subject: How A Mutual Fund Works As An Investment And Its Cost To You [print this page] Investing in mutual funds is attractive to retirees because they offer the advantages of diversification and professional management. But investors should understand how a mutual fund makes money for them and at what cost to them. Here's the scoop...
A mutual fund is a company that pools money from many investors and invests the money in stocks, bonds, short-term money-market instruments, or some combination of these investments. The combined holdings is known as its portfolio of the mutual fund.
Each mutual fund share represents an investor's proportionate ownership of the fund's portfolio and determines his share of income that the fund generates. A mutual fund is an 'open-end company' since it creates more mutual fund shares in proportion to additional investors money that goes into the fund.
The value of your mutual fund share is its 'net asset value' (NAV). This is the current market value of a fund's holding less the fund's liabilities, all divided by the total number of mutual fund shares held by investors. Most funds determine their NAV daily after the close of trading. So actual buying and selling takes placed at the end of the day when the NAV calculated.
You make money from your mutual fund in three ways:
1. Dividend Payments - The portfolio securities will produce income for the fund by their dividends and interest. The fund, in turn, pays its shareholders this income (minus disclosed expenses) in the form of its mutual fund dividends.
2. Capital Gains Distributions - The portfolio securities when sold will produce capital gains or losses. Most funds distribute these capital gains (minus any capital losses) to investors at the end of the year - and labelled as such.
3. Increased NAV - As the underlying securities in the portfolio increase in value, it increases the fund's NAV. So your share value increases accordingly. This will reflect the capital gain of your share.
Hopefully each of these contributes to a satisfactory return of your investment. But what are the costs to you?
*Fees and Expenses:
Running a mutual fund is a business with costs. These costs include shareholder transaction costs, investment advisory fees, and marketing and distribution expenses. Typically they're broken down into direct Shareholder Fees and the Annual Fund Operating Expenses - see list for possible expenses. Shareholder fees maybe imposed at some or all share transactions. The annual fund operating expenses cover management fees, distribution [and or service fees] designated 12b-1 fees.
The SEC (the Security and Exchange Commission), which regulates mutual funds, requires funds to disclose both shareholder fees and operating expenses in a 'fee table' near the front of a fund's prospectus. Be sure you're aware of them.
For your convenience, the Total Annual Fund Operating Expenses "Expense Ratio" - the line of the fee table that represents the total of a fund's annual fund operating expenses - is expressed as a percentage of the fund's average net assets. Knowing this expense ratio helps you compare the costs of different funds.
If you do consider investing in any type of mutual fund please carefully consider investment objectives, risks, charges, and expenses before investing. For this and other information about any mutual fund investment, always obtain a prospectus and read it carefully before you invest.
