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Over the past decade, mutual funds have become one of the most popular ways
for Americans to invest. Mutual funds have three benefits that have
contributed to their popularity - diversification, professional management
and convenience.
The basics
The concept of a mutual fund is quite simple. A mutual fund is a company
that makes investments in other companies. You buy shares in the mutual fund.
Your money is pooled with money of other investors and the mutual fund buys a
diversified portfolio of stocks or bonds of other companies. The investment
manager, or portfolio manager, is responsible for the buy, sell and hold
decisions of the fund.
Your benefits include any distributions the fund makes from interest or
dividends it receives and any appreciation in the underlying value of the
securities the fund holds. You can usually have any distributions made to you
in cash or reinvested for additional shares.
Factors to consider when choosing a mutual fund
Determine what type of fund matches your investment objectives and risk
tolerance. Even within the general categories of stock and bond funds, there
are categories like large capitalization stocks, small caps, global and
utility funds. There are also bond funds comprised of Treasuries, high grade
corporate bonds, municipal bonds, junk bonds and all types of combinations
thereof. There are many sources of mutual fund information at your library,
on the Internet or from your investment advisor that you can use to select
the fund type that you are seeking.
After choosing a type of fund that best matches your objective, the
decisions get more difficult.
You want a fund that will perform well. However, there are no guarantees of
performance. Past performance is no guarantee of future results. You should
examine the performance track record of funds you are considering. Be sure to
look at both the long-term results and the short-term results. Since the
results come from the decisions the portfolio manager makes, be sure to check
whether the results you are reviewing are the results of the current manager.
Another area to consider is the level of expenses of the fund. The mutual
fund incurs expenses its operation. This includes fees for asset management,
accounting, reporting and other activities. All fees and expenses reduce the
returns to the mutual fund shareholders. Be sure the fund you choose has a
reasonable level of expenses.
Finally, you must decide whether you want to pay a commission to buy the
fund. There are many "load" and "no-load" funds that have
identical objectives and similar track records. Any commission you pay
reduces the funds working for you. If you elect to go the "load"
route, you should expect your broker or financial advisor to provide you with
the help and ongoing counseling to justify the commission. If you want to do
the homework yourself, using a "no-load" fund may be right for
you.
Another issue - Income tax consequences
The income tax consequences of owning a mutual fund are a bit complex.
Mutual funds pay no income taxes provided they abide by IRS rules. Any
distributions made by the fund are taxable to the shareholders and reported
on a Form 1099. The tax rules also require the fund to distribute any net
capital gains it earns during the year from the sale of securities it owns
and those gains are also taxable to the mutual fund shareholders.
Now the complex parts. If you have your distributions reinvested, you
report the taxable distributions on your tax return and pay tax on them even
if you received no actual cash. This happens regardless of the change in the
net asset value of your mutual fund shares.
If you have your distributions reinvested, you must also increase your tax
basis in your shares by the amount of the taxable distributions. When you
sell your shares, the tax accounting can be difficult especially if you only
sell some of the shares and you have to determine what part of any gain or
loss qualifies as short-term or long-term. Be sure to keep good records and
to consult your tax advisor about the tax aspects of investing in mutual
funds.
Final words
Mutual funds offer many conveniences to make investing easier. However,
there are risks. Be sure to do your homework. Read the mutual fund prospectus
carefully before making any decision.
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