Educational Programming Video
The Value Line Mutual Fund Survey
Program 3: What is a mutual fund? Part 2
Our last session discussed what a mutual fund is and some of the benefits of owning these funds. In this session, we focus on mutual funds in more detail and finish off by describing some of the disadvantages of owning a mutual fund. At the conclusion of this lesson, you will have a much better understanding of mutual funds.
Diversification and the knowledge that a fund has a specific investment target or goal are two of the major benefits of mutual fund investing I discussed earlier. Other benefits are the fact that fund companies take care of most of the paper work, and fund managers do all of the investment research and make all of the investment decisions.
Many individual investors have neither the time, energy, or desire to maintain investment records or follow the stock market and research investments. If you have a job and a family, I'm sure you can relate to this. With a mutual fund, you don't have to cope with these things. The fund company handles most of the paper work, sending you summary statements and reports all year long. Believe it or not, they even send you tax statements in an easy to understand format. And the fund manager does all of the investment research and makes all of the investment decisions. You only have to make the initial choice of which fund to invest in, and all the rest is done for you. You can sit back, put your feet up and take comfort in the fact that you are leaving your money in the hands of a professional.
Here are some other facts you should be aware of: One unique thing about a mutual fund is that you actually buy shares from the fund itself and then sell them back to the fund. The shares are not traded in the open market (as are common stocks, for example) and do not rise and fall in price because of supply and demand. An open-end fund has no set number of shares, and the mutual fund company stands ready to sell you shares and buy them back at any time at the fund's Net Asset Value, or NAV. The NAV, which can also be referred to as the fund's price, is derived by taking the total value of all of the fund's holdings at any one time and dividing that sum by the number of shares outstanding. NAV is the value of one share of the fund.
Some funds, though, carry sales charges, often referred to as "loads." Loads come in two general varieties, front-end and back-end. Each works just like it sounds; a front-end load is a sales charge levied when you purchase a fund; a back-end load is a sales fee charged when a fund is sold.
Another important thing to understand is that while investors in open-end mutual funds actually own a specific number of shares in the fund, purchases and sales of funds are usually made in dollar amounts, not share amounts. So, if you have $5,000 to invest, you can buy $5,000 worth of shares, even though it means you will probably receive fractional shares (102.55 shares, for example). With a load fund, you would purchase the number of shares equal to your original dollar amount minus the sales charge. For example, if you invested in a fund with a front-end load (one that you pay upon purchase) of 5%, a $5,000 purchase would buy $4,750 worth of shares. And, if the value of all of your shares is $7,000 when you go to sell the fund, you get $7,000. For a fund with a back-end load, however, you would receive the value of your shares minus the sales load. So, if the back-end load is 5%, and you sell $7,000 worth of the fund, you would receive $6,650.
One other thing you should know is that mutual funds are generally only priced once a day and can only be purchased or sold one time a day--after the market closes. If you want to buy or sell mutual funds quickly, you simply can't do it. You will have to wait until the closing bell on Wall Street.
To many investors, however, this is a small price to pay for the benefits that open-end mutual funds afford.
Another potential disadvantage of a mutual fund: taxes. Fund managers buy and sell stocks in a portfolio at their discretion, and in doing so they may take capital gains or losses. In a market such as the one in most of the 1990s, there were many more gains than losses. While rising stock prices are great, the investor may be shocked toward the end of a year, when a fund sends a notice saying that there will be a large capital gains distribution that year. When you own a mutual fund, you have to accept the fact that you may incur capital gains even though you would prefer not to have them. Of course it is nice to have gains, but it is also nice to decide yourself when to take those gains.
Well, we have told you a lot about mutual funds. In the next few session, we will discuss how to track a fund's performance.