Mutual Funds
Mutual Funds
Mutual Funds
Mutual Funds
Over the past decade, American investors increasingly have
turned to mutual funds to save for retirement and other financial goals. Mutual funds can offer the advantages of diversification and professional management. But, as with other investment
choices, investing in mutual funds involves risk. And fees and
taxes will diminish a funds returns. It pays to understand both
the upsides and downsides of mutual fund investing and how to
choose products that match your goals and tolerance for risk.
This brochure explains the basics of mutual fund investing, how
mutual funds work, what factors to consider before investing,
and how to avoid common pitfalls.
Table of Contents
HOW MUTUAL FUNDS WORK . . . . . . . . . . . . . . . . . . . 4
What They Are . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
Characteristics of Funds. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
Advantages and Disadvantages. . . . . . . . . . . . . . . . . . . . . . . . . . . 6
Different Types of Funds. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
How to Buy and Sell Shares. . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
How Funds Can Earn Money for You . . . . . . . . . . . . . . . . . . . . 10
FACTORS TO CONSIDER . . . . . . . . . . . . . . . . . . . . . . . 12
Degrees of Risk. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Fees and Expenses. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Classes of Funds. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Tax Consequences. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
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12
16
17
18
21
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2 | MUTUAL FUNDS
Legally known as an open-end company, a mutual fund is one of three basic types
of investment companies. While this brochure discusses only mutual funds, you
should be aware that other pooled investment vehicles exist and may offer features
that you desire. The two other basic types of investment companies are:
C
losed-end fundswhich, unlike mutual funds, sell a fixed number of shares at
one time (in an initial public offering) that later trade on a secondary market; and
U
nit Investment Trusts (UITs)which make a one-time public offering of only
a specific, fixed number of redeemable securities called units and which will
terminate and dissolve on a date specified at the creation of the UIT.
4 | MUTUAL FUNDS
CHARACTERISTICS OF FUNDS
Some of the traditional, distinguishing characteristics of mutual funds
include the following:
Investors
purchase mutual fund shares from the fund itself (or through
a broker for the fund) instead of from other investors on a secondary
market, such as the New York Stock Exchange or Nasdaq Stock Market.
The price that investors pay for mutual fund shares is the funds per share
net asset value (NAV) plus any shareholder fees that the fund imposes at
the time of purchase (such as sales loads).
Mutual
utual funds generally create and sell new shares to accommodate new
M
investors. In other words, it sells its shares on a continuous basis, although
some funds stop selling when, for example, they become too large.
C
osts Despite Negative ReturnsInvestors must pay sales charges,
annual fees, and other expenses (which we discuss in detail on page 13)
regardless of how the fund performs. And, depending on the timing of
their investment, investors may also have to pay taxes on any capital gains
distribution they receiveeven if the fund went on to perform poorly
after they bought shares.
L
ack of ControlInvestors typically cannot ascertain the exact make-up
of a funds portfolio at any given time, nor can they directly influence which
securities the fund manager buys and sells or the timing of those trades.
P
rice UncertaintyWith an individual stock, you can obtain real-time
(or close to real-time) pricing information with relative ease by checking
financial websites or by calling your broker. You can also monitor how a
stocks price changes from hour to houror even second to second. By
contrast, with a mutual fund, the price at which you purchase or redeem
shares will typically depend on the funds NAV, which the fund might
not calculate until many hours after youve placed your order. In general,
mutual funds must calculate their NAV at least once every business day,
typically after the major U.S. exchanges close.
Prepayment Riskthe chance that a bond will be paid off early. For
example, if interest rates fall, a bond issuer may decide to pay off (or
retire) its debt and issue new bonds that pay a lower rate. When this
happens, the fund may not be able to reinvest the proceeds in an investment with as high a return or yield.
Stock Funds
Although a stock funds value can rise and fall quickly (and dramatically)
over the short term, historically stocks have performed better over the
long term than other types of investmentsincluding corporate bonds,
government bonds, and treasury securities.
Overall market risk poses the greatest potential danger for investors in stocks funds. Stock prices can fluctuate for a broad range of
reasonssuch as the overall strength of the economy or demand for
particular products or services.
