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Archive-name: investment-faq/mutual-funds Compiler: Randy Marks, marks@ssdevo.enet.dec.com Posting-Frequency: monthly Last-modified: 04-Nov-1994 ---------------------------------------------------------------------------- V2.2 Frequently Asked Questions (FAQ) for misc.invest.funds ---------------------------------------------------------------------------- Use and copying of this information, distribution of the information on electronic media, and preparation of derivative works based upon this information are permitted, so long as the following conditions are met: * No fees or compensation are charged for this information, excluding charges for the media used to distribute it. * Proper attribution is given to the authors of individual articles. * This notice is included intact. DISCLAIMER: ----------- This question and answer list is given in the hope that it is useful, but with no express or implied warranty for accuracy, usefulness, up-to-date-ness, or anything else. Use the information contained in this list at your own risk. Before investing in any mutual fund, be sure to read the latest prospectus for the fund in its entirety. This FAQ should NOT be used in place of competent advice from investment, accounting and legal professionals. This FAQ applies to mutual funds in the USA - most things are likely to differ elsewhere. TABLE of CONTENTS: ------------------ 1: What is a mutual fund? 2: Why do people use mutual funds? 3: Are there any disadvantages to using a mutual fund? 4: What is a "closed-end fund" vs. an "open-end fund"? 5: What is "net asset value"? 6: A fund is "closed". Is that the same as a closed-end fund? 7: What expenses are there for a mutual fund? 8: What are typical expenses of a mutual fund? 9: Can mutual fund performance be guaranteed? 10: What is a "prospectus"? 11: What is a "statement of additional information"? 12: What is a "signature guarantee"? 13: What are "dividend distributions"? 14: What are "capital gain distributions"? 15: What else is there to know about distributions? 16: What is the difference between yield and return? 17: What do mutual funds invest in? 18: What is a "socially responsible" fund? 19: Where can I get comparative information on mutual funds? 20: How does buying funds directly compare with buying through a broker? 21: What does family of funds do compared to a single fund? 22: What are the tax implications of mutual funds for individuals? 23: What dates are important when investing in mutual funds? 24: How do I put mutual funds in an IRA? 25: What are the various forms of mutual fund account registration? 26: What resources are available on the Internet? ........................................................................... 1: What is a mutual fund? A: A mutual fund, or investment company, is a corporation or partnership which makes investments and passes gains, losses, and taxability through to its shareholders or partners. 2: Why do people use mutual funds? A: (1) Mutual funds provide diversification, since a fund typically owns a few dozen to hundreds of securities. (2) Mutual funds, by pooling funds from many investors, can hire investment managers less expensively, since it does not cost twice as much (in research, brokerage fees, etc.) to run a fund that is twice as large. (3) Mutual fund investment managers are subject to frequent reviews by various publications. This means that information useful for selecting a mutual fund is easier to find than information useful for selecting one's own investment manager. 3: Are there any disadvantages to using a mutual fund? A: (1) All mutual funds charge management, brokerage, and marketing expenses. These expenses vary from fund to fund. (2) Buying mutual fund shares at the wrong time can subject the buyer to earlier than normal payment of taxes. 4: What is a "closed-end fund" vs. an "open-end fund"? A: A closed-end fund has a fixed number of shares outstanding and is traded just like other stocks on an exchange or over the counter. The more common open-end funds sell and redeem shares at any time directly to shareholders. Sales and redemption prices of open-end funds are fixed by the sponsor based on the fund's net asset value; closed-end funds may trade a discount (usually) or premium to net asset value. 5: What is "net asset value"? A: The net asset value (NAV) is the value of the fund's underlying securities. It is calculated at the end of the trading day. Any open-end fund buy or sell order received on that day is traded based on the net asset value calculated at the end of the day. A few funds calculate net asset value at more frequent intervals and process trades at those values. 6: A fund is "closed". Is that the same as a closed-end fund? A: No. Some open-end funds are closed to new investors because the fund manager feels that it cannot be as effective with a very large amount of money. This typically happens with funds that invest in small companies. The open-end format remains the same, but investments are not accepted from those who do not already have accounts. 