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Mutual Fund Basics

There are basically two ways to invest your money, either do-it-yourself or hire someone to do it for you. If you decide to hire an outside money manager, one of the most popular investing vehicles is the mutual fund. The first step in selecting an appropriate fund is being sure you understand the basics.

Mutual funds are based on the concept of “mutuality” whereby many small investors pool their money together and hire an outside money manager that they normally may not have been able to afford on their own. The mutual fund company issues shares to the many different investors that represent their pro-rata ownership of the fund. If the mutual fund company, also called an investment company, continually accepts new investors and issues new shares, they are referred to as an “open-end fund”. If they only issue a finite number of shares they are referred to as a “closed-end fund”. The day-to-day value of the shares, called the Net Asset Value (NAV), is based on the value of the underlying securities less any expenses.

There are many different types of mutual funds. Funds may be comprised of investments in stocks, bonds, real estate, or even a mix of the various holdings to create “balanced” funds. You should first read the fund’s prospectus, which is the official document that details what types of investments the fund is allowed to make for its shareholders. Then, depending on your investment objective, you can determine if the fund is appropriate for you. Whether you are a conservative or an aggressive investor, you should have no problem finding an appropriate fund. There are literally thousands of funds from which to choose.

Since investing in a mutual fund is essentially hiring a money manager, you will also have to pay the money manager. Depending on how a fund is distributed, or sold, funds are usually broken down into two large categories: “load funds” and “no-load funds”. Load funds are typically sold through a third party intermediary, such as a stockbroker, insurance agent, or bank; while no-load funds are distributed directly by the money manager. Since load funds are sold through a third party, there is an extra fee to compensate the salesperson.

All funds, load or no-load, have an internal fee called the expense ratio. This is how the money manager gets paid and it is the first and most important fee of which investors should focus. The expense ratio, which may fluctuate anywhere from approximately .30% - 2.0%, is assessed annually, forever, on the entire account. This fee is what ultimately costs investors the most money and therefore should be looked at closely. Other fees, such as 12b-1 distribution fees, may also be imbedded in the expense ratio fee.

Load funds, since they are sold through representatives, will typically have either an “up front” or “back end” fee that may range anywhere from approximately 1.0%-5.75%. Also, it is only assessed initially on the new investment money and it is used to pay the salesperson. This is usually referred to as an A or B share. In recent years the C share has been invented, which usually has no up front or back end fee, but instead assesses an extra annual fee on top of the normal expense ratio. Also in recent years some investment advisors have begun offering investors no load funds but then “wrapping” an extra management fee around the fund to compensate them for their services.

The bottom line on fund basics is that if you have money to invest and do not want to make all the investment decisions on your own, you may want to use a mutual fund as the investment vehicle to reach your goals. Or if you need a lot of advice, you should probably purchase a load fund through an Investment Advisor. If you feel you understand some of the basics such as the different types of funds and their uses, you may want to invest in a no-load fund so as to reduce your expenses. Regardless of the method, if you have chosen well-run funds with reasonable expenses, good track records, and funds that are appropriate for your investment objectives, there is a very good chance you will earn a competitive rate of return on your investment over the years.

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