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If you're thinking about buying mutual funds, then some of the terminology you'll encounter can be confusing; especially for the novice investor. This is the first article in a four-part series dedicated to buying mutual funds. In this first installment, we're going to discuss the popularity of mutual funds, their risks, and some of the terminology you'll encounter.
Growing Popularity of Mutual Funds
The prospects of low interest rates on Certificates of Deposits and money market funds have caused many investors to seek higher returns on their investment through the stock market. Unfortunately, picking individual stocks is a complex matter and not that appealing to many "beginner investors."
Mutual funds provide investors with several benefits, especially if they are thinking about investing their money cautiously. The single most important benefit of mutual funds is the fact they are a bundle or portfolio of stocks.
Mutual Fund Risks
Portfolios of stocks, such as mutual funds, offer the investor an overall lower risk for their investment dollar. That's because when you're investing in stocks, you're assuming two kinds of risk:
- Individual Stock Risk - this is the risk carried by a single company. The risk is the company underperforms versus expectations, or experiences some kind of downturn in their outlook.
- Market Risk - even though an investor is buying stock in a single company, the investor is also exposed to market risk, or industry risk. This risk involves macro-economic factors, and all stocks are exposed to market risk. For example, rising interest rates make the cost of borrowing more expensive for all companies.
Since mutual funds are a portfolio of stocks, they allow the investor to lower the individual stock risk which they are exposed to through diversification. This is one reason mutual funds are popular with individuals that are new to investing.
Mutual Fund Terms
If you're convinced that buying mutual funds is a good way to invest your money, then you have to learn how to pick a good fund. Choosing the right fund is going to take research. Before we can go to that step, you're going to have to understand the terms you're likely to encounter when researching a mutual fund.
Listed below are some of the more common, and important, terms you're going to see on a website or in a prospectus. Once you're familiar with these terms, we'll be able to move on to researching mutual funds.
12b-1 fee
The 12b-1 fees are deducted from the earnings of a mutual fund to cover expenses associated with the sales and marketing of the fund.
Annual Report
An annual report is a document detailing performance of a mutual fund over the last twelve months.
Annual Return
The annual return for a fund is the change in a mutual fund's net asset value (NAV) over a 12 month period of time. The annual return takes into account factors such as dividend payments, capital gains, and the reinvestment of these distributions.
Beta Value
Beta values are the measure of a fund's volatility relative to the entire stock market. The lower the beta value of a fund, the less relative risk involved with a fund.
Capital Gains
Capital gains are the profits an investor realizes when securities are sold.
Closed End Funds
Closed-end funds are funds that have shares traded on an exchange in the same way stocks are traded. With closed-end funds, the price per share doesn't always equal the net asset value of a share.
Distributions
Distributions are usually dividends and capital gains paid by mutual fund companies directly to their shareholders.
Dividends
Dividends are one form of profits that a mutual fund distributes to its shareholders.
Front-End Loads
A front-end load is a sales commission that an investor pays for the right to purchase shares of a mutual fund.
Fund Advisor
The person or entity responsible for making the actual mutual fund investment decisions is called a fund advisor. The fund advisor can also be an organization hired by the mutual fund to provide advice on the fund's investments and asset management approach.
Management Fees
The fees paid to individuals responsible for managing the mutual fund are called management fees.
Net Asset Value
The net asset value, or NAV, of a mutual fund is the value of each share of a fund's investment. Net asset value is sometimes referred to simply as the share price.
No-Load Mutual Funds
Mutual funds that are sold without a sales commission are known as no-load mutual funds.
Open-End Fund
An open-end fund is one that permits the ongoing purchase, and redemption, of shares in that fund. Most mutual funds are open-end funds.
Prospectus
A prospectus is a legal document disclosing information the Securities and Exchange Commission believes investors need in order to make an informed purchase decision for a mutual fund.
Risk
Risk is simply the chance an investor takes that an undesired outcome will result. When investing in mutual funds, risk should be balanced with reward. This relationship is sometimes referred to as an individual's risk tolerance.
S&P 500 Index
The S&P 500 index is a composite of 500 large companies, deemed to be representative of the overall stock market and economic conditions. Most mutual funds are judged in terms of how frequently they are able to "beat" the S&P 500 Index. In other words, can the mutual fund's management team outperform the stock market?
Specialty Funds
The growing popularity of mutual funds has resulted in a sharp rise in the number of specialty funds. A specialty mutual fund is a fund that invests in one specific sector of the economy or industry.
Total Return
The total return for a mutual fund is the calculated return on an investment that includes the reinvestment of all distributions.
Up Next: Researching Mutual Funds
We've explained why mutual funds are so popular with investors, the risks involved with these funds, and some of the terms you're likely to encounter. Next up, we're going to explain how to research a mutual fund.
About the Author - Buying Mutual Funds Part I
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