7: What expenses are there for a mutual fund? A: (1) Closed-end funds charge annual expenses for research and trading expenses. To buy and sell closed-end fund shares, the investor must usually pay additional brokerage fees, unless the investor finds someone to buy from or sell to directly. (2) Open-end funds charge annual expenses for research and trading expenses. In addition, they sometimes charge the following: (a) A front end load or sales charge. These vary from 1% to 8.5% subtracted from the amount paid and are usually used to pay commissions to brokers and financial advisors who sell the funds. Very large investors can sometimes get discounts on the front end loads. Currently, fund sponsors determine loads, but the SEC is proposing a rule to allow brokers and other salespeople to discount loads. (b) A redemption fee, deferred sales charge, or back end load. These work the same way as front end loads, but are charged when you redeem shares. In many cases, they decline or disappear after a long enough holding period. (c) A Rule 12b-1 fee. Used to pay marketing expenses, which means either commissions or advertising expenses. This is a fee that adds to the annual expenses; it may be as large as 1.25% per year. Declining back end loads are common in funds with large 12b-1 fees. A mutual fund that has neither (a) nor (b) is generally referred to as a no-load fund. No-load funds are generally not sold through brokers or financial advisors, but are sold directly to investors. Many advertise in business and financial periodicals. All of the above expenses for open-end funds are described on the first or second page of the prospectus in a standardized form. Brokerage fees paid by the fund in its trading activity are _not_ normally included in such expense tables as they are usually accounted for in the cost of securities bought. 8: What are typical expenses of a mutual fund? A: Stock funds tend to be the most expensive, with annual expenses ranging from 0.2% to 3.0% with most between 1.0% and 1.5%. Small company and international funds tend to be more expensive. Bond fund expenses range from 0.2% to 2.0%, with most around 1.0%. Money market funds tend to be the least expensive, ranging from about 0.2% to 1.0%. See a later answer for a more detailed description of these funds. Note that some funds, particularly money market funds, waive expenses for a limited time to boost yield (and make good ad copy). About one half of stock and bond funds have loads (front or back end), but money market funds do not normally have loads, though some have 12b-1 fees. 9: Can mutual fund performance be guaranteed? A: No. As many funds state, past performance is no guarantee of future results, and the fund shares are not backed or guaranteed by the FDIC or other government agency. Note that while some funds buy government backed securities, that is not the same as backing the market value of the fund shares. 10: What is a "prospectus"? A: It is a document which an open-end fund, or newly issued closed-end fund, is required to provide to investors. Funds say that investors should read it carefully before investing or sending money. A prospectus contains descriptions of: (1) fees, in a standardized format (2) investment objective (3) some financial data (4) investment methods, risk description (5) investment manager and compensation (6) how to buy shares (7) how to sell shares, including signature guarantee requirements (8) dividend and capital gain distributions (9) other services 11: What is a "statement of additional information"? A: It is a document that is designed to be read along with the prospectus; however, it is not required to be given to investors before or after they invest (i.e. investors have to ask for it). It contains information such as brokerage selection, description of the fund's investment adviser, etc. 12: What is a "signature guarantee"? A: It is a guarantee by a financial institution that your signature is genuine and the financial institution accepts liability for any forgery. It is typically required for large or unusual redemptions of open-end mutual funds, though some funds require it for all redemptions. At many funds, the guarantor must be a commercial bank or NYSE member brokerage firm; some funds accept savings and loan associations or credit unions (be careful, some savings and loan associations have bank-like names). 13: What are "dividend distributions"? A: A mutual fund may receive dividend or interest income from the securities it owns; it is required to pay out this income to its investors. Most open-end funds offer an option to purchase additional shares with the distributions. Dividend distributions are often made monthly or quarterly, though many funds make distributions only yearly. 14: What are "capital gain distributions"? A: A mutual fund may, in the process of trading, realize capital gains. These must be distributed to investors. As with dividends, there is usually the option to reinvest in additional fund shares. Capital gain distributions generally occur late in the year, but some funds make additional distributions at other times. Funds with high turnover of securities often make significant capital gain distributions every year, while funds with low turnover of securities may accumulate unrealized gains for several years before making a large capital gain distribution. Also, funds that are increasing in size tend to make smaller capital gain distributions because they buy more than they sell, while funds decreasing in size tend to make larger capital gain distributions because they sell more than they buy. 15: What else is there to know about distributions? A: A distribution lowers the net asset value of the fund by the amount of the distribution. The shareholder does not actually lose money because of the distribution, since s/he gets cash or additional shares to compensate for the lower net asset value. Distributions have important tax consequences as detailed later. 