Understanding Mutual Funds: Nine Key Questions

Contents

1. Investment Goals
2. Investment Strategy
3. Risks and Returns
4. Fees and Expenses
5. Investment Manager
6. Buying Shares
7. Selling Shares
8. Distributions and Taxes
9. Fund Services

Understanding Mutual Funds: Nine Key Questions

With so many different investment choices available to you today-mutual funds among others-the more informed you are, the better your investment decisions will be. The Investment Company Institute, the national association of the mutual fund industry, and its mutual fund members have a long-standing commitment to provide investors with the information they need to understand the risks and the rewards of investing.

An estimated 90 million Americans-or 50 percent of all households-own mutual funds. Seven out of every 10 shareholders say they're saving primarily for their retirement, and 97 percent identify themselves as long-term investors.

How is a mutual fund different from other investments?

A mutual fund is an investment company that pools the money from its shareholders to buy dozens of different securities for its portfolio. In this way-by owning them indirectly through the fund-most investors can hold many more securities than they could investing on their own.

By diversifying its assets across so many securities, a mutual fund also enables you to reduce your exposure to the risk of any one security.

Professional investment managers decide which securities to buy and sell for the fund.

A mutual fund investment is liquid: You can sell all or part of your mutual fund shares on any business day. By law, a fund must stand ready to redeem or buy back its shares.

All funds are stringently regulated by the U.S. Securities and Exchange Commission (SEC) under federal laws. As part of this regulation, you must be provided with extensive disclosures about the fund.

There are nine key questions you should ask about a mutual fund before you invest. These are questions that both the SEC and the mutual fund industry agree you should consider in making your investment choice.

Currently, you can find information about each of these key questions in the fund's prospectus-document that all funds are required by law to provide free of charge to investors.

Let's look at the nine key questions one by one.

The first question you should ask about a fund is: What is the fund's investment goal? The fund's goal should match your own. As your goals change over time, you may need to reevaluate your investments.

If you invest primarily for growth, your goal is to increase the value of your investment over the long term.

If you invest primarily for income, your goal is to receive a regular flow of earnings from your investment.

If you invest primarily for stability, your goal is to protect your investment from loss.

No investment can maximize all three goals simultaneously. Some funds emphasize one goal; others try to assign priorities among goals; still others try to strike a balance among two or three goals.

The second question you should ask about a fund is: What is its principal investment strategy? What types of investments does it make? How does it make these decisions?

The fund's investment strategy relates to its-and your-goals. For instance, if you're investing for a long-term goal, like retirement, you might choose a fund that invests in stocks chosen for their long-term growth potential. The fund's investment strategy is also closely related to its risks and returns, which is the third question you should ask.

Understanding risk in all its varieties is critical to being an informed investor. As you know, markets can go up and down and you can lose money in any investment. This general investment risk is what most people think about when considering risk.

But there are also specific risks with each fund, such as those listed here. For example:

Unless you are familiar with the risks involved in an investment, you won't know what to expect from your fund's performance, and you won't know how to properly evaluate it. In general, there is a tradeoff between the level of risk you decide to assume and your opportunity for reward.

Although past performance cannot predict future results, looking at performance will give you a good idea how this fund has behaved in different market conditions and how it compared to other relevant performance measures.

All funds are required to present a bar graph showing performance information (total returns) for each of the past 10 years or the life of the fund. In addition, funds must disclose their best and worst quarters during the 10-year period. Finally, funds must include a comparison chart that shows the fund's performance against an appropriate market index over the past 1, 5, and 10-year periods. A sample performance graph and comparison chart are shown below. Keep in mind that the actual performance of funds you select may vary from this example.

The bar graph shows how this growth stock fund performed in each of the past 10 years. When looking at performance, ask yourself if you would have been comfortable with these results. Volatility is a normal part of investing in stock and bond funds. Investors with long-term goals should expect setbacks from time to time. If you maintain a long-term perspective, short-term swings become less significant. Historically, gains have offset losses: on average, the stock market has returned about 10 percent per year since 1926.

