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Mutual Funds: What They Are and How They Work
By Susanna M. Zysk

Mutual funds are a popular investment choice for many investors. There are currently over 93 million Americans investing in over 10,000 mutual funds.* Although the first mutual funds were established in 1924, their popularity has grown most significantly in the last 20 years, since the introduction of Individual Retirement Accounts (IRAs) and 401(k) plans. Before you invest in mutual funds, it is important to fully understand what they are and how they work.

* Source: 2002 Mutual Fund Fact Book: A guide to trends and statistics in the mutual fund industry, 42nd Edition, Investment Company Institute.

What is a Mutual Fund?

A mutual fund is a professionally managed pool of money invested in a variety of individual securities, such as stocks and/or bonds. In addition, mutual funds may hold cash or cash equivalents. Investors purchase shares in a fund that represents an ownership in the fund’s holdings. Your money is pooled together with other investors and the fund’s manager invests the money for you.

Benefits of Mutual Funds

There are many kinds of mutual funds, but they all share common benefits.

Professional Management. Investment companies offer mutual funds managed by fund managers who choose investments that match the fund’s objectives. Their investment decisions are based on their extensive knowledge and research of market conditions and the financial performance of individual companies and specific securities. When economic conditions change, the fund manager will adjust the investments’ mix in the fund so that it continues to meet its investment objectives.

Diversification. Mutual funds generally own stocks and bonds from many companies, which offers instant diversification. Investing in a variety of securities helps reduce risk by offsetting losses from some with the gains of others. Your exposure to risk is reduced by investing in a wide range of securities offered through a mutual fund rather than one or two individual stocks.

Convenience and Accessibility. Mutual funds are relatively easy to buy. Individual investors have access to many stocks and bonds that previously may not have been available, or required prohibitive minimum-dollar investments.

Variety. There are thousands of mutual funds representing a wide variety of investment objectives – ranging from conservative to aggressive – available to you. The fund types cover many investment strategies and risk levels, so you should be able to find a fund that meets your personal financial goals and risk tolerance.

Strict Regulation. Mutual funds are highly regulated by the federal government through the Securities and Exchange Commission (SEC). The regulations require funds to meet certain operating standards, observe strict antifraud rules, and disclose complete information to current and potential investors. Disclosure about a particular fund can be found in the fund’s prospectus. The prospectus provides such information as investment objective and methods, how to buy and sell shares, risk assumed, and fees and expenses.

Types of Mutual Funds

There are three basic types of mutual funds: money market, bonds and stock (also called equity).

Money Market Funds are generally comprised of money market investments, certificates of deposit (CDs) and U.S. Treasury securities. They can also include Guaranteed Investment Contracts (GICs) issued primarily by insurance companies.

· Benefits: A high degree of security, designed to protect your original investment.
· Risks: Stable value funds don’t offer the income potential of bond funds or the growth potential of stock funds.

Bond Funds invest in many individual government and corporate bonds. Bond funds generally earn interest, which is also referred to as income or yield.

· Benefits: Bond funds generally offer greater income potential than stable value funds and not as much risk as stock funds.
· Risks: Typically, bond funds don’t offer the growth potential of stock funds, and are riskier than stable value funds.

Stock Funds or equity funds offer different investing strategies, ranging from conservative to aggressive, with varying degrees of risk and return potential. Stock funds invest in many different individual stocks.

· Benefits: Historically, stocks have provided larger long-term gains than other asset classes.
· Risks: The value of stocks can go down over short periods of time. As a result, there is greater risk to your savings, including your principal, compared to other asset classes.

Common types of stock funds include:

Ø Growth Funds invest in corporations with the potential for increased future earnings.
Ø Value Funds invest in underpriced stocks that a fund manager determines are a bargain. For example, if the company’s industry or business situation improves, so might its stock prices.
Ø Index Funds seek to match the performance of a broad segment of a securities market, like the Standard & Poor’s 500, which is made up of 500 leading U.S. corporations.
Ø International Funds invest in stock markets of foreign countries. Foreign investment has the potential to provide long-term growth opportunities.
Ø Global Funds invest in many countries around the world, including the United States.

Benefit from Investing Regularly

Making regular contributions to a mutual fund allows you to take advantage of a strategy called dollar-cost averaging. Using dollar-cost averaging, you buy more shares when the price is lower, and fewer shares when the price is higher. The result is a lower per-share price compared to a lump-sum investment.

Tax Considerations

Generally, you must pay income taxes on the dividends and capital gains distributed to you from any mutual funds you own. Each fund will provide an IRS Form 1099 to you annually that summarizes the fund’s dividends and distributions. When you sell shares of a fund, you will realize either a taxable gain or a loss.

Before you choose a mutual fund, determine your investment objectives and decide how much risk you are comfortable assuming. You may want to speak with a financial planner to discuss which mutual funds are right for you.

About the author: Susanna M. Zysk is BPO’s Family Money Editor. She has more than 14 years experience in the financial services industry, and holds communications degrees from Syracuse University and Simmons College. She can be reached at zysk@attbi.com.