out of the fund by selling your shares. The size of the redemption fee depends on the fund you are invested in; each fund has its own fee structure, often on a sliding scale, so that the redemption fee decreases the longer you hold the fund.
For example, a typical redemption fee structure provides that, if you redeem your mutual fund shares within a six-year window, you can expect to pay anywhere from 6% to 1% — 6% during the first year, 5% during the second year, and so on. The redemption fee drops off at the seventh year. (By design, the fee structure encourages you to hold on to your investment for a longer time, which benefits the fund company.) Carefully study the sales brochure or prospectus for any fund you’re thinking of investing in. Make sure you understand the nature, size, and structure of any load charge.
Some load funds impose up-front sales charges; others include redemption fees; others levy annual commissions for as long as you own the fund; and still others impose various combinations of these charges. Read the fine print so you won’t be blindsided by unanticipated expenses.

Understanding load funds

A load is a sales charge or commission payable to the person who sells you a mutual fund. A load fund is a mutual fund on which such fees are charged.
Typically, a financial professional sells a load fund. Some load funds are sold by full-service brokers — salespeople who advise you on your investment choices, provide you with brochures and research reports, and pocket a commission in return for their work. Financial planners, bankers, insurance agents, and other financial professionals also sell load funds.
All load funds carry attached sales commissions, usually representing about 5% of your investment. For example, if you invest $1,000 in a certain load stock fund with a 5.75% sales charge, $57.50 comes off the top to pay the broker. The remaining $942.50 is your investment in the mutual fund itself.

Learning about Balanced Funds

A balanced fund owns both stocks and bonds. It’s a conservative type of fund investment, one that attempts to make it easy for investors to enjoy some of the safety of bonds along with the growth potential of stocks through a single investment.
The typical balanced fund is 60% invested in stocks and 40% in bonds. Its investment objective is to conserve principal (that is, avoid losing any of the money invested), pay current income (that is, dividends), and achieve long-term growth.
If you’re a brand-new investor, a balanced fund can be an easy, safe choice. If you have a little more experience, consider creating your own “balanced” fund by dividing your money between stock and bond funds of your choice.

By selecting funds that closely fit your own investment goals, you’re likely to achieve better results than you can get from a prepackaged balanced fund.

Corporate bond funds

A corporate bond fund invests in debt issued by companies that need to raise money. Such bonds are rated for their safety by Standard & Poor’s and Moody’s, two companies that specialize in examining the finances of companies and determining whether they are likely to be able to pay off their debts in a timely fashion.
Standard & Poor’s and Moody’s rate bonds using letter grades — S&P’s AAA and Moody’s Aaa represent the highest possible grades. In general, investors want to invest in bond funds that hold bonds rated in the four highest categories: AAA (“triple A”), AA, A, and BBB, according to S&P or Aaa, Aa, A, and Baa, according to Moody’s. The companies that issue these bonds are unlikely to go bankrupt or to fail to repay their debts, so the risk is fairly low. However, corporate bond funds are still slightly riskier than government bonds, so corporate bonds pay slightly better interest to compensate.
One type of corporate bond for most investors to avoid is the so-called high-yield bond, also known as a junk bond. As the latter name implies, such bonds are very risky. They’re offered by companies that are small, sometimes struggling, and prone to great shifts of fortune, either up or down.
Fortunes have been made by high-yield bond investors — and also lost. If you’re offered the opportunity to invest in a high-yield bond fund, examine it cautiously, and only invest money that you can afford to lose. It may happen.
Because investors are wary of high-yield or junk bonds, some brokers or other bond funds salespeople may try to sell you a high-yield bond fund without identifying it as such. If you are offered shares in a bond fund with an interest rate two or three percentage points higher than other funds you are considering, be careful! Chances are that the risk associated with the fund is very high, even if the salesperson doesn’t reveal the fact.

