Investing in Mutual Funds

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:

  1. Diversification
  2. Professional management
  3. 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 distributions of the fund’s realized capital gains. You can usually have any distributions made to you in cash or reinvested for additional shares. You also have the benefit of rising mutual fund share prices if the values of the underlying portfolio rise. However, if the value of the underlying portfolio falls, the value of your mutual fund shares will fall as well.

Factors to consider

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 combinations. There are many sources of mutual fund information at your library, on the internet or from your investment advisor you can use to select the fund type you are seeking.

After choosing a type of fund best matching your objective, the decisions get more difficult.

You want a fund which performs 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. Because 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 in 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 with 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 can be complex. Mutual funds pay no income taxes provided they abide by IRS rules. Any distributions of dividends and interest 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. Read the mutual fund prospectus carefully before making any decision.


    This content has been provided by Financial Wisdom and is intended to serve as a general guideline.