Not all stock funds are the same. For example:
Growth funds focus on stocks that may not pay a regular dividend but have
the potential for large capital gains.
Income funds invest in stocks that pay regular dividends.
I ndex funds aim to achieve the same return as a particular market index,
such as the S&P 500 Composite Stock Price Index, by investing in allor
perhaps a representative sampleof the companies included in an index.
S
ector funds may specialize in a particular industry segment, such as technology or consumer products stocks.
EXCHANGING SHARES
The easiest way to determine the value of your shares is to call the funds
toll-free number or visit its website. The financial pages of major newspapers
sometimes print the NAVs for various mutual funds.When you buy shares, you
pay the current NAV per share plus any fee the fund assesses at the time of purchase, such as a purchase sales load or other type of purchase fee.When you sell
your shares, the fund will pay you the NAV minus any fee the fund assesses at
the time of redemption, such as a deferred (or back-end) sales load or redemption fee. A funds NAV goes up or down daily as its holdings change in value.
10 | MUTUAL FUNDS
Factors to Consider
Thinking about your long-term investment strategies and tolerance for
risk can help you decide what type of fund is best suited for you. But
you should also consider the effect that fees and taxes will have on your
returns over time.
DEGREES OF RISK
All funds carry some level of risk. You may lose some or all of the
money you investyour principalbecause the securities held by a
fund go up and down in value. Dividend or interest payments may also
fluctuate as market conditions change.
Before you invest, be sure to read a funds prospectus and shareholder
reports to learn about its investment strategy and the potential risks.
Funds with higher rates of return may take risks that are beyond your
comfort level and are inconsistent with your financial goals.
A WORD ABOUT DERIVATIVES
E
xchange Feea fee that some funds impose on shareholders if they
exchange(transfer)toanotherfundwithinthesamefundgrouporfamilyoffunds.
A
ccount Feeafeethatsomefundsseparatelyimposeoninvestors
inconnectionwiththemaintenanceoftheiraccounts.Forexample,
some funds impose an account maintenance fee on accounts whose
valueislessthanacertaindollaramount.
Annual Fund Operating Expenses
Management Feesfeesthatarepaidoutoffundassetstothefunds
investment adviser for investment portfolio management, any other
managementfeespayabletothefundsinvestmentadviseroritsaffiliates,andadministrativefeespayabletotheinvestmentadviserthatare
notincludedintheOtherExpensescategory(discussedbelow).
Distribution [and/or Service] Fees (12b-1 Fees)feespaidby
thefundoutoffundassetstocoverthecostsofmarketingandselling
fundsharesandsometimestocoverthecostsofprovidingshareholder
services.Distribution fees include fees to compensate brokers and
otherswhosellfundsharesandtopayforadvertising,theprintingand
mailingofprospectusestonewinvestors,andtheprintingandmailing
ofsalesliterature.ShareholderServiceFeesarefeespaidtopersons
torespondtoinvestorinquiriesandprovideinvestorswithinformationabouttheirinvestments.
O
ther Expensesexpenses not included underManagement Fees
orDistributionorService(12b-1)Fees,suchasanyshareholderservice expenses that are not already included in the 12b-1 fees, custodialexpenses,legalandaccountingexpenses,transferagentexpenses,and
otheradministrativeexpenses.
T
otal Annual Fund Operating Expenses (Expense Ratio)
thelineofthefeetablethatrepresentsthetotalofallofafundsannual
fundoperatingexpenses,expressedasapercentageofthefundsaverage
netassets.Lookingattheexpenseratiocanhelpyoumakecomparisons
amongfunds.
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Be sure to review carefully the fee tables of any funds youre considering, including no-load funds. Even small differences in fees can
translate into large differences in returns over time. For example, if you
invested $10,000 in a fund that produced a 10% annual return before
expenses and had annual operating expenses of 1.5%, then after 20 years
you would have roughly $49,725. But if the fund had expenses of only
0.5%, then you would end up with $60,858an 18% difference.
Some funds call themselves no-load. As the name implies, this means that the
fund does not charge any type of sales load. But, as discussed above, not every type
of shareholder fee is a sales load. A no-load fund may charge fees that are not sales
loads, such as purchase fees, redemption fees, exchange fees, and account fees. Noload funds will also have operating expenses.
