Mutual Funds: How to choose Mutual Funds
Although mutual funds provide
diversification, there are no guarantees that your invested money will not
decline. You can only increase the odds of your investment success by not
investing in funds that cost too much. Costs are the biggest problem with mutual
funds and some funds give you more for your money than others. The charges you pay to buy or sell a fund, as well as the fund operating
expenses eat into your return, and they are the main reason why the majority of
funds underperform the market. Since fees are deducted from your
investment, all other things being equal, no-load fund is preferable to a
load-fund. Because the loaded funds reduces the size of your invest, you
earn less in a load fund over time than you would by placing the same amount of
money in a no-load fund that produced the identical performance record.
There are two kinds of fees:
-
Loads (commissions to buy and sell)
-
Operating expenses (Ongoing yearly fees)
1. Loads
- Loads are just fees that a fund uses to compensate brokers or other
salespeople for selling you the mutual fund. Loads typically range from
3 percent to as high as 8 percent. Because commissions are paid to the
salesperson and not to the fund manager, the manager of a load fund does
not work any harder than the fund manager with no loads.
- Front-end loads - These are
fees are paid when you purchase the fund. If you invest $10,000 in a
mutual fund with a 4% front-end load, $400 will pay for the sales charge,
and $9,600 will be invested in the fund.
- Back-end loads - You pay this fee when you sell shares in the
fund. It's also know as redemption fees and contingent deferred sales load. Typically, the
charge, which is a percentage of the value of the assets you have in the
fund, applies only during the first few years you own your shares. In
most cases, too, the percentage you pay declines each year during that
period and then is dropped. A typical example is a 5%
back-end load that decreases to 0% in the sixth year. The load is 5%
if you sell in the first year, 4% in the second year, 3% in the third
year, etc. If you don't
sell the mutual fund until the sixth year, you don't have to pay the
back-end load at all.
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Loaded or not loaded?
If you are investing for
income, a back-end load may be better than a front-end load because
more of your original investment goes to work earning interest. But
if you are investing for a capital gains, a fund that charges a
front-end load will cost you less than a fund that charges a back-end
load because front-end load will be based on a smaller amount.
All else
being equal, you should invest in "no-load"
(commission-free) funds. There
is little to no evidence that shows a correlation between load funds and
superior performance. In fact, studies confirm that average load fund
perform worse than a no-load fund. There are enough no-load funds
to satisfy your investment needs. |
2. Operating expenses
- All mutual funds charge ongoing
fees and the expense ratio. The fees pay for operational costs of
running a fund (employees' salaries, marketing, mailing material, etc.).
A fund's expenses are quoted as an annual percentage of your investment
and deducted before you're paid any return. You can find fund's
operating expense s in the fund's prospectus. Look in the expense
section and find a line that says "Total Fund Operating Expenses". Here
are the costs that are in the total operating expenses.
- Management fee -This is the cost of hiring the fund manager(s), this cost is between 0.5% and 1.0% of assets on average. While it
sounds small, imagine a mutual fund with 1% fee and $200 million in
assets, that's $2 million in management fee. It's true that paying managers is a
necessary fee, but don't think that a high fees goes hand in hand with superior
performance.
- Administrative costs - These include necessities such as
mailing statements,
record keeping, customer service, accounting fees, computers for
tracking investments, and so on.
- 12B-1 Fee - Some load
and no-load mutual funds levy 12b-1 fees on the value of your mutual
fund account to pay brokerage commissions an to offset the fund's
promotional and marketing expenses. These asset-based fees,
typically amount to somewhere between 0.5% and 1% annually of the net
assets in the fund. A fund that charges 12b-1 fees must detail those
expenses, along with other fees it imposes, in its prospectus. So if you
invest in a fund with a 12B-1 fee, you are paying for the fund marketing
and advertising expenses to sell itself for it's own benefit!
On the whole, expense ratios range from as low as 0.2% for index funds to as high as 2.0%
for a international or specialty funds. The average equity mutual fund charges
around 1.3%-1.5%. You'll generally pay more for specialty or
international funds because they require more research and expertise from managers.
Performance History Record:
Another factor to consider when selecting a
mutual fund is its historic rate of return compare to market as a whole,
and relation to other funds of its type. When picking a fund,
compare its performance and volatility over an extended period of time
to a market index, depending on the fund's objective. For example, you
will use Standard & Poor's 500 index if the fund you are selecting
invest in large U.S. companies. Do not pick funds based on 1 to 3 year
return. History has shown that many winners of yesterday can turn into
losers fast (case in point: technology funds of the past few years). In
order for a fund to be considered a great fund, it must consistently
deliver a decent return with a appropriate degree of risk for a long
period of time (about 10 to 15 years).
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Mutual Fund as a long term
investment? If you
are investing in mutual fund, it is very advantageous for you to
invest for the long term, especially those that concentrate on
growth. While the value of your fund usually changes very little in
the short term, growth funds in particular can produce strong returns
and increased value over an extended period.
That doesn't mean you should
be stuck with a fund once you have invested in it or your investment
goals have changed. It does mean riding out possible downturns
in performance when none of the funds objectives or yours has
changed.
Learn
more on when you should sell your mutual funds. |
Tax Consideration:
You
can not overlook the tax implications of your non-retirement accounts.
There is a big difference between the before-tax and after-tax return
generated by stock mutual funds. All mutual funds buy and sell stocks
during the course of a year and any gain or loss from those securities
must be distributed to fund shareholders in the form of capital gains.
Mutual funds also produce dividends that may be subject to higher income
tax rates for some investors. Both capital gains and dividends are
taxable distribution, as such, more taxes you have to pay. Choose a
mutual fund that minimize taxable distribution helps you to defer taxes
on your profits. You receive a higher rate of return on investments by
allowing your money to compound (grow) as it would in a retirement
account. Most mutual funds distribute capital gains in December. It's a
good idea to delay purchasing until the capital gains is distributed.
You can find out the distribution date by calling the 800 number of that
specific fund.
Next-->>
How
to purchase and track Mutual Funds
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