16: What is the difference between yield and return? A: Do not confuse the two terms. Return is sometimes called total return. The formula for total return (ignoring any taxes paid on gains and income during the holding period) is: TR=((Ending Market Value)/(Beginning Market Value))-1 Yield is a very different number --- it is prospective not retrospective. It is a measure of income not capital gains. It is usually associated with debt not equity. For instance, the yield quoted on a bond will almost never be the same as the total return realized after the bond matures or is sold. 17: What do mutual funds invest in? A: Almost anything. There are funds that invest in almost anything an investor could want to invest in. The most common types are described below. (1) Money market funds: these try to maintain a constant (usually $1) NAV per share (though they cannot guarantee that), while yielding dividends from their investments in short term debt securities. They offer very low risk, but usually low long term return. Most restrict investments to the top two (out of four) Moody's and Standard and Poor ratings for short term debt; some (including national government only funds) restrict themselves to only the top rating, providing a bit of extra credit safety, usually at a slightly lower yield. Most also invest in repurchase agreements (repos) collateralized by short term debt securities; these are subject to credit or fraud risk of the other party in the repo (regardless of the credit risk of the securities being repoed). Their market value is NOT insured by the FDIC or other government agency. Enough defaults in the fund's securities can cause it to be unable to maintain its constant NAV. (a) Regular funds: invest in short term debt of all types. (b) Government funds: invest only in national government or government agency debt or repos involving such debt. Slightly lower credit risk than regular funds. (c) Treasury funds: invest only in direct obligations of the national government or repos involving these securities. Lowest credit risk and dividend distributions are exempt from state income taxes in most states. (d) Municipal funds: invest only in debt of state or local governments. For most individuals, dividend distributions are exempt from national income taxes. (e) Single state municipal funds: invest only in debt of one state or its political subdivisions. For most individuals, dividend distributions are exempt from national income taxes and that state's income taxes. Note that a single state fund is usually less diversified than a regular municipal fund and might be considered riskier for this reason. (2) Bond funds. These invest in longer term debt securities. Thus the short term risk is greater than the infinitesimal risk of the money market. But returns are usually higher. Their NAVs may fluctuate due to both interest rate risk and defaults. Unlike individual bonds, most bond funds do not mature; they trade to maintain their stated future maturity. The types of debt are similar to those of money funds (but longer term); however, futures and options are sometimes used for hedging purposes. The other classifications are described below: Time to maturity, interest rate risk: (a) Short term: usually less than 5 years maturity. Interest rate risk is low. (b) Long term: up to 30 year average maturity. Interest rate risk is high. (c) Mortgage backed securities: have some unusual interest rate risks. When interest rates rise, they lose value like other bonds. When interest rates fall, homebuyers refinance, causing them to prepay old mortgages, which in turn causes bonds backed by these mortgages to be called. In addition, when rates rise, the MBSs extend due to slower prepayments --- thus their duration goes up with interest rates and the bonds lose money at an accelerating rate. When rates fall the prepayments speed up and the bond gains money at an ever slower rate. This property is called Negative Convexity. It is also a gross over-simplification. There are MBSs with positive convexity. A 14 year old 13% MBS's prepayments are functionally independent of rate moves for example, also prepayment risk is shuffled all over the place in CMOs. The compensation paid to MBS holders for the negative convexity is in higher yield. Basically the buyer of a mainstream MBS is betting that rates will not change too much (that interest rate volatility will be lower than the volatility implicit in the price). Over time this is true. MBS indices have outperformed Treasuries in all but a couple of the last 12 years. (d) Adjustable rate: this type of fund is like other mortgage backed funds, but it invests in adjustable rate mortgages. Therefore, the two sided interest rate risk faced by fixed rate mortgage backed bonds in considerably reduced. However, the interest income will fluctuate widely, even though the principal value is more stable. Since most adjustable rate mortgages have caps on how high the rate can go (typical limits are a 2% increase during a year and 6% increase during the life of the loan), risk increases if interest rates increase quickly or by a large amount. (e) Target maturity: the few funds in this category buy only bonds of the given maturity date. Thus one can actually hold these to maturity. Credit risk: (a) Investment grade: restricted only to bonds with low to medium-low credit risk (national government bonds are usually considered lowest risk). This generally means the fourth highest Standard and Poor's or Moody's rating (S&P BBB or Moody's Baa). Some funds have higher standards. (b) High yield or junk: buys bonds of any credit rating, seeking maximum interest yield at a greater risk of default. (3) Stock funds. These invest in common and/or preferred stocks. Stocks usually have higher short term risk than bonds, but have historically produced the best long term returns. Stock funds often hold small amounts of money market investments to meet redemptions; some hold larger amounts of money market investments when they cannot find any stock worth investing in or if they believe the market is about to head downward. Some of the possible investment goals are described below. They are not necessarily mutually exclusive. (a) Growth. These funds seek maximum growth of earnings and share price, with little regard