Some mutual funds that charge front-end sales loads will charge lower sales loads
for larger investments. The investment levels required to obtain a reduced sales load
are commonly referred to as breakpoints.
The SEC does not require a fund to offer breakpoints in the funds sales load. But, if
breakpoints exist, the fund must disclose them. In addition, a brokerage firm that is a
member of FINRA (formerly known as the National Association of Securities Dealers)
should not sell you shares of a fund in an amount that is just below the funds sales
load breakpoint simply to earn a higher commission.
Each fund company establishes its own formula for how it will calculate whether an
investor is entitled to receive a breakpoint. For that reason, it is important to seek out
breakpoint information from your financial advisor or the fund itself. Youll need to ask
how a particular fund establishes eligibility for breakpoint discounts, as well as what
the funds breakpoint amounts are.
CLASSES OF FUNDS
Many mutual funds offer more than one class of shares. For example,
you may have seen a fund that offers Class A and Class B shares.
Each class will invest in the same pool (or investment portfolio) of securities and will have the same investment objectives and policies. But
each class will have different shareholder services and/or distribution
arrangements with different fees and expenses. As a result, each class
will likely have different performance results.
A multi-class structure offers investors the ability to select a fee and
expense structure that is most appropriate for their investment goals
(including the time that they expect to remain invested in the fund).
Here are some key characteristics of the most common mutual fund
share classes offered to individual investors:
lass A SharesClassAsharestypicallyimposeafront-endsalesload.
C
Theyalsotendtohavealower12b-1feeandlowerannualexpensesthan
othermutualfundshareclasses.Beawarethatsomemutualfundsreduce
thefront-endloadasthesizeofyourinvestmentincreases.IfyoureconsideringClassAshares,besuretoinquireaboutbreakpoints.
C
lass B SharesClassBsharestypicallydonothaveafront-endsales
load. Instead, they may impose a contingent deferred sales load and a
12b-1fee(alongwithotherannualexpenses).ClassBsharesalsomight
convertautomaticallytoaclasswithalower12b-1feeiftheinvestor
holdstheshareslongenough.
C
lass C SharesClassCsharesmighthavea12b-1fee,otherannual
expenses,andeitherafront-endorback-endsalesload.Butthefront-end
orback-endloadforClassCsharestendstobelowerthanforClassAor
ClassBshares,respectively.UnlikeClassBshares,ClassCsharesgenerally
donotconverttoanotherclass.ClassCsharestendtohavehigherannual
expensesthaneitherClassAorClassBshares.
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TAX CONSEQUENCES
When you buy and hold an individual stock or bond, you must pay
income tax each year on the dividends or interest you receive. But
you wont have to pay any capital gains tax until you actually sell and
unless you make a profit.
Mutual funds are different. When you buy and hold mutual fund
shares, you will owe income tax on any ordinary dividends in the year you
receive or reinvest them. And, in addition to owing taxes on any personal
capital gains when you sell your shares, you may also have to pay taxes each
year on the funds capital gains. Thats because the law requires mutual funds
to distribute capital gains to shareholders if they sell securities for a profit
that cant be offset by a loss.
Bear in mind that if you receive a capital gains distribution, you will
likely owe taxeseven if the fund has had a negative return from the
point during the year when you purchased your shares. For this reason,
you should call the fund to find out when it makes distributions so
you wont pay more than your fair share of taxes. Some funds post that
information on their websites.
SEC rules require mutual funds to disclose in their prospectuses
after-tax returns. In calculating after-tax returns, mutual funds must use
standardized formulas similar to the ones used to calculate before-tax
average annual total returns. Youll find a funds after-tax returns in the
Risk/Return Summary section of the prospectus. When comparing
funds, be sure to take taxes into account.
SOURCES OF INFORMATION
Prospectus
When you purchase shares of a mutual fund, the fund must provide you
with a prospectus. But you can and should request and read a funds
prospectus before you invest. The prospectus is the funds selling document and contains valuable information, such as the funds investment
objectives or goals, principal strategies for achieving those goals, principal risks of investing in the fund, fees and expenses, and past performance. The prospectus also identifies the funds managers and advisers
and describes how to purchase and redeem fund shares.
