Friday, December 12, 2008

Mutual Funds Investment Guide. How to invest in Unit Trusts. Cheap Investment Books. Discount Business Finance EBooks.

Mutual Funds or Unit Trusts Investment

A mutual fund is a company (or a trust) that sells shares of its own stock and utilizes the proceeds to make other investments. These investments may include the stocks of publicly traded companies, corporate or municipal bonds, real estate, or short-term money market instruments. By purchasing shares in a mutual fund, the investor obtains a number of benefits that would otherwise be unavailable.

1. Mutual funds can be an excellent vehicle to carry out a well-conceived investment plan. Once an investor has a disciplined, well thought out strategy, there are many choices available in the mutual fund universe to execute the investment plan with reasonable costs.
2. Mutual funds can provide a high degree of security of principal and income through diversification of securities. Few individuals could afford to buy as many different types of stocks or other investments as the typical mutual fund holds. This spreading of risk makes it unlikely that poor performance by any one security will result in financial disaster.
3. The purchase of shares in a mutual fund allows an investor to hire top notch investment management expertise, thus freeing the investor from the responsibility of managing the portfolio of securities on a day-to-day basis.
4. Most mutual funds “maintain a market” in their own shares. Such funds are referred to as “open-end” investment companies. This means that the mutual fund company has obligated itself to buy back its shares from investors. An investor can require the fund to redeem its shares at any time. This requirement provides the purchaser of fund shares with a high degree of liquidity.
A small category of funds, referred to as “closed-end” funds, do not buy and sell their own shares. Instead, their shares are traded on the open market much like the shares of publicly traded companies. These funds may be listed on the organized stock exchanges or traded on the over-the-counter market. (Although closed-end funds technically are not mutual funds, the shareholders of a fund that qualifies and makes the necessary election to be taxed as a regulated investment company will be taxed like mutual fund shareholders.)
5. Several large discount brokerage firms have created “fund supermarkets” where an investor can have a wide mix of funds, from hundreds of separate fund groups, all in one brokerage account. This makes it easy for an investor to put together a diversified portfolio of funds from different fund families, with top-notch management and low costs. Investors can easily rebalance and make changes within the one brokerage account.
6. Mutual fund organizations have promoted the concept of a “family of funds.” A company will sponsor a number of funds with different investment objectives and underlying assets. The investor can decide to switch assets back and forth from one fund to another. The advantage is that the investor can quickly, conveniently (and typically without any additional sales charges) move assets into one or more funds that better meet his investment needs or desires.
7. From time to time—typically after down periods in the market—mutual funds may have significant realized capital losses that can be used to offset taxable capital gain distributions in the future. Further, the fund may have significant unrealized depreciation in assets. This means that future appreciation, up to the original cost basis of the security, is “tax free” within the fund itself. These two factors can make some funds more tax efficient, at least in the short run, than if the investor had purchased the same securities themselves.

1. Purchasing shares from many mutual funds involves payment of a sales charge, commonly called a “load.” This charge covers the cost of marketing the fund through brokerage firms and certain other fees. Sales charges can be as high as 8.5% of the original investment, but this is very unusual. Market forces have reduced the typical front end load down to an average of about 4.75% for bond funds and 5.75% for stock funds. There are now many share classes, and the fees and commission structure can be very confusing (front load, back load, level load, etc). There are many “no-load” funds that market their products directly to the public by mail and through newspaper advertising. These funds do not charge a sales fee.
2. Annual management fees and administrative charges can reduce the overall return on the investment. Management fees can range from 0.5% to 3% or more of the value of the investment. Administrative charges may be imposed in addition to management fees and frequently cost from $5 to $25 annually per account. These small administrative charges are frequently waived for accounts that reach a minimum balance. These fees can eat up a significant portion of the return to an investor. For example, a bond fund earning 5% on Treasury notes with a 2% expense ratio will only return 3% to the investor. The expenses are eating up 40% of the returns.
3. While professional management relieves the investor of certain obligations and responsibilities, it also eliminates his personal involvement in the management of the fund. The purchaser of a mutual fund cannot control the selection of specific assets or the timing of purchases and sales. Unlike the investor who buys stock directly and who can select the time to sell and recognize a gain or loss, the mutual fund shareholder has no choice. He cannot control the amount of any capital gain distribution, or when it must be reported. Capital gain distributions are paid annually and must be reported each year on the shareholder’s tax return.