Municipal bond funds

A municipal bond is an IOU issued by a state, country, city, or other local government, often designed to raise money for a particular purpose. A county may issue bonds, for example, in order to borrow money to build a new airport, fix local roads, or expand a park. A municipal bond fund invests in a portfolio of such bonds.
Municipal bonds often pay slightly lower interest rates than other government or corporate bonds. Their popularity stems from their tax advantages. The interest from most municipal bonds is exempt from federal income taxes. Furthermore, you don’t pay state taxes on municipal bonds issued within your own state; and, if you pay local income taxes (as residents of New York City do, for example), you can even find triple tax exempt bonds that are free from local income taxes, too.
To decide whether a municipal bond fund makes sense for you, figure out what tax bracket you are in. (This will depend on your annual income as well as the number and kind of tax exemptions and deductions you enjoy. Any tax advisor can help you determine this.)

Money market funds

A money market mutual fund invests in short-term bonds issued by the U.S. government, large corporations, states and local governments, banks, and other rock-solid institutions. A money market fund is considered a conservative investment with little possibility of losing money; in fact, many investors and financial experts refer to money market funds as a cash equivalent, almost as safe and liquid as money in the bank.
Because money market investments are short-term (that is, bonds that are to be paid off within a few weeks or months), they closely reflect current interest rates. Most money market mutual funds are currently earning about 4% interest (computed as an annual growth rate).
During the early 1980s, when inflation and interest rates were both very high, money market funds earned over 10% annually. Such growth is unlikely to return unless economic conditions change dramatically.
You can invest in money market funds through a mutual fund company or a bank. In most cases, banks pay slightly lower interest rates than do mutual fund companies. Also remember that your money market investment through a bank is not federally insured, unlike ordinary bank deposits. A money market fund is a good place to keep money that you may need in a hurry. It’s also a handy parking place for money that you plan to invest somewhere, but you just haven’t decided exactly where.
For example, Joanne gets a larger-than-expected end-of-year bonus from the company where she works — $2,500. She can deposit the bonus check in a money market fund managed by a mutual fund companies. It will immediately begin earning about 4% interest. Over the next month or two, Joanne can take her time to research other investment opportunities. If she then decides to invest the bonus in a growth fund (for example), she can move the money from the money market fund into the growth fund simply by placing a call to the mutual fund company.

Exploring Bond (Fixed Income) Funds

Bond funds invest in many kinds of bonds, which represent IOUs from business or government agencies to which money has been lent. The primary objective of a bond fund is income from the interest paid on the loans. Whereas the value of a stock constantly changes in ways that are often unpredictable, the interest income on a bond is predetermined and can be relied upon, unless the business or government agency runs into serious financial difficulties. Thus, bonds are sometimes called fixed income securities, and bond funds may be referred to as fixed income funds. Because bond funds are usually less volatile and lower-risk than stock funds, they are often chosen by investors whose main objective is safety. Therefore, consider bond funds for short-term investment goals. In addition, many investors like to keep a portion of their money in bonds at all times, as a way of guarding against large, unexpected shifts in the stock market.

Emerging Market Mutual Funds

An emerging market mutual fund is a type of international fund that invests in so-called emerging markets, such as Latin America, Africa, Southeast Asia, the Middle East, and Eastern Europe.
Emerging market funds are relatively risky for several reasons. Currency values are often volatile, making currency risk greater than with the developed nations of Europe or Asia; political problems are more likely, which can affect the economic prospects of a country and therefore the value of your investments. In addition, stock markets in emerging nations are usually less liquid because you have fewer investors looking for stocks to buy.
You can make big returns from an emerging market fund, especially if your fund’s manager is fortunate enough to pick countries or companies that are on the verge of successful business breakthroughs.
But the potential for large losses is always present. Consider investing part of your portfolio in an emerging market fund, but only a portion that you can afford to lose.