for dividends. Usually tend to be volatile. (b) Aggressive growth. Similar to growth funds, but even more aggressive; tend to be the most volatile. (c) Equity income. These funds are more conservative and seek maximum dividends. (d) Growth and income. In between growth funds and income funds, they seek both growth and a reasonable amount of income. (e) Small company. Focuses on smaller companies. Usually of the growth or aggressive growth variety, since smaller companies usually don't pay much dividends. (f) International. Focuses on stocks outside the USA, generally investing in many nations' companies. (g) Country or regional funds. These funds buy stocks primarily in the designated country or region. (h) Index funds. These funds do no management, but just buy some index, like the Standard and Poor 500. Some index funds, particularly those emulating indices with large numbers of stocks such as the Wilshire 4500 or Russell 2000, emulate the index by buying a subset with similar industry mix, capitalization, price/earnings ratio, etc. Expenses are usually very low. (i) Sector funds. These funds buy stocks only in one industry. Usually considered among the riskiest stock funds, though different sectors tend to have different levels and types of risk. (4) Balanced funds. By mixing stocks and bonds (and sometimes other types of assets) a balanced fund is likely to give a return between the return of stocks and bonds, usually at a lower risk than investing in either alone, since different types of assets rise and fall at different times. An investor can create his/her own balanced fund by buying shares of his/her favorite stock fund(s) and his/her favorite bond fund(s) (and other funds, if desired) in the desired allocation. (a) Regular balanced funds: These funds usually hold a fixed or rarely changed allocation between stocks and bonds. (b) Asset allocation funds: These funds may switch to any allocation, usually based on market timing to some degree. (5) Multifunds. These funds buy primarily other mutual funds. They choose other funds based on one or more of the investment goals outlined above. (a) No-management funds: These funds hold fixed proportions of other funds. They are offered by fund companies as cheap balanced funds -- the underlying funds are other funds managed by the same company. There are generally little or no expenses other than those of the underlying funds. (b) Managed funds: In these funds, a manager picks which other funds s/he believes are managed well. Sometimes these funds are market timing funds which prefer to leave the stock picking to other managers. These funds have expenses above and beyond those of the underlying funds. 18: What is a "socially responsible" fund? A: In addition to the usual investment goals, these funds restrict their investments to whatever they define as socially responsible. Such criteria can include: avoiding military, alcohol, tobacco, and gambling industries, avoiding South Africa, preferring companies that treat their employees and the environment well. Different funds have different social and investment criteria. 19: Where can I get comparative information on mutual funds? A: Brokers and financial advisors offer information, but they usually give information only on load funds. However, many periodicals have regular mutual fund review issues: Barron's (quarterly) Money Magazine (Nov.) Business Week (Feb.) Forbes (Sept.) Fortune (fall) Consumer Reports Wall Street Journal Investors Business Daily Morningstar Mutual Fund Report In addition, there are many books available on mutual fund investing. Different periodicals and books use different criteria to rate funds. These periodicals and books usually have phone numbers which you can call to get the fund's prospectus and other information. Note that some ratings account for loads, while others do not. Past performance is no guarantee of future results of either the fund or the securities markets in general. 20: How does buying funds directly compare with buying through a broker? A: A load fund usually costs the same whether bought directly or through a broker. A no-load fund can be bought directly at no charge; most brokers will charge a commission to buy a no-load fund. Some discount brokers now offer some no-load funds at no transaction fees; normally, they receive a portion of the funds' annual expenses instead. Holding funds in a broker may make it easier to trade from one fund to another, however. Closed-end funds usually need to be traded through a broker, like regular stocks, though some have dividend reinvestment plans. 21: What does family of funds do compared to a single fund? A: Families of funds sometimes offer additional services, such as telephone switching from one fund to another within the family. With load fund families, switching from one load fund to another is sometimes allowed without paying a second load. Some families may make bookkeeping easier by listing all of an investor's different funds on one statement. Others reduce expenses by sharing services which realize economies of scale. Note, however, that the good advertised performance of one fund in a family may or may not be shared by others. 