After she was widowed, Mary received a lump sum from her husband’s life insurance policy. Mary needed current income and also wanted to invest for her retirement. Her financial planner, Harriet, suggested mutual funds.
Harriet explained that a mutual fund is a professionally managed pool of stocks and/or bonds that provide reduced portfolio risk through diversification. Investors buy or sell shares of the pooled securities, which provide liquidity and the convenience of automatic reinvestment of dividends and capital gains. Because there are over 9,000 funds, there are plenty of funds that are right for every investor.
Harriet explained to Mary about “no-load” and “load” funds. No-load funds can be purchased directly from the fund without incurring a sales charge. Load funds typically involve a commissioned broker who markets the fund. “NAV” (net asset value) refers to the share price.
Harriet stressed the importance of carefully reading the fund’s prospectus, which describes the fund’s objectives, manager’s style, other pertinent information regarding the fund, and fees.
All funds charge fees, referred to as the “expense ratio”, for professional management and operating expenses. For example, 12b-1 fees cover advertising and promotion of the fund. Look for other fees such as deferred sales charges, exchange fee, or redemption fees.
Harriet warned that fees reduce your return dollar for dollar. A 20% return less a 2% fee nets 18%. Not bad. An 8% return less a 2% fee nets 6%. Not so good. Harriet also warned that most of the returns are taxable each year as income.
There are two kinds of mutual funds: open-end and closed-end.
Open-end funds create more shares as more money is received by the fund and are bought or sold by the fund or a broker. Closed-end funds have a fixed number of shares and are bought or sold on stock exchanges using a broker.
Given Mary’s goals of retirement and income, safety and preservation of capital is important. Harriet described to Mary how mutual funds are classified by risk.
- Aggressive growth: Greatest long-term growth generally in small to medium cap stocks. Highly risky.
- Growth: Long term growth generally in large cap growth companies with solid track records. Less risky than aggressive.
- Growth and Income: Long-term growth with emphasis on stable companies that pay dividends. Moderate risk.
- Income: Generally consists of bonds or high-paying dividend stock such as utilities. Moderate to low risk (no junk bonds).
Harriet also explained the often-used terminology for naming funds.
- Stock funds: Consist of large/medium/small cap stocks, value or growth companies.
- Global funds: The manger invests in U.S and foreign stocks.
- Foreign funds: Fund invests in developed foreign and emerging markets.
- Index funds: These funds track or mirror the performance of particular indexes. These funds have low stock turnover, thus minimal capital gains.
- Balanced funds: A combination of stocks and bonds to reduce risk.
- Bond Funds: A fund consisting of bonds, such as government, corporate or municipals.
- Money Market Funds: Consist of highly liquid and safe short term investments and pay a higher interest rate than a savings account.
With Harriet’s guidance, Mary selected an investment portfolio with; a balanced fund for safety and preservation of capital, a growth stock fund her retirement, an index fund to minimize taxes, and an income fund to satisfy her current need for living expenses.