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Mutual Funds- What You Need To Know

Mutual funds, also known as open-ended management companies, provide independent investors with professional money management, diversification, and greater liquidity compared to other investments. Before purchasing a mutual fund it is important to know exactly what you are getting into and who you are paying. This series on mutual funds will explain how a mutual fund is managed, how it is organized, and how shares are sold. This series will be greatly beneficial when on your quest to financial independence and building a balanced portfolio. An important fact about mutual fund ownership is revealed; a must know for every savvy investor...

Before we get started about the inner workings of a mutual fund, a quick review of the basics is a must. Mutual funds by nature are referred to as open end companies because new shares are continuously issued. Mutual funds continuously make their own market, so when investors seek to sell their shares of a fund, they simply sell back to the fund; not in the open market. This creates greater liquidity of mutual fund shares and a greater attraction to risk averse investors.

A mutual fund share gives an investor an undivided interest in the portfolio of assets held by the mutual fund. A mutual fund share does not in any way give the investor any ownership of the individual securities in the mutual fund's portfolio, but rather an interest in the income from the investments comprised in the fund's portfolio. This is a common misconception, but also a key factor to the composition of a mutual fund.

Types of mutual funds differ greatly. Some funds can be focused on specific sectors whereas other mutual funds may be focused internationally. The focus of a mutual fund will be defined by the fund's investment objectives and are described in the fund's prospectus. Reading the prospectus can be a daunting task and sometimes can put even seasoned investors to sleep. So, be sure to consume a healthy amount of caffeine before tackling this task.

When reviewing the fund's prospectus and determining the suitability of a particular investment, you may wonder about the different options or types of mutual funds that exist. Before buying into a mutual fund, be sure to investigate all types of funds to gain a clear picture as to exactly how it will complement your portfolio (i.e. income, growth, etc.). There are a few types of mutual funds, so listed below are just some of the popular types of mutual funds:

Balanced Fund. A mutual fund classified as a balanced fund will combine differing types of stocks (growth & income) as well as bonds. A balanced fund must maintain bond holdings amounting to at least 25% of the fund's assets to be classified as balanced. Balanced funds are attractive investments for those investors who remain somewhere between risk takers and risk averse.

Growth Fund. Growth funds will focus portfolios on stocks that reinvest earnings in efforts to experience growth. The objective of a growth fund is to deliver appreciation of value by means of growth of the underlying securities over a long period of time. This type of fund is generally for the speculative investor willing to accept low or zero returns now for a higher return in the future.

Income Fund. Income funds will generally not focus on future gains or growth; they will see current gains. Income fund portfolios will be focused on high dividend yielding stocks and bonds. This can be classified as a moderate to low risk investment because speculation of future earnings is not a factor; historic earnings are used to gauge current earnings.

Tax Exempt Fund. These types of funds mostly are comprised of municipal bonds yielding tax exempt returns. This is a form of an income investment because only income is generated, not growth. Generally individuals seeking tax exempt returns will be in higher tax brackets. Generally the yield on tax exempt investments will be lower than other comparable investments, so some financial analysis may need to be completed before purchasing a tax exempt investment.

Money Market Fund. Generally money market funds invest in short term, liquid securities that are highly rated such as certificates of deposit, commercial paper, etc. Most money market funds are very different from other funds; one key difference is a money market fund will aim to maintain a fund price of $1. The stability of a money market fund presents an attractive benefit to risk averse investors.

Specialized Fund. Funds deemed to be specialized are required to maintain at least 25% of portfolio asset holdings in specific geographic areas, industries, or sectors of a market. A specialized fund can be a fund with an objective of providing international diversification and can be a complementing addition to many portfolios.

The Investment Company Act of 1940 provides that mutual fund companies are not exempt securities and must abide by the following:

  • Provide a prospectus to investors before a purchase of fund shares is made
  • Maintain an accurate fund prospectus
  • Provide annual reports including: a balance sheet, income statement, a list of all securities held in the fund's portfolio

Share Classes
  • A shares- You pay sales loads when you purchase shares
  • B shares- You pay sales loads when you sell shares
  • C shares- You pay sales loads over ownership period of the shares. You do not pay when you buy or sell, however, you will pay a higher annual fee.

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