1. Ordinary income distributions from mutual funds are generally taxed to individual shareholders at ordinary income tax rates. However, under JGTRRA 2003, “qualified dividend income” (generally, dividends paid by domestic corporations and certain foreign corporations to shareholders) is treated as net capital gain and is, therefore, eligible for the 15%/5% tax rates, instead of the higher ordinary income tax rates. Ordinary income dividends paid by mutual funds are eligible for the 15%/5% tax rates only if the income being passed from the fund to shareholders is qualified dividend income in the hands of the fund, and not short-term capital gain or interest from bonds (both of which continue to be taxed at ordinary income tax rates). Mutual funds will report on Form 1099-DIV the nature of the dividend being distributed to shareholders (i.e., whether the dividend is qualified dividend income subject to the 15%/5% rates, or a nonqualifying dividend subject to ordinary income tax rates). Unless designated by the mutual fund as net capital gain, all distributions to shareholders are to be treated as ordinary income dividends.
2. Capital gain distributions are generally treated as long-term capital gain, and are taxable in the year in which the distribution is declared.
3. The income paid from municipal bond funds is not subject to federal income tax, but is normally taxed at the state level. Capital gains, however, are fully taxable.
4. Every time a “switch” is made within a family of funds, shares of one fund are technically sold and shares of another fund are purchased. These sales are taxable events and result in a gain or loss. Of course, if the funds are purchased through an IRA, Keogh, or qualified corporate pension or profit-sharing plan, tax is deferred until an actual or constructive distribution occurs.
5. The sale or other disposition of less than all of an investor’s shares (or of shares acquired on various dates at various prices) can cause difficulty in determining the basis of the shares sold. Several methods are available for establishing the basis of shares and, thus, for determining the amount of taxable gain.
6. Some funds are set up as limited partnerships in order to allow investors an exemption from state and local taxes on interest from U.S. government securities; however, this exemption does not apply in all states.

The sales charge for purchasing a load fund generally ranges from 3% to 5.75% of the net asset value of the fund. Net asset value is the total value of the fund’s assets, minus any liabilities, divided by the number of outstanding shares of the fund. For example, assume that Consolidated Fund, a hypothetical mutual fund, charges a 5% load to purchase its shares. If the fund’s shares had a net asset value of $10.00 per share, the sales charge would be $0.50, and the purchase price of a share for investors would be $10.50.
The load fee for mutual funds may be as high as 8.5%; however, the vast majority of load funds charge less than this amount. Investors should be cautious in purchasing these funds since some also charge a redemption fee that may be as high as 5% of the value of any shares sold. This fee is assessed whenever the investor sells shares of the fund and is subtracted from the amount the investor is paid. This redemption fee may be waived if the investor sells shares of the fund but reinvests the money in another fund of the same group. The load, plus the “12b-1 fee” (see below), plus the redemption charges cannot exceed 8.5%.
The entire fee structure of “load funds” is now quite complex. Over the past 10 years, there has been a shift away from front end load funds (commonly called “A” shares) to back end load funds (“B” shares) and level load funds (“C” shares) and a number of variations. It’s imperative that prospective investors understand what they are buying, and what the annual fees are, including 12b-1 fees and surrender charges.
The costs of buying and selling shares of so-called “closed-end” funds are similar to those of buying and selling any shares of stock. The transaction cost will be determined by the number of shares traded and the total value of the transaction. Typically this cost will be 2% to 3% of the total value of the shares purchased or sold.
As their names implies, no-load funds do not charge a fee for the purchase or sale of their shares. These funds may be identified in newspaper listings of mutual funds by the indication of “N.L.” in the column of offering prices. These funds may be purchased or sold at their indicated net asset value with no additional sales charges. However, investors should be aware that while these funds do not charge a sales fee, they do assess administrative charges and management fees, and may charge “12b-1 fees” to cover the costs of marketing and advertising (typically on an annual basis). These fees can range from 0.2% to 1.25%. Further, service charges of 0.5% to 3% of the investment may be charged when shares are purchased or dividends reinvested.

Today there are more than 15,000 different mutual funds available to investors. These funds have a wide variety of investment objectives and vary considerably in terms of size, fees, management, performance, and services offered to investors. Selecting the right fund for a particular investment situation may not be easy and should be given a great deal of thought.

Described below are some of the important factors to consider in making such a decision:

1. The selection process should begin with an evaluation of the fund’s investment objective. This information can be found in the fund’s “prospectus”, which can be obtained from a brokerage firm or from the fund itself. In addition to describing the fund’s investment objectives, the prospectus will provide some data on its historical performance. While there are a great many mutual funds, their objectives can be grouped into a few common categories:

Growth Funds – more aggressive than common stock funds, these funds concentrate on long-term capital gains and high future income; generally invest in more speculative issues that provide little or no current income; most of their investments are in common stocks, and possibly a few convertible bonds. The most aggressive funds—with above-average growth potential, high portfolio turnover, high degree of leverage, and high risk—are called performance or “go-go” funds.

Income Funds – specialize in securities that pay higher-than-average current rates of return from either dividends or interest by investing in securities not generally favored by the investment community; frequently invest a high percentage of their assets in bonds rather than common stocks.

Balanced Funds – the most conservative of the funds investing in common stock; these funds have as their primary objective the preservation of capital and moderate growth of income and principal; secondary consideration is capital gains; generally diversify their investments among both stocks and bonds; during bear markets typically offer the best investor protection.