International Mutual Funds

More and more investors today are seeking investment opportunities outside the United States. This makes economic sense. Although the United States is still a dynamic, growing nation, it’s also a mature country, whose business, social, and economic structures are largely in place. By contrast, some other regions of the world have the potential of growing very quickly in the years ahead, as they try to rapidly catch up to the United States in terms of industry and consumer spending.
Investors seeking growth opportunities should consider putting at least part of their money into international or global mutual funds, which specialize in foreign investments. Naturally, international investing involves many complexities. Someone who invests in foreign stocks has to worry about foreign economies, interest rates, tax laws, political conditions, and business practices. But with an international mutual fund, the fund manager does all the research — and the worrying — for you. You gain exposure to overseas opportunities without the headaches.
One type of risk that is unique to international investing is currency risk. When you put $1,000 in an international fund, you are, in effect, buying foreign currency, because the fund has to change your dollars into German marks, Russian rubles, Indian rupees, or some other foreign money before it can be invested.
As you know, the exchange rate between U.S. currency and other currencies is constantly in flux, based mainly on changes in the world and local economies. One day, the U.S. dollar may be worth 110 Japanese yen; the next day, it may rise to 150 yen. When the U.S. dollar is up, the relative value of your foreign holdings will go down. On the other hand, when the dollar drops, your foreign currencies go up, which is an added benefit to your portfolio.
To minimize the dangers of currency risk, try to limit your international investing to long-term money — funds you won’t need to withdraw quickly. By exercising patience, you can wait for a favorable movement in currency values before you sell your shares. Also, try to diversify your international holdings. Pick funds that invest in several international economies rather than just one. Currency losses in one country can offset profits in another.
International funds include funds that invest in specific countries, such as England or Japan, as well as regional funds. The term global is generally used to describe funds that invest in U.S. companies as well as foreign ones.

Growth and Income Funds

A growth and income fund is generally lower in risk than a growth fund. Such a fund invests in companies that have good growth potential but also pay dividends to their investors.
The fact that the fund profits in at least two ways from its investments cushions volatility, making it more of an “allweather” fund than the more uncertain growth fund. This type of fund is less volatile because the dividends keep coming even if the stock price goes down.
In most cases, stock dividends represent a relatively minor portion of the profits you make from a mutual fund. In a recent year, for example, stocks listed in the S&P 500 Index paid an average dividend of about 1.3%. (Thus, if you owned a share of stock priced at $75 which paid the average dividend, you’d receive, in the course of the year, checks totaling $0.97 per share — not a huge sum by any standard.) On the other hand, the average dividend yield from an aggressive growth fund in the same year was just 0.2%. Obviously, if the security of knowing that dividends are rolling in is important to you, stay with a growth and income fund rather than seeking aggressive growth.

Aggressive Growth Funds

If a growth fund seeks companies that can grow at 60 miles per hour, an aggressive growth fund is like a race-car driver. The manager of such a fund buys stocks she thinks have the most exciting growth possibilities, including small cap stocks, stocks of companies that are developing new technologies, and stocks in firms whose business is likely to double or triple within a few years.
In pursuit of higher returns, aggressive growth funds take greater risks and are subject to greater volatility. If you invest in an aggressive growth fund, your money may shrink by 50% one year and grow by 100% the next. Don’t pick this kind of fund unless you can handle a financial roller-coaster ride. An aggressive growth fund also may use financial techniques that involve more risk. One example is the use of options and other so-called derivative instruments. When an investor buys an option, he buys the right to buy or sell a stock (or other security) at a prespecified price at some time in the future. In effect, an option is a bet that the price of a security will move in a specific direction, up or down. If the investor bets right, the profits can be large; if he bets wrong, the losses can be just as large.
If you suspect that a mutual fund is being managed in a highrisk fashion, study the prospectus carefully. If the document indicates that the fund manager is investing in options, futures, or other derivative instruments, make sure you understand the degree and nature of the financial risk involved. And don’t invest more money than you can afford to lose. Gambling a little can be fun — but not with the money you’re relying on for retirement or your kids’ education.

