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 If you're thinking about buying mutual funds 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 on buying mutual funds. In this first part 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 many investors seeking higher returns on their investment through the stock market. But picking individual stocks is a complex matter and not that appealing to most individuals that are "beginner investors."
Mutual funds provide investors