What is a Mutual Fund?

A mutual fund is an investment company that pools investors’ money to invest in securities. An open-end mutual fund continuously issues new shares when investors want to invest in the fund, and it redeems shares when investors want to sell. A mutual fund trades directly with its shareholders, and the share price of the fund represents the market value of the securities that the fund holds.
There are several advantages that mutual funds offer individual investors. They provide:
Professional investment management usually at a low cost, even for small accounts;
A diversified group of securities that only a large portfolio can provide;
Information through prospectuses and annual reports that facilitates comparisons among funds;
Special services such as check writing, dividend reinvestment plans, telephone switching, and periodic withdrawal and investment plans;
Account statements that make it easy to track the value of your investment and that ease the paperwork at tax time.
Successful investing takes time and effort, and it requires special knowledge and relevant, up-to-date information. Investors must spend a considerable amount of energy searching for opportunities and monitoring each investment. Professional investment management is relatively cheap with mutual funds. The typical adviser charges about 0.5% annually for managing a fund’s assets. For an individual making a $10,000 investment, that comes to only $50 a year.

Of course, mutual fund investing does not preclude investing in securities on your own. One useful strategy would be to invest in mutual funds and individual securities. The mutual funds would ensure your participation in overall market moves and lend diversification to your portfolio, while the individual securities would provide you with the opportunity to apply your specific investment analysis skills.
If there is one ingredient to successful investing that is universally agreed upon, it is the benefit of diversification. This is a concept that is backed by a great deal of research, market experience, and common sense. Diversification reduces risk. Risk to investors is frequently defined as volatility of return—in other words, how much an investment’s return might vary over a year. Investors prefer returns that are relatively predictable, and thus less volatile. On the other hand, they want returns that are high, but higher returns are accompanied by higher risks. Diversification eliminates some of the risk without reducing potential returns.

Mutual funds, because of their size and the laws governing their operation, provide investors with diversification that might be difficult for an individual to duplicate. This is true not only for common stock funds, but also for bond funds, municipal bond funds, international bond and stock funds—in fact, for almost all mutual funds. Even the sector funds that invest only within one industry offer diversification within that industry. The degree of diversification will vary among funds, but most will provide investors with some amount of diversification.
Investors should realize that:
A load is a sales commission that goes to the seller of the fund shares;
A load does not go to anyone responsible for managing the fund’s assets and does not serve as an incentive for the fund manager to perform better;
Funds with loads, on average, consistently underperform no-load funds when the load is taken into consideration in performance calculations;
For every high-performing load fund, there exists a similar no-load or low-load fund that can be purchased more cheaply;
Loads understate the real commission charged because they reduce the total amount being invested: $10,000 invested in a 6% front-end load fund results in a $600 sales charge and only a $9,400 investment in the fund;
If the money paid for the load had been working for you, as in a no-load fund, it would have been compounding over your holding period.
The bottom line in any investment is how it performs for you, the investor, and that performance includes consideration of all loads, fees, and expenses. There may be some load funds that will do better even if you factor in the load, but you have no way of finding that fund in advance. The only guide you have is historical performance, which is not necessarily an indication of future performance. With a heavily loaded fund, you are starting your investment with a significant loss—the load. Avoid unnecessary charges whenever possible
It is best to stick with no-load or low-load funds, but they are becoming more difficult to distinguish from heavily loaded funds. The use of high front-end loads has declined, and funds are now turning to other kinds of charges. Some mutual funds sold by brokerage firms, for example, have lowered their front-end loads, and others have introduced back-end loads (deferred sales charges), which are sales commissions paid when exiting the fund. In both instances, the load is often accompanied by annual charges.

On the other hand, some no-load funds have found that to compete, they must market themselves much more aggressively. To do so, they have introduced charges of their own.

The result has been the introduction of low loads, redemption fees, and annual charges. Low loads—up to 3%—are sometimes added instead of the annual charges. In addition, some funds have instituted a charge for investing or withdrawing money.

Redemption fees work like back-end loads: You pay a percentage of the value of your fund when you get out. Loads are on the amount you have invested, while redemption fees are calculated against the value of your fund assets. Some funds have sliding scale redemption fees, so that the longer you remain invested, the lower the charge when you leave. Some funds use redemption fees to discourage short-term trading, a policy that is designed to protect longer-term investors. These funds usually have redemption fees that disappear after six months.

Some funds, usually index funds, may charge a fee, 1% for example, on all new money invested in the fund. This charge defrays the cost of investing the new money. In effect, the new investment pays its way rather than having the transaction costs charged to investments already in the fund.

Probably the most confusing charge is the annual charge, the 12b-1 plan. The adoption of a 12b-1 plan by a fund permits the adviser to use fund assets to pay for distribution costs, including advertising, distribution of fund literature such as prospectuses and annual reports, and sales commissions paid to brokers. Some funds use 12b-1 plans as masked load charges: They levy very high rates on the fund and use the money to pay brokers to sell the fund. Since the charge is annual and based on the value of the investment, this can result in a total cost to a long-term investor that exceeds a high up-front sales load. A fee table is required in all fund prospectuses to clarify the impact of a 12b-1 plan and other charges.

The fee table makes the comparison of total expenses among funds easier. Selecting a fund based solely on expenses, including loads and charges, will not give you optimal results, but avoiding funds with high expenses and unnecessary charges is important for long-term performance.