22: What are the tax implications of mutual funds for individuals? A: Like shares of any stock, selling mutual fund shares may cause you to realize a capital gain or loss. Mutual funds also distribute dividends received and their own realized capital gains, usually at the end of the year; these distributions, whether taken in cash or reinvested, are taxable (note that the nontaxability of municipal bond funds applies only to dividend distributions; capital gain distributions are always taxable). Thus it is often a bad idea to buy a mutual fund just before the distribution date, since part of your investment will be immediately returned to you as a taxable distribution, resulting in you paying taxes much earlier than if you bought just after the distribution. Although the distribution lowers the net asset value of your shares, allowing you to "deduct" it when you sell the shares, paying taxes sooner rather than later prevents you from gaining investment income on the amount that is taxed. Note that reinvesting is considered identical to taking the distribution in cash and sending the same amount into the fund as a new investment, so don't forget about it when calculating the basis in your account. When selling, it is best to know the different methods of calculating the basis of shares sold ahead of time, since some methods require that you designate which shares are to be sold. For more information, call 1-800-TAX-FORM and ask for publications 544, 550, and 564, and schedules B and D, but note that tax rules can change since the last tax year. 23: What dates are important when investing in mutual funds? A: There are several important distribution related dates to be aware of when buying and selling mutual fund shares. * Declaration date: This is the date on which the distribution is declared, followed by... * Ex-dividend date: This is the date the shares trade without the dividend. * Record date: Shareholders who own shares on this date will receive the distribution on the .... * Payment date: This is the date on which the dividend is actually paid out. 24: How do I put mutual funds in an IRA? A: Most funds have a bank or trust company arranged to be an IRA custodian for any IRA shareholders. If you buy the fund directly, using this custodian, you must use a different application available from the fund company. The custodian usually charges $10 to $15 per fund account per year. This is a significant expense for small accounts, not too significant for larger accounts. Alternatively, you can open a brokerage account IRA and purchase mutual funds within that. This would be similar to using a broker to buy funds normally, but incurs a single IRA custodian fee (usually $25 to $50). Custodian fees, but not loads or commissions, may be paid separately from the contribution, and may be separately tax deductible. Call 1-800-TAX-FORM and ask for publication 590 and form 8606 for general IRS information about IRAs (but note that tax rules can change since the last tax year). Note that the tax issues of distributions as detailed previously don't affect IRA accounts. 25: What are the various forms of mutual fund account registration? A: The way in which your mutual fund account is registered is an important factor in estate planning. The disposition of property or assets after the death of an individual is often governed by the way that property or account is titled. Listed below are descriptions for three common forms of mutual fund account registration. THESE DESCRIPTIONS ARE FOR GENERAL REFERENCE ONLY. SEEK COMPETENT LEGAL ADVICE FOR YOUR LOCALE AND CIRCUMSTANCES! Sole Ownership: Individual registration is the simplest form of ownership because one person has absolute control of the property. Owner must plan for transfer of the account when he/she dies; commonly done with a will. Otherwise state rules of succession and state inheritance laws dictate disposition of account upon death. Joint Tenant: Most common form of ownership involving 2 or more individuals. Each person owns an individual interest in the entire account. Consequently, income generated from the account is owned equally by all of the parties involved in the joint tenancy. Right of survivorship dictates that upon the death of a joint tenant, the account immediately and automatically passes to the surviving owner(s). Joint tenants do not have to be related individuals. Tenants In Common: Differs from joint tenancy in several ways. Tenants in common each own a specific portion of the account. If no specific allocation is made (e.g. two-thirds/one-third or one-half/one-half), the account is said to be equally divided among all of the tenants. Income earned on the account is divided based upon the specific allocation of ownership. As in joint tenancy, tenants in common do not have to be related individuals. There are no survivorship rights for assets held in tenancy in common. Upon the death of one of the tenants, the assets will pass to whomever the decedent names in a will. Note: Community property is a specific form of registration that is only available in certain states. The following states are community property states: Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin In community property states it may be advantageous to have title held as community property (when that is appropriate) rather than joint tenants or tenants in common because the basis (cost) of the inherited half is set to the value of the property at the time one spouse dies. It is my understanding that this basis adjustment does not occur with the other forms of title. Get the final word on tax and estate implications regarding specific forms of registration from a competent tax or legal professional. 26: What resources are available on the Internet? A: Following is a list of some Internet resources available which relate to mutual fund investing. If you are aware of resources which are not listed, feel free to E-mail a description of them to the FAQ Compiler identified at the beginning of this file. *** WWW resources *** - Experimental Mutual Fund Charts http://www.ai.mit.edu/stocks/mf.html - Free Mutual Fund quotations direct from NASDAQ http://networth.galt.com/www/home/info/nav/netnav.htm - The Mutual Fund Market Manager http://networth.galt.com/www/home/mutual/mutualmn.htm *** Newsgroups *** - misc.invest misc.invest FAQ - misc.invest.funds misc.invest.funds FAQ (this file)