While they may seem daunting at first, mutual fund prospectuses contain a treasure trove of valuable information. The SEC requires
funds to include specific categories of information in their prospectuses
and to present key data (such as fees and past performance) in a standard
format so that investors can more easily compare different funds.
Heres some of what youll find in mutual fund prospectuses:
Date of IssueThedateoftheprospectusshouldappearonthefront
cover.Mutualfundsmustupdatetheirprospectusesatleastonceayear,
soalwayschecktomakesureyourelookingatthemostrecentversion.
Risk/Return Bar Chart and TableNearthefrontoftheprospectus,
rightafterthefundsnarrativedescriptionofitsinvestmentobjectivesor
goals,strategies,andrisks,youllfindabar chartshowingthefundsannual
totalreturnsforeachofthelast10years(orforthelifeofthefundifitis
lessthan10yearsold).Allfundsthathavehadannualreturnsforatleast
onecalendaryearmustincludethischart.
18 | MUTUAL FUNDS
1-YEAR
5-YEAR
(OR LIFE
OF FUND)
10-YEAR
(OR LIFE
OF FUND)
Index
(reflects no deductions for fees,
expenses, or taxes)
Here youll find net asset values (for both the beginning and end of
each period), total returns, and various ratios, including the ratio of
expenses to average net assets, the ratio of net income to average net
assets, and the portfolio turnover rate.
Profile
Some mutual funds also furnish investors with a profile, which summarizes key information contained in the funds prospectus, such as the funds
investment objectives, principal investment strategies, principal risks, performance, fees and expenses, after-tax returns, identity of the funds investment adviser, investment requirements, and other information.
Statement of Additional Information (SAI)
Also known as Part B of the registration statement, the SAI explains
a funds operations in greater detail than the prospectusincluding the
funds financial statements and details about the history of the fund,
fund policies on borrowing and concentration, the identity of officers,
directors, and persons who control the fund, investment advisory and
other services, brokerage commissions, tax matters, and performance
such as yield and average annual total return information. If you ask,
the fund must send you an SAI. The back cover of the funds prospectus
should contain information on how to obtain the SAI.
Shareholder Reports
A mutual fund also must provide shareholders with annual and semiannual reports within 60 days after the end of the funds fiscal year and
60 days after the funds fiscal mid-year. These reports contain a variety
of updated financial information, a list of the funds portfolio securities,
and other information. The information in the shareholder reports will
be current as of the date of the particular report (that is, the last day of
the funds fiscal year for the annual report, and the last day of the funds
fiscal mid-year for the semi-annual report).
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PAST PERFORMANCE
A funds past performance is not as important as you might think. Advertisements, rankings, and ratings often emphasize how well a fund has performed in the past. But studies show that the future is often different. This
years number one fund can easily become next years below average fund.
Be sure to find out how long the fund has been in existence. Newly
created or small funds sometimes have excellent short-term performance records. Because these funds may invest in only a small number
of stocks, a few successful stocks can have a large impact on their performance. But as these funds grow larger and increase the number of
stocks they own, each stock has less impact on performance. This may
make it more difficult to sustain initial results.
While past performance does not necessarily predict future returns, it
can tell you how volatile (or stable) a fund has been over a period of time.
Generally, the more volatile a fund, the higher the investment risk. If youll
need your money to meet a financial goal in the near-term, you probably
cant afford the risk of investing in a fund with a volatile history because
you will not have enough time to ride out any declines in the stock market.
A GUIDE FOR INVESTORS | 21
Dont confuse a money market fund with a money market deposit account. The
names are similar, but they are completely different:
A
money market fund is a type of mutual fund. It is not guaranteed or FDIC
insured. When you buy shares in a money market fund, you should receive a
prospectus.
A
money market deposit account is a bank deposit. It is guaranteed and FDIC
insured. When you deposit money in a money market deposit account, you
should receive a Truth in Savings form.
22 | MUTUAL FUNDS
Conversiona feature some funds offer that allows investors to automatically change from one class to another (typically with lower annual
expenses) after a set period of time. The funds prospectus or profile will
state whether a class ever converts to another class.
Deferred Sales Chargesee back-end load (above).