Understanding Growth Funds

A growth fund is a stock fund managed primarily in pursuit of capital gains — that is, most of the profit sought by the manager takes the form of higher share prices rather than dividends paid. The manager of a growth fund is interested in finding industries that are rapidly expanding due to economic, business, or social trends and individual companies that are managed so effectively that they are growing quickly. A growth fund may invest in stocks of large, small, or mid cap companies. The success of the fund depends heavily on the expertise of its manager and his ability to pick winners from among the many companies competing in a particular industry.
For example, one industry for which many economists predict a bright future over the next two decades is pharmaceuticals, which manufacture drugs, medicines, and other health-related products. As the large baby boom generation born in the 1940s and 1950s ages, their need for medical care is likely to increase, and pharmaceutical companies are positioned to enjoy growing sales and profits.
The manager of a growth fund probably wants to follow the pharmaceutical industry closely. However, to be successful, the fund manager also needs to identify the individual companies in the industry whose stock is likely to perform best. Key to successful fund management is staying informed about the management of the leading pharmaceutical firms — Pfizer, Merck, Glaxo, Lilly, and others — and listening for news about breakthrough medicines in development at each company.
The growth fund manager who can accurately guess which firms are destined to do well in the years to come will make profitable stock selections, and investors in his fund will benefit accordingly.
A growth fund is usually a good investment for the long-term investor. For example, if you’re investing for a retirement that is 20 years or more in the future, you may want to put half or more of your investment money into a growth fund, which should benefit from upward trends in the economy during the coming decades.

Understanding Mid Cap Funds

As its name suggests, a mid cap stock fund (also known as medium cap) falls between small cap and large cap funds, usually owning shares in companies that have market capitalization between $1 billion and $5 billion. Some business sectors that contain mid cap stocks are utility companies (such as oil, gas, and electric companies), service companies (such as retail chains), and some technology companies. Mid cap fund performance tends to fall between that of small and large companies, too: mid caps face less risk of failure than small cap stocks, but have better earnings potential than large cap stocks.

Understanding Large Cap Funds

A large cap fund specializes in stocks with a market value of more than $5 billion. Such a fund focuses on large, wellestablished companies, which tend to have lower risk than small companies. Large firms also often provide dividend income, which smaller and newer firms rarely do. Examples of large cap companies are IBM and General Motors. (They are also known as blue chip stocks, named after the most expensive chips used for gambling games like poker.)
As always, the benefits of large cap funds come with tradeoffs.

Although a large cap fund is relatively low-risk, growth is likely to be steady, but slow in most economic circumstances. A big, old company like General Motors has a well established position in the auto marketplace, and the number of cars sold in the United States or the world is probably not going to double or triple in the next five years. By contrast, sales could grow that quickly in a brand-new industry such as biotechnology. Thus, a large cap fund is a good choice for a more conservative investor, or for that portion of your portfolio that you don’t want to take chances with. (These generalizations don’t always hold true. At times, large cap funds actually grow more quickly than small cap funds. But such times are the exception rather than the rule.)

Understanding Small Cap Funds

Some stock mutual funds are characterized by the market capitalization of the companies whose shares they own. Market capitalization is the value that the stock market assigns to a company, derived by multiplying the stock price by the total number of shares.
For example, if a particular company’s stock has a current price of $42 per share, and 10 million shares of stock are held by investors, the company’s market capitalization would equal $42 10 million = $420 million. Theoretically, this is the purchase price to buy all the shares of the company on the open market.
A small cap fund specializes in companies with a relatively small market capitalization — usually below $1 billion. Some small cap funds focus on start-up companies, often in new or emerging industries such as high technology. Others focus on established companies that have plenty of room for growth. Office Depot, the popular chain of office supply stores, is a current example of a growing small cap company. The smaller firms whose stock is owned by a small cap fund can be very profitable investments, but they can also be risky. If the company managers make a few mistakes — expanding too quickly, for example, or sinking too much money into an unproven technology — the firm may go bankrupt. Thus, the manager of a small cap fund needs to have a shrewd sense of business judgment in order to separate the truly promising small firms from those that are shaky.
You may want to put a portion of your investment money into a small cap fund — but not all of it. For example, if you invest 20% of your savings in a small cap fund, you have the opportunity to enjoy rapid growth if the fund does well, without running the risk of losing your whole retirement or college portfolio if the fund runs into bad luck.

