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 -
diversification, professional management and convenience.
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
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
You want a fund that will perform well. However, there are no guarantees of performance.
Past performance is not a sure indicator 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
Another area to consider is the level of expenses of the fund. The mutual fund incurs
expenses of 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 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