Distribution Feesfees paid out of fund assets to cover expenses for
marketing and selling fund shares, including advertising costs, compensation for brokers and others who sell fund shares, and payments for
printing and mailing prospectuses to new investors and sales literature
prospective investors. Sometimes referred to as 12b-1 fees.
Exchange Feea fee that some funds impose on shareholders if they
exchange (transfer) to another fund within the same fund group.
Exchange-Traded Fundsa type of an investment company (either
an open-end company or UIT) whose objective is to achieve the same
return as a particular market index. ETFs differ from traditional openend companies and UITs, because, pursuant to SEC exemptive orders,
shares issued by ETFs trade on a secondary market and are only redeemable from the fund itself in very large blocks (blocks of 50,000
shares for example).
Expense Ratiothe funds total annual operating expenses (including management fees, distribution (12b-1) fees, and other expenses)
expressed as a percentage of average net assets.
Front-end Loadan upfront sales charge investors pay when they
purchase fund shares, generally used by the fund to compensate brokers.
A front-end load reduces the amount available to purchase fund shares.
Index Funddescribes a type of mutual fund or Unit Investment
Trust (UIT) whose investment objective typically is to achieve the same
return as a particular market index, such as the S&P 500 Composite
Stock Price Index, the Russell 2000 Index, or the Wilshire 5000 Total
Market Index.
A GUIDE FOR INVESTORS | 25
Investment Advisergenerally, a person or entity who receives compensation for giving individually tailored advice to a specific person on
investing in stocks, bonds, or mutual funds. Some investment advisers
also manage portfolios of securities, including mutual funds.
Investment Companya company (corporation, business trust, partnership, or limited liability company) that issues securities and is primarily engaged in the business of investing in securities. The three basic
types of investment companies are mutual funds, closed-end funds, and
unit investment trusts.
Loadsee Sales Charge.
Management Feefee paid out of fund assets to the funds investment adviser for investment portfolio management, any other management fees payable to the funds investment adviser or its affiliates, and
any administrative fee payable to the investment adviser that are not
included in the Other Expenses category. A funds management fees
appears as a category under Annual Fund Operating Expenses in the
Fee Table.
Market Indexa measurement of the performance of a specific basket of
stocks considered to represent a particular market or sector of the U. S. stock
market or the economy. For example, the Dow Jones Industrial Average (DJIA)
is an index of 30 blue chip U. S. stocks of industrial companies (excluding
transportation and utility companies).
Mutual Fundthe common name for an open-end investment company. Like other types of investment companies, mutual funds pool
money from many investors and invest the money in stocks, bonds,
short-term money-market instruments, or other securities. Mutual
funds issue redeemable shares that investors purchase directly from the
fund (or through a broker for the fund) instead of purchasing from investors on a secondary market.
26 | MUTUAL FUNDS
NAV (Net Asset Value)the value of the funds assets minus its liabilities. SEC rules require funds to calculate the NAV at least once
daily. To calculate the NAV per share, simply subtract the funds liabilities from its assets and then divide the result by the number of shares
outstanding.
No-load Funda fund that does not charge any type of sales load.
But not every type of shareholder fee is a sales load, and a no-load
fund may charge fees that are not sales loads. No-load funds also charge
operating expenses.
Open-end Companythe legal name for a mutual fund. An openend company is a type of investment company.
Operating Expensesthe costs a fund incurs in connection with
running the fund, including management fees, distribution (12b-1) fees,
and other expenses.
Portfolioan individuals or entitys combined holdings of stocks,
bonds, or other securities and assets.
Profilesummarizes key information about a mutual funds costs, investment objectives, risks, and performance. Although every mutual
fund has a prospectus, not every mutual fund has a profile.
Prospectusdescribes the mutual fund to prospective investors. Every mutual fund has a prospectus. The prospectus contains information about the mutual funds costs, investment objectives, risks, and
performance. You can get a prospectus from the mutual fund company
(through its website or by phone or mail).Your financial professional or
broker can also provide you with a copy.
Purchase Feea shareholder fee that some funds charge when investors purchase mutual fund shares. Not the same as (and may be in addition to) a front-end load.
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1-800-732-0330
www.investor.gov
SEC Pub. 002 (08/07)