Understanding Index Funds

To understand index funds, you must first understand what a stock market index is.
A stock market index is a list of stocks whose combined performance is tracked by investors as an indication of the health of a particular portion of the economy. Even people who know little or nothing about the stock market have heard of some of the more famous indexes and the companies they track—for example, the Dow Jones Industrial Average, the oldest and best-known index, tracks the stocks of 30 of America’s bigger, more famous firms, including American Express, Coca-Cola, Walt Disney, McDonald’s, and Wal-Mart Stores.
The value of the Dow is calculated by combining the share prices of all 30 companies according to a special formula. As the values of these companies rise and fall, the Dow rises and falls with them.
Because the Dow reflects the performance of the stock of only 30 companies, it can’t accurately reflect the diversity of the entire U.S. economy — much less the world economy. So over the years, other indexes have been invented by various financial companies, each mirroring the performance of a different group of stocks:

• The Standard and Poor’s (S&P) 500 Index: Tracks the performance of some 500 large U.S. companies. S&P 500 is often referred to as a “broader” index than the Dow because it’s more inclusive and therefore reflects more general trends in American industry.
• The Wilshire 5000 Index: Tracks virtually the entire U.S. stock market.
• The Russell 2000 Index: Tracks smaller, fast-growing companies.
• The Morgan Stanley Select Emerging Markets Index: Tracks companies in developing regions of the world, such as South America, Southeast Asia, and Eastern Europe.

An index fund is a mutual fund that buys the stocks contained in a particular index. For example, the Vanguard Index Trust — the first index fund, founded in 1976 — owns shares of all the companies in the S&P 500. The investment objective of an index fund depends on the index being followed. A broad index reflects changes in the overall economy, which usually moves more gradually than any single business sector. Thus, a broad index is usually less volatile than a more narrow one; and so, in general, the broader the index, the more conservative the fund. Index funds are available today based on every popular stock market index.
As you may imagine, managing an index fund is less challenging than managing most other fund types. The manager of an index fund is simply charged with buying and selling stocks to match those contained in its index. This style of fund management is sometimes called passive investing. By contrast, other funds are run by managers who must constantly make independent investment decisions; this is known as active investing.
Because passive investing calls for less complicated managerial decisions, the cost of running an index fund is less than with other fund types. Thus, investors in index funds generally incur lower management fees.
In general, index funds perform well; in fact, the majority of funds that are actively managed actually grow less quickly than such broad indexes as the S&P 500! “Beating the indexes” isn’t an easy challenge, even for a highly skilled professional money manager. So index fund investing has become a particularly popular choice among investors who want to enjoy some of the strong growth possible in the stock market while minimizing the risks that go with active management. Because passively managed funds trade less often than actively managed funds, index funds generate less capital gain income than most other funds.

Defining Stock (Equity) Mutual Funds

Stock mutual funds (sometimes also called equity mutual funds) invest primarily in stocks (also called equities). Although you can find many specific types of stock funds with widely varying risk and reward characteristics, stock funds in general outperform bond funds. Stock funds are top performers because they’re invested in the stock market, which has proven, over many decades, to be the world’s fastest-growing investment arena.
Over the past 20 years, the return of stock funds has been quite good — about 14.8% in average annual gain, including all kinds of profits (growth in net asset value, dividends, and capital gains).
However, a tradeoff is involved. The higher growth of stock funds comes with somewhat greater risk. Stock funds may rise or fall, depending on the behavior of the overall stock market, of particular industries, or of the specific companies selected by the fund manager. In a prolonged bear (declining) market, stock funds may even stagnate for a period of months or years.
The longer your investment horizon (that is, the more you are focused on long-term rather than short-term investment goals), the more appropriate stock funds are for your portfolio. If you expect to cash in your investment within the next three years, you should consider keeping all or most of your money in bond funds or other relatively safer investments. Not all stock funds behave alike. Wide variations are possible among stock funds in terms of risk, volatility, and growth potential. The following sections highlight some common types of stock funds, with explanations of how each kind of fund can be expected to perform.

No maturity dates

Another disadvantage of mutual funds relates specifically to bond funds — that is, funds that specialize in bonds rather than stocks or other investments. Typically, when you invest in an individual bond, you are given a maturity date — that is, the date when the loan represented by the bond comes due. On that date, you get back the amount you paid for the bond (the principal), plus interest. The return is certain, unless the company or the government body that issued the bond runs into financial difficulties. An investment in a bond fund works differently. The fund manager is continually buying and selling bonds with a variety of maturity dates. Periodically, you receive a portion of the interest earned by the fund. However, no specific maturity date exists for your shares in the fund, and thus no certainty about the amount you can expect to receive when you decide to sell your shares. You may end up selling your shares in the fund for more or for less than you paid.

