First Steps in Mutual Fund Investing

Mutual funds can be a great fit for a first-time investor.
Because they’re managed by a professional, you don’t have to
wrack your brain about what individual stock or bond to buy
or when to buy it or sell it. At the same time, you get a fairly
diversified portfolio in one fell swoop, which involves much
less risk than if you invest in only one stock.

If you’re uncomfortable with the kind of risk that stocks present,
find a good mutual fund for your launch into investing.
Starting out with a
mutual fund doesn’t represent the end of
your quest; it’s the beginning. You can always select a
handful
of decent stocks down the road to add to your portfolio.

With more than 8,000 mutual funds to choose from, the
world may be your oyster, but you eventually have to make
selections that suit you best. In the next three sections, I talk
about three types of mutual funds that can be good first
investments.

You want to see consistent returns over time and relatively
low expenses (ideally 1% or less). If you read the
report carefully, you can also get a
sense of how a manager
approaches his or her investments, and whether the style is
more aggressive than you’re comfortable dealing with.

Also review the fund’s prospectus, which outlines the fund’s
investment objectives and policies, expenses, and risks. Some
better mutual fund companies are starting to graphically
depict the worst quarter and year they’ve experienced, along
with the best, so that you can quickly get an idea of how low
and high the fund may go with your money.

Balanced funds

Although managers of balanced funds invest to earn
respectable returns, they manage first and foremost to avoid
sizeable losses. To do this, many invest in bonds. In some
fund portfolios, bonds account for as much as 30% or more
of the balanced fund’s holdings.

Balanced funds seek income and capital preservation as their
goal, so they offer moderate capital appreciation as compared
to growth funds. Balanced funds don’t take as hard a hit as
more aggressive funds when the market dips.

Large U.S. growth funds

Large U.S. growth fund managers look for large and mid-size
U.S. companies that are fairly stable performers, but have the
potential to continue growing. Changes in society, such as
the aging of the Baby Boom generation, may be one reason
that some companies have good growth potential. For example,
some managers like companies in health care, entertainment,
travel, and financial services because they have the
potential to benefit from the dollars of older, richer Boomers.

A large-company growth index fund

A manager of an index fund invests in companies whose
stocks are listed in an index such as the Standard & Poors
500. The fund tracks the performance of the index. The S&P
has been the index with the best performance in the past
decade. (See Chapter 8 for details on the S&P.) If you want
even more diversification, try a fund that invests, for example,
in the Wilshire 5000, which tracks all of the stocks listed
in the American Stock Exchange, the New York Stock
Exchange, and Nasdaq.

Rather than trying to predict the direction of the market, the
index funds are designed to match the performance of the
index. These funds are considered to be unmanaged because
they invest and hold the same stocks as in the index.
Unfortunately, the fact that index funds match the performance
of the index is the worst part, too, because in a bear market
(when stock prices drop significantly), index funds have
no place else to turn for investments but to the index.
Remember, however, that index funds can offer the investor
long-term, steady growth.

You can pick a small-company mutual fund, a medium-company
mutual fund, a bond mutual fund, and an international
mutual fund as you continue building your portfolio, but it’s
a good idea to start with a fund that invests in large company
stocks. Because, since the late 1920s, these types of stock have
historical average annual returns of more than 11%, this type
of fund can anchor the rest of your portfolio.

Analyzing mutual funds

As you begin your search for mutual funds, make sure that
your performance evaluation produces meaningful results.
Performance is important because good, long-term earnings
enable you to maximize your investments and ensure that
your money is working for you. Gauging future performance
is not an exact science.

A fund’s prospectus, which you can
request from a fund’s toll-free phone number, also outlines
the important features and objectives of the fund.

As an additional check on your selection process, compare
all your choice funds before making a final decision; avoid
choosing one fund in isolation. A single fund can look spectacular
until you discover it trails most of its peers by 10%.
Look for the following information when you select mutual
funds:

 One-, three-, and five-year returns: These numbers
offer information on the fund’s past performance. A look
at all three can give you a sense of how well a fund fared
over time and in relation to similar funds.

Year-to-date total returns: This is a fund’s report card
for the current year, minus operating and management
expenses. The numbers can give you a sense of whether
earnings are in line with competing funds, out in front,
or trailing.

 Maximum initial sales charges, commissions, or
loads: Unlike stocks and bonds, mutual funds have builtin
operating and management expenses. These expenses
are in addition to any commission you may pay to a broker
or financial planner to buy a fund. A sales charge on
a purchase, sometimes called a load, is a charge you pay
when you buy shares. You can determine the sales charge
(load) on purchases by looking at the fee and expense
table in the prospectus. No-load funds don’t charge sales
loads. There are no-load funds in every major fund category.
However, even no-load funds have ongoing operating
and management expenses.

Go for lower-priced funds or no-load mutual funds,
which by definition must have expenses no higher than
0.25%. Load funds can have charges of up to 5.75%.
What that means is that you must deduct that 5.75%
from any annual performance a fund turns in. If it’s
10%, you can expect to earn 4.25% after you pay the
load or commission.

