By Steven Joshua Samuel JD, MBA, AIF® (April 2012)

About half of US households own mutual funds, according to MarketWatch (April 12, 2012, Kirk Spano). Although mutual funds are a good choice for many investors, some buy mutual funds for their retirement plan, college savings or personal accounts before understanding even the basics of how they work and what they cost. Each investment vehicle is different and may or may not be appropriate for various kinds of investors for various reasons. Here are answers to five commonly asked questions about mutual funds. Please be sure to talk to your advisor about your situation, as this is not intended to be advice and is offered as general information only.

1. What is a Mutual Fund?

A mutual fund is an investment account that pools money from a large number of investors and hires professional managers to buy and sell stocks or bonds or other investments. Having a much larger amount of money than each individual investor, the professionally managed mutual fund can help reduce risk by buying many different stocks, bonds or other investments. Also, with pooled money, the professional managers can afford a staff of analysts to assist in selecting investments. Each mutual fund has a board of directors and officers responsible for administering the fund and is overseen by the Securities and Exchange Commission (SEC), a federal government agency.

Mutual funds typically invest in four basic different investments: money market, bonds (also called “fixed income”), stock (also called “equity) and hybrid, meaning combinations of the other categories. There are many subcategories of these basic four investments that are related to the fund’s investment objectives (i.e. dividend income; aggressive growth) or the fund’s investment focus (large or small company, US or non-US companies).

2. How Do the Basic Types of Mutual Funds Differ: Open End and Closed End and ETFs?

Most mutual funds are “Open End,” meaning they are willing to sell and buy fund shares from investors. Their share price is determined only once a day, after the investment markets close, based on each day’s closing market price of the investments the fund owns. When a new investor wants shares, an Open End fund issues new mutual fund shares and the fund’s professional managers use the new investor’s money to buy more investments for the fund. In 2010, there were about 7,600 Open End mutual funds in the US holding nearly $12 trillion (Investment Company Institute Fact Book, www.icifactbook.org, 2011).

“Closed End” funds, also professionally managed, issue their shares to the public just once (when the fund is created) and do not repurchase shares from investors. Investors may sell their shares to other investors, at a price determined by the market, whether it is more or less than the value of the fund’s investments. In 2010 there were 624 Closed End funds with about $241 billion of investments (Investment Company institute fact Book, www.icifactbook.org, 2011).

Exchange Traded Funds (ETFs) combine attributes of open and closed end funds. Like open end funds, ETFs are priced based on the value of the investments they own and buy and sell their shares to and from investors. Like closed end funds, ETFs trade at market prices throughout the day. Most ETFs are also Index Funds (see below).

ETF investing involves principal risk—the chance that you won’t get all the money back that you originally invested—market risk, underlying securities risk, and secondary market price. ETF Shareholders are subject to risks similar to those of holders of other diversified portfolios. A primary consideration is that the general level of stock or bond prices may decline, thus affecting the value of an equity or fixed income ETF, respectively. This is because an equity (or bond) ETF represents interest in a portfolio of stocks (or bonds). Moreover, the overall depth and liquidity of the secondary market may also fluctuate. Therefore, value of the shares, when redeemed, may be worth more or less than their original cost.

3. What are Index Funds and Managed Funds?

An Index Mutual Fund tries to mimic a particular index (representation of a collection of companies based on size, geographical location, and or industry among other criteria) rather than cherry pick individual stocks or bonds. For example, an Index Fund seeking to duplicate the Standard & Poor Index of Largest 500 US companies (S&P 500) buys an equal (or sometimes, weighted) share in each of the 500 companies comprising the Index. The fund manager’s role is to match the index holdings and performance, not beat the index performance. In addition to the S&P 500, there are many other index funds that track other investment categories. For example the MSCI EAFE and MSCI Emerging Markets cover European, Australian, Asian, South American and other non-US company stock, and the Barclay’s Capital Aggregate Bond Index covers US government and corporate bonds.

Managed Mutual Funds pick only investments that the fund professional managers believe will beat its applicable index in the future.

Although exchange traded index funds are designed to provide investment results that generally correspond to the price and yield performance of their respective underlying indexes, the trusts may not be able to exactly replicate the performance of the indexes because of trust expenses and other factors. An exchange traded sector fund may also be adversely affected by the performance of that specific sector or group of industries on which it is based.

4. What are the Advantages and Disadvantages of Index Funds and Managed Mutual Funds?

As for investment performance, advocates of Managed Mutual Funds believe that a staff of research analysts can identify individual investments and regularly beat the performance of the fund’s relevant index. Warren Buffet, though not necessarily an advocate of Managed Mutual Funds, is perhaps the best example of someone who has successfully picked high performing individual companies based on research and analysis, so it can be done. Advocates of Index Mutual Funds argue that identifying winning stocks and winning individual professional managers in advance is very, very difficult. About one half to two thirds of all Managed Mutual funds outperform their relevant index in any particular year but over longer time periods, especially the 20-plus year time horizon of retirement investments, very few Managed Funds beat their index.

As for costs, Managed Funds employ research staff and pay brokers to buy and sell securities much more frequently than Index Funds. Index Funds, not burdened by big research staff and frequent trading, are usually less expensive Managed Funds. As for tax consequences, Managed Mutual funds trade frequently. When they generate a profit, they must pass along that profit to investors who must then pay capital gain tax, even in a year in which the overall performance of the same Managed Mutual Fund was negative. Index Funds generally do not buy and sell as much and are generally less likely to cause tax problems for investors. This does not affect funds held in tax deferred accounts such as IRAs and 401ks.

5. What do Mutual Funds Cost?

Investors must pay all fees and expenses of the mutual fund in which they invest. Total mutual fund expenses (not including sales charges) range from less than 1 percent to more than 3 percent per year. Consequently, understanding and comparing one fund’s expenses to another is important.

Industry regulations require all mutual fund companies to uniformly compute and disclose some (but not all) fees and expenses. Expense ratio and Share Class are terms that describe the fees and expenses to which the disclosure rules apply. Expense ratios include the mutual fund’s annual recurring fees and expenses; for example: payments to Boards of Directors and professional management, as well as custody, filing, audit, and legal fees. For some funds, the expense ratio may include marketing expenses (called 12-b1 fees for the SEC rule). Annual expense ratios range from less than 1/10 of 1 percent for some Index Funds to more than 2 percent per year for some Managed Funds.

Share Class is the term the mutual fund industry uses to describe the conditions in which an investor must pay a sales charge. A single mutual fund typically offers at least this array of choices:

Class A: sales charge of 4 percent – 5.75 percent of the investment amount, combined with a relatively low recurring annual expense ratio; (or sales charge waived if purchased through a fee for service financial advisor);
Class B: sales charge only on withdrawals for several years after the initial investment is made and then converting to Class A, combined with a higher than Class A annual expense ratio while it is Class B;
Class C: a sales charge for one or two years after the initial investment is made, never converting to another Class, combined with a higher than Class A annual expense ratio;
Class I: no sales charge and lower than Class A annual expense ratio, but with very high minimum investment amounts (minimums sometimes waived if purchased through an investment advisor);
Class R: applicable to retirement plan accounts with widely varying annual expense ratios.

Fortunately, the Financial Industry National Regulatory Authority (FINRA, the industry self-regulatory agency) website offers a tool allowing comparison of the above fees and expenses, www.finra.org/fundanalyzer. Unfortunately, there are additional costs that industry regulators have so far not required mutual funds to disclose in meaningful ways and are not included in the FINRA software tool.

Managed funds, in particular, buy and sell large quantities of securities and pay significant payments to brokers and traders for these transactions. These expenses are simply deducted from the mutual fund share value and not included in expense ratios or share classes, so they are not identified in any meaningful way to investors. Studies conducted in 2007 and 2009 and reported in the Wall Street Journal (March 1, 2010) estimated that undisclosed expenses for buying and selling securities ranged from 1/10 of 1 percent to almost 3 percent annually for mutual funds, in addition to the reported expense ratios of the funds.

While mutual funds offer many advantages, the prudent investor is well advised to understand how they work and what they cost before investing. For those able to spend the time to gain understanding, there are many free resources in public libraries and online; and, consulting a reputable financial professional is another good choice.

Additional Considerations and Information About Risk

All indices are unmanaged and investors cannot invest directly into an index. Unlike investments, indices do not incur management fees, charges, or expenses. Past performance is no guarantee of future results. International, global and asset allocation funds invest in varying degrees in foreign investments, which are subject to certain risks, such as currency fluctuations, economic instability, and political developments, not present with domestic investments. Bond funds are subject to a number of investment risks including credit risk, interest rate risk, and prepayment risk.

Investors should consider the investment objectives, risks and charges and expenses of the investment company carefully before investing. The prospectus contains this and other information about the investment company. You can obtain a prospectus from your financial representative. Read the prospectus carefully before investing.

Samuel Financial, Inc. is located at 858 Washington St. Dedham, MA 02026 and can be reached at (781)461-6886. Securities and advisory services offered through Commonwealth Financial Network, member FINRA/SIPC, a registered investment adviser. www.samuelfinancial.com