Tax-Exempt Funds – operate principally to provide investors with high after-tax returns on their investments; generally limit their investments to municipal securities or other types of issues that offer tax-sheltered income.

Index Funds – these funds are designed to track a particular market index, such as the S&P 500, with very low annual expenses. The idea is to give an investor a vehicle to achieve “market performance” in a particular asset class, be it large U.S. stocks, small U.S. stocks, REITs, international stocks, or certain categories of bonds. This is also known as “passive investing.” The primary advantage of this form of mutual fund investing is the lower costs (both annual expenses and transactional) that give an inherent advantage, and the ability of an investor to eliminate the risk of manager underperformance and be assured of “market” performance.

Sector Funds – restrict investments to a particular sector of the market, such as energy, electronics, chemicals, or health care; these funds tend to be more volatile than a more diversified portfolio. See “Questions and Answers,” below for more information on sector funds.
Diversified Common Stock Funds – concentrate principally on long-term capital growth, with current income being a secondary consideration; a majority of the assets are invested in good quality common stocks with the balance in cash or short-term government notes. These funds follow a more conservative approach.

Specialty Funds – seek to achieve their objectives by concentrating their investments in a single industry, in a group of related industries, in an industry within a specific geographic region, or even in non-security assets such as real estate investment trusts that purchase real property or loans secured by real property.

Hedge Funds – use the most aggressive techniques, including high leverage, short sales, and the purchase of put and call options to achieve maximum growth of capital; for the most speculative investor.

Money Market Funds – typically no-load funds that invest exclusively in money market instruments such as Treasury bills, CDs, and corporate commercial paper, providing current income and relative safety of principal; offer competitive services such as check writing privileges and free conversion privileges to other types of funds managed by the same investment group.

Commodity Funds – designed to bring the small investor into the commodities market; organized as limited partnerships, these funds offer an inflation-hedge in an inflationary environment and an opportunity for large gains, but with a high degree of risk.

Bond Funds – possess several advantages over direct bond investing, provided expenses are kept low; offer a variety of portfolio types, and proven track records; allow an investor to indirectly participate in the bond market without acquiring the expertise necessary to invest in the market directly.

Foreign Stock And Bond Funds – open-end and closed-end funds that invest in foreign stocks and bonds; some invest exclusively in the securities of one nation while others invest more broadly in foreign regions, or in all foreign markets.

Asset Allocation Funds – in essence, these funds offer one-stop shopping for a complete investment portfolio and offer a substitute for the investor’s own allocation of investment dollars among several different traditional funds. These funds offer diversification not only within asset classes but among asset classes, and they may include nontraditional asset classes, such as commodities and real estate.

2. Another important selection factor is the fund’s historical performance. Relatively few funds have outperformed the market as a whole over long periods of time, but some have consistently done better than others. Each fund’s prospectus will give some indication of its rate of return during the last five or 10 years. Most funds will show what a typical investment would have returned in the form of dividends and capital gains. Various investment sources (see below) will also provide comparative information on large numbers of mutual funds. Investors should use this information to select those funds that have regularly been above average in their investment performance.
In analyzing the performance of mutual funds, it is important to note that many funds perform quite differently in bull markets as compared to bear markets. Growth funds, especially those that concentrate in speculative issues, tend to do well when economic conditions are good and the general trend of the stock market is up. However, these same funds have been relatively poor performers when market conditions are weak and the economy is in a decline. In contrast, income funds and some balanced funds tend to do better than growth funds when the market is weak. Few funds have been able to turn in better than average performance under all market conditions.

3. Investors should concentrate on those funds with low sales charges, management fees, and expense ratios. As noted above, funds differ considerably as to the cost of purchasing their shares. This should not be the only consideration, but high sales charges can sharply reduce an investor’s overall rate of return on investment. Similarly, funds that charge high portfolio management fees have to provide better than average returns to compensate for those charges. Funds also have normal business expenses and these charges, referred to as a fund’s “expense ratio,” should be a factor in selecting a particular mutual fund for investment.

4. The range of services offered by the fund is another important consideration in making a selection. Most funds will provide for automatic reinvestment of dividends into additional shares of the fund. Another common feature is automatic payout of a specified amount on a monthly, quarterly, or annual basis. This feature is especially important to older investors who may be using the fund to provide retirement income. In addition, many offer convenient methods for purchasing shares at the day’s net asset value, either by telephone, by wire transfer, or by logging onto the Internet.

5. It is desirable that a fund be a part of a “family of funds” that provide the investor with flexibility in terms of diversification and the opportunity to alter his investment objective. As noted above, few funds have done well under all market conditions, and the investor should be prepared to transfer investments when market conditions change. Also, it is not unusual for one person to have a variety of investment needs, and the opportunity to make investments in a number of funds within the same management group is attractive.

For more Information:
Mutual Funds or Unit Trusts Investment
Investment Planning Guide, Guide to Investment Strategy—How to Understand Markets, Risk, Rewards and Behaviour.



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