 Annual expenses: Also called annual operating expense
ratios (AOERs), these costs can sap your performance.
Before you settle on one fund, review the numbers on at
least a few competitors to determine if the fund’s
expenses are in line with typical industry charges. In general,
the more aggressive a fund, the more expenses it
incurs trading investments. Before you invest in a particular
fund, be cautious if it has an extremely high
AOER compared to that of similar funds.

To develop a sense of how expenses can take a big bite
out of earnings over the years, consider this example: A
$10,000 investment earns 10% over 40 years with a 1%
expense ratio, which yields a return of $302,771. The
same investment with a 1.74% expense ratio returns
$239,177, or $63,594 less.

Manager’s tenure: Consider how long the current fund
manager (or managers) has been managing the fund. If
it’s only been a year or two, take that into consideration
before you invest — the five-year record that caught your
eye may have been created by someone who has already
moved down the road. Fund managers move around a
often. In an ideal world, your funds are handled by managers
with staying power.

 Portfolio turnover: This tells you how often a fund
manager sells stocks in a the course of a year. Selling
stocks is expensive, so high turnover over the long run
will probably hurt performance. If two funds appear
equal in all other aspects, but one has high turnover and
the other low turnover, by all means choose the fund
with low turnover.

 Underlying fund investments: For your own sake, take
a look at the top five or ten stocks or bonds that a fund
is investing in. For example, a growth fund may be getting
its rapid appreciation from a high concentration in
fairly risky technology stocks, or a global fund may have
more than 50% of its holdings in U.S. stocks. Neither
of these strategies is a mortal sin if you know about and
can live with it. If you can’t, keep looking for a fund that
matches your goals. Looking at underlying investments
not only helps minimize your surprises as markets and
economies shift, but also enables you to create a balanced
portfolio.

Defining Mutual Funds

A mutual fund is managed by an investment company that
invests (according to the fund’s objectives) in stocks, bonds,
government securities, short-term money market funds, and
other instruments by pooling investors’ money.
Mutual funds are sold in shares. Each share of a fund represents
an ownership in the fund’s underlying securities (the
portfolio).

By law, mutual funds must calculate the price of their shares
each business day. Investors can sell their shares at any time
and receive the current share price, which may be more or
less than the price they paid.

When a fund earns money from dividends on the securities
it invests in or makes money by selling some of its investments
at a profit, the fund distributes the earnings to shareholders.
If you’re an investor, you may decide to reinvest these distributions
automatically in additional fund shares.

A mutual fund investor makes money from the distribution
of dividends and capital gains on the fund’s investments. A
mutual fund shareholder also can potentially make money as
the fund’s share per share (called net asset value, or NAV)
increases in value.

NAV of a mutual fund = Assets
– Liabilities
÷ Number of shares in the fund
(Assets are the value of all securities in a fund’s portfolio; liabilities
are a fund’s expenses.) The NAV of a mutual fund is
affected by the share price charges of the securities in the
fund’s portfolio and any dividend or capital gains distributions
to its shareholders.

Unless you’re in immediate need of this income, which is taxable,
reinvesting this money into additional shares is an excellent
way to grow your investments.

Shareholders receive a portion of the distribution of dividends
and capital gains, based on the number of shares they own.
As a result, an investor who puts $1,000 in a mutual fund
gets the same investment performance and return per dollar
as someone who invests $100,000.

Mutual funds invest in many (sometimes hundreds of ) securities
at one time, so they are diversified investments. A diversified
portfolio is one that balances risk by investing in a
number of different areas of the stock and/or bond markets.
This type of investing attempts to reduce per-share volatility
and minimize losses over the long term as markets change.
Diversification offsets the risk of putting your eggs in one
basket, such as technology funds.

A stock or bond of any one company represents just a small
percentage of a fund’s overall portfolio. So even if one of a
fund’s investments performs poorly, 20 to 150 more investments
can shore up the fund’s performance. As a result, the
poor performance of any one investment isn’t likely to have
a devastating effect on an entire mutual fund portfolio. That
balance doesn’t mean, however, that funds don’t have inherent
risks: You need to carefully select mutual funds to meet
your investment goals and risk tolerance.

The performance of certain classes of investments — such as
large company growth stocks — can strengthen or weaken a
fund’s overall investment performance if the fund concentrates
its investments within that class. If the overall economy
declines, the stock market takes a dive, or a mutual fund
manager picks investments with little potential to be profitable,
a fund’s performance can suffer.

Unfortunately, unless you have a crystal ball, you have no
way to predict how a fund will perform, except to look at the
security’s underlying risk. If a fund has existed long enough
to build a track record through ups and downs, you can
review its performance during the last stressful market.
Fortunately for all investors, some companies use a statistical
measure called standard deviation, which measures the
volatility in the fund’s performance. The larger the swings in
a fund’s returns, the more likely the fund will slip into negative
numbers.