Mutual Funds Give Investors Many
Advantages
Mutual funds offer many advantages for individual investors. “By
pooling money from many investors, a mutual fund company provides
diversification and the skills of professional managers to select
and monitor the securities within the mutual fund,” says
Pat Swanson, CFP® and families specialist with Iowa State
University (ISU) Extension’s Invest Wisely Project (www.extension.iastate.edu/investwisely). Investments
in mutual funds may be stocks, bonds or cash instruments.
According to Swanson, other advantages of mutual funds include
their liquidity, that is, they can easily be converted into cash. The
ease of purchase and the smaller minimums needed to invest initially
or in subsequent automatic monthly purchases also make mutual
funds attractive.
However, the choices can be mind-boggling. “There
are more mutual funds to choose from than there are stocks listed
on the New York Stock Exchange. To narrow your search look at
financial magazines and Web sites that evaluate funds. Then
read the fund’s prospectus. This is a document a mutual
fund company must provide you before you invest. The Securities
and Exchange Commission requires specific information be included
in the prospectus.”
Swanson suggests you select a mutual fund whose investing objectives
and risk level match your own. For example, an investor
with the goal of providing retirement income that is many years
in the future may select an aggressive growth or growth fund
depending on the investor’s risk tolerance. An individual
already retired may want a growth and income fund or a fixed-income
fund.
“When you invest in a mutual fund you pay for someone
else’s expertise and along with this comes annual management
fees,” Swanson adds. In addition there may be other
fees. “Avoid load funds that either charge an up-front
sales fee or a redemption fee when you redeem your shares within
a certain number of years. Also avoid funds that charge
12b-1 marketing fees.”
The return to you is significantly affected by these fees and
expenses so shop for funds with a low expense ratio, Swanson
says. “This is the percentage of the fund’s
net assets that go to annual operating expenses. To evaluate
these various charges you can use a mutual fund calculator such
as one provided by the Securities and Exchange Commission at
www.sec.gov/investor/tools.shtml. Compare the costs of
owning different funds before you buy.”
Swanson says there are tax consequences of owning mutual funds
you also should be aware of. A mutual fund company earns dividends
and interest. A mutual fund also has capital gains when
it sells securities. After deducting its expenses the remainder
must be distributed to its investors. The distribution
may be received in cash or reinvested to buy additional shares. The
distributions must be reported by the investor as income annually
unless the mutual fund is part of a tax-deferred account – e.g.,
401(k) or an IRA. “Some of the income will be reported
as dividends on your income tax return and taxed at your ordinary
tax rate and some will be reported as capital gains and taxed
at your capital gains rate.”
In addition to the tax on income made by the mutual fund while
you own it, when you sell mutual fund shares you may have a capital
gain or loss. “It is important to keep cost basis
records of your mutual fund purchases (original cost and transaction
costs plus reinvestment dividends and capital gains or losses)
because you will need this to calculate your taxes,” Swanson
concludes.
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The ISU Extension Invest Wisely
Project provides a series of newspaper, radio, and web resources
for investors. It is funded by a grant from the Investor
Protection Trust (IPT). The IPT is a nonprofit organization
devoted to investor education. Since 1993 the IPT has
worked with the States to provide the independent, objective
investor education needed by all Americans to make informed
investment decisions. www.investorprotection.org.
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