When comparing the performance of two or more funds, make sure you're comparing apples with apples: that is, make sure the funds have similar investment objectives. For example, stock funds with growth goals tend to be more volatile than bond funds with income goals.

(Total return, the measure of performance used here, takes into account dividends, capital gains distributions, and changes in the price of your shares. It is the most comprehensive performance measure, expressed as the percentage change in the total value of the fund over the course of the year.)

For additional comparison purposes, this chart shows the fund's performance against an appropriate market index-for instance, a stock index for stock funds, a bond index for bond funds, an international index for international funds. Use this chart to compare how the fund performed over this period vis-a-vis a market index for the type of investments in which the fund invests.

Fourth, you should consider the costs of investing. As required by law, all mutual fund fees and expenses are fully disclosed in a standardized format in every prospectus called the fee table. The fee table lists two different types of expense and includes a hypothetical example.

You must decide if the cost of owning a particular fund is acceptable to you. Although cost is an important consideration in making any investment, keep in mind that you can make - or lose - considerably more money in a mutual fund than the fees you pay. So make certain you select a fund within the range of risk you are prepared to assume.

A sample fee table is shown below. Keep in mind that the actual expenses of funds you select may vary from this example.

The first half of the fee table lists "shareholder fees." These are charges you pay directly.

The second half of the fee table lists "operating expenses." These are the fund's costs of doing business. They are not charged directly to you. Instead, they are paid by the fund from its assets before any earnings are distributed. These expenses are calculated as a percentage of the fund's average net assets.

To make it easier for you to compare costs, a hypothetical example follows the fee table. It illustrates the effect of all expenses, given the assumptions indicated.

According to ICI research, among a list of 10 different items, the fund's performance is considered most often, followed closely by the fund's risks: 75 percent of investors review performance, 69 percent review risk. Fees and expenses are considered by 43 percent of investors and the portfolio manager's background by 25 percent.

The fifth question you should consider is: What firm serves as the fund's investment adviser and who manages the fund's portfolio? The adviser or management company is the firm responsible for deciding how, where, and when to invest the fund's assets. The prospectus will also give you information about the portfolio manager's background.

The sixth question to consider is how to buy shares of the fund, including finding out about any investment minimums.

Some mutual funds offer their shares through investment professionals who provide investment advice, such as brokers, bank representatives, and financial planners. Other funds offer shares directly to investors - through the mail, by telephone, over the internet, or at their own retail offices. Funds may also be offered through employer retirement plans. No matter how or where you invest, mutual funds, unlike bank deposits, are not insured nor guaranteed by the federal government.

The seventh question to consider is how to sell your fund shares. By law, the fund must stand ready to buy back your shares on any business day. Depending on their value at the time you redeem, you may receive more or less than you paid for them. Mutual fund shares must be priced daily and this information is published in many daily newspapers. Redemptions may be made through your investment professional or by contacting the fund company directly.

The eighth question concerns your earnings or fund distributions. These include dividends earned on the investments the fund holds, and any capital gains made when the fund sells investments for more than it paid for them. Many shareholders elect to have their distributions reinvested in the purchase of additional shares of the fund, rather than taking them out as cash.

It may also be important to you to determine when distributions are made and how they're taxed. Unless you've invested in a tax-exempt fund or a tax-advantaged retirement plan, you will be taxed on all distributions, whether you take them as cash or reinvest them in additional shares. The tax rates you pay on capital gains distributions will depend on the length of time the fund held these assets. And if you sell your fund shares, you may realize a gain or loss which is also subject to taxation.

Finally, you should identify any fund services that are important to you and check to make sure the fund you're considering offers them. For instance, most funds allow you to exchange shares of one fund for shares of another in the same fund "family" for a low or no charge. Other services may include automated information and transaction options, electronic transfers, automatic investment and withdrawal plans, retirement plan options, and checkwriting.

We believe that answering these nine questions will help give you the information you need to compare mutual funds and to make informed investment decisions. We hope you use this checklist to help you choose the mutual funds that best meet your needs and expectations.

September 2002