Uncertainty about redemption price

When you own an individual stock, you can choose to sell it at any time during the trading day (that is, while the stock market is in operation), and you will get the price that’s current at the moment you sell. When the stock market, or a particular stock, is very volatile, your selling price can change significantly throughout the day.
For example, the stock of an individual company may start the trading day at a price of $40.00 per share, rise to $45.00 by the middle of the day, and then fall to $37.50 by the end of the day. A simple calculation shows how time can affect the amount of money you may make from selling 100 shares: from an early morning $4,000, to an afternoon $4,500, to a day’s end $3,750.
When you want to redeem (that is, sell) shares of a mutual fund, the time of the day when you submit your request (by phone, fax, Internet, or mail) doesn’t matter. Although the net asset value (NAV) of the fund may rise and fall throughout the day, you always end up receiving a check based on the closing price for the end of the trading day (4 p.m. Eastern time). If you want to be relatively certain of the NAV at which your shares will be redeemed, place your sale order at or near the end of the trading day. That way, you know that the price quoted over the phone will probably be the same, or almost the same, as that day’s closing price.

Tax inefficiency

Another disadvantage to mutual funds is that stock funds (also called equity funds) are not very “tax-efficient.” Here’s how this inefficiency plays out in your overall investment picture:

When you own individual stocks, you decide when to buy and sell them.
When you sell a stock that has increased in price, you receive a type of profit known as a capital gain. At the end of the year, you must pay taxes to the IRS on all the capital gains you enjoyed during that year. But with mutual funds, the schedule of stock purchases and sales is up to the fund manager —you don’t have control of the timing.

Fortunately, there are funds managed specifically to minimize tax inefficiency. I explain how this works in Chapter 9. Many stock investors carefully regulate their sales of stock so that they incur capital gains when the additional money is less burdensome to their tax situation. For example, a stock investor might choose to realize her capital gains during a year when her salary from work is smaller, thereby reducing her overall tax rate.
Mutual fund investing, however, means that you may receive capital gains distributions from the fund at any time. Of course, you end up paying taxes on these at the end of the year. At tax time, mutual fund firms send out copies of Tax Form 1099-DIV to their mutual fund investors. The document details taxable earnings. Don’t fail to report this income on your return; the fund company is also reporting it to the IRS, which will check for discrepancies.

If you are in a high tax bracket — that is, if your overall income is large enough to make your federal tax rate burdensome — and if you have a significant amount of money to invest in the stock market (say, $25,000 or more), you may want to consider investing in individual stocks rather than mutual funds so that you can better control the tax effects of your investments.

Lack of insurance for fund investments

Unlike your deposit in a bank, credit union, or savings and loan association (S&L), your investment in a mutual fund is not insured by the Federal Deposit Insurance Corporation or any other government agency. (Supervision of investment companies by the Security Exchange Commission and other organizations does not insure the value of your investment.) Therefore, when the fund invests in securities that rise and fall in value, you have the possibility of losing your initial investment.
In some states, mutual funds may be sold by banks and S&Ls or by brokerage companies associated with them and housed on the same premises. Read the fine print, and don’t be confused. Although you may make a mutual fund investment over a counter in your local bank, your money will not be insured the way a bank deposit is. Walk, don’t run, from any banker who implies the opposite.

Unclear investment approach

Sometimes funds are managed in ways that contradict the image presented in advertising or promotion. A fund that is touted as a conservative fund — one that selects investments so as to minimize risk and volatility — may be managed in an aggressive manner, putting money into highly volatile small-company stocks, for example.
A fund that calls itself a stock fund may actually keep a sizeable portion of its investment money in cash or in short-term government bonds, which are considered equivalent to cash; thus, it may miss out on some of the gains enjoyed during a strong period for the stock market.
Instead of relying solely on advertising, press accounts, or the advice of a broker, always ask for a prospectus before investing in a fund. This is a detailed description of the fund and its investments, written according to government guidelines. Compare what you read in the prospectus with the sales pitch presented in ads or by a broker. If you feel there’s a contradiction between them, don’t hesitate to ask about it.

Risk involving changes in the market

Even with expert management, however, the risk involved in mutual fund investing does not disappear. Sometimes, the stock or bond market as a whole may be in decline, and even smart investors are unable to make a profit. Such hard times are referred to as bear markets.
The opposite of a bear market is a time when the markets are steadily rising — bull market. Pessimistic investors are sometimes referred to as bears, while optimists are bulls. Now you understand the livestock references that you often hear scattered throughout financial news reports!
If you’re a long-term investor, bear markets may not be a problem. You can probably wait until the market rebounds before selling your shares. A short-term investor, however, may get stuck with losses. Although you can’t avoid risk altogether, you can choose money market mutual funds or other investments that don’t tend to fluctuate dramatically.

Risks involving fund management

These days, mutual funds are among your safer investment options. Diversification, professional management, and the fraud-prevention exercised by the Security Exchange Commission and other regulatory bodies all help ensure that mutual funds stay relatively safe. Nonetheless, investing in mutual funds carries various kinds of risk that can impact your financial planning.

One risk that’s inherent in the nature of mutual funds is the fact that you, the investor, have no control over what’s being purchased for the portfolio. You are putting your money —and your investment fate — in the hands of the fund manager, which is why you need to study the track record of the fund company and the individual manager before you invest. Making sure that you’re giving your money to a reliable partner is important to your pocketbook and your peace of mind.

Another unpredictable challenge may arise when a fund’s “star” manager retires or changes jobs, leaving the fund without his expertise or brilliance. For example, Peter Lynch was one of the most successful and famous mutual fund managers in the world for many years. Under his guidance, the Fidelity Magellan Fund grew into the largest mutual fund anywhere, with over $72 billion in assets. Millions of investors poured money into Magellan, attracted largely by Lynch’s reputation and prestige. Since Lynch’s retirement in 1990, however, Magellan has performed with far less success, despite the strong performance of the stock market overall. If you’re a fund investor, follow the financial news. Be aware when changes in the management of your funds occur. You may want to consider switching funds when the manager responsible for your fund’s track record departs the scene.

Shareholder services of Mutual Funds

Many mutual fund companies offer a range of useful, sometimes valuable services to their customers. These may include

• Check-writing privileges
• Ability to invest, withdraw, or move money via mail, telephone, or the Internet
• Automatic investment via payroll deduction
• Record-keeping for filing your income tax return
• Access to research reports about companies, funds, and economic trends

A fund’s prospectus tells you more about such services.

Liquidity of Mutual Funds

Liquidity refers to the ease with which you can buy or sell an investment. Buying or selling a particular stock or bond, especially one held by relatively few people, may be difficult. If you need cash in an emergency, this obstacle to turning your investment into legal tender can cause inconvenience and may cost you money. By contrast, mutual fund shares can be cashed in quickly at any time by redeeming them with the managing company, usually at little or no cost.

Professional management of Mutual Funds

Mutual funds hire smart investment experts to manage your money, and they have access to extensive research into companies, economic conditions, and market trends. Most people would have a hard time keeping track of a large number of investments in many different businesses; staying on top of that financial activity is part of the daily routine for the research staff of a mutual fund.

Low cost entry of mutual funds

You can get started in mutual fund investing with relatively little money — a benefit when finances are tight, but you’re mentally ready to roll with an investment experience. When you buy shares of an individual stock, any purchase less than 100 shares is usually considered an odd lot, on which you must pay a high sales commission. But a bundle of 100 shares of stock isn’t easy for most investors to afford. If a stock is trading at (for example) $75 per share, 100 shares will cost $7,500 — a significant amount of money for most people.

By contrast, you can start investing in most mutual funds for just $1,000 to $2,000, and add to your investment later with even smaller amounts by sending a check to the fund company or arranging for automatic deductions from your checking account.) If you have only a small amount of money to invest but are eager to get started in mutual funds. This list, which is based on information provided by The Mutual Fund Education Alliance, gives you a sampling of fund companies and categories to consider when you’re looking to invest $500 or less. You can request information on specific funds by contacting any broker, the fund companies themselves, or The Mutual Fund Education Alliance (www.mfea.com).