Answers To Your Big Questions About Mutual Funds

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Investors are pouring big money into mutual funds. Yet I'm always surprised at how little most people know about the mutual funds in which they invest.

Here are answers to the most common questions I'm asked by average mutual fund investors:

  • Do I really have to read a fund's prospectus before investing? Yes. Though a common prospectus can be complex, the good news is that you don't have to read all of it.

    There are only two sections that are vital to making investment decisions. The rest is often information the mutual fund has to mention in order to fulfill its legal obligations. What to read:

    • Statement of objectives. This outlines the types of investments the mutual fund makes, such as in large- or small-capitalization companies, bonds or international stocks. It also discusses the strategy the fund's manager uses, such as investing for capital appreciation or for income. The statement is usually found in the first few pages of the document.

      While this section of the prospectus is usually in plain English, some mutual fund families group all or many of their funds in the same document. Be sure to look for the statements that relate to the specific mutual funds in which you are interested.

      Warning: Mutual funds have been known to stray from their stated objectives and invest in securities other than the ones described in their prospectuses.

      Solution: Make sure the mutual fund is buying the types of securities you expected. You can do this either by monitoring its annual, semi-annual or quarterly reports, or by calling the mutual fund company and asking for the most recent top 10 holdings. You can be misled easily by the name of the mutual fund or its advertising.
    • Fee table. This discloses all the costs you'll pay to buy and own mutual fund shares. If it's a load mutual fund, the table will tell you what the charges are when you first buy into and/or sell off shares.

      It will also tell you if there are any management fees, which are deducted from your account annually and are used to pay for marketing, distributing and advertising. The fee table is on page two or three of the prospectus.

      Important: Avoid mutual funds that have total operating expenses of 2% or more for a domestic equity fund--slightly higher for an international mutual fund, or 1% or more for a bond mutual fund. This information can be found in the fee table or by calling the mutual fund company.
  • How many mutual funds should I own? That depends on how much money you have to invest.

    If you only have a few thousand pesos to invest, buy one or two asset-allocation mutual funds. They invest in a combination of stocks, fixed-income securities and cash--depending on the state of the markets.

    If you have a much larger sum and you want to be well diversified, investing in 10 mutual funds is not out of line--provided there is little or no duplication in the investment style and portfolios of the mutual funds.
  • What red flags should I look for when considering a mutual fund? To me, the most important reason to avoid a mutual fund is poor performance. However, one year doesn't tell you enough about a fund's performance. Three to five years is a much better indicator.

    We've all heard the adage that past performance is no guarantee of future results, and that's certainly true. But, for the most part, it's the only thing investors really have to go on.

    Strategy: Always compare a fund's performance with its peer-group average. You can check rankings in an independent mutual fund research service or in newspapers and magazines. Avoid a mutual fund if it has underperformed or performed wildly throughout its history.
  • Do bond mutual funds make sense? And if so, when? Bond mutual funds make the most sense for conservative investors who want to diversity their bond holdings--in other words, when you want to own a lot more types of bonds than Treasuries.

    The argument can also be made that riskier types of bonds, such as corporate bonds or high-yield bonds, are best purchased through a mutual fund. That's because the mutual fund can buy far more types of issues than you can hold as an individual.

    In addition, it is often difficult for individuals to buy small amounts of these types of bonds through their brokers.

    Beware:Bond mutual funds aren't actually bonds. And bond-fund managers don't necessarily buy and hold each issue the way individuals would hang onto them--collecting interest and getting back the principal. Instead, bond-fund managers are constantly trading and, therefore, are subject to the daily price fluctuations that typically occur in the bond market.

    Though bond mutual funds provide more stability than stock mutual funds, there are many different types of bond funds with different types of risk.

    Example: A Treasury bond fund has no credit risk--but it has high interest rate risk. Other mutual funds, such as high-yield bond funds, have less interest rate risk but high default risk.

    Municipal bonds are best for those people looking for tax-advantaged investments. Funds are often a great way to invest in municipal bonds because you can diversity your credit risk and because municipal bonds are often hard for individuals to obtain.

Adapted from: Bottom Line Year Book 1997, based on Sheldon Jacobs, editor and publisher of The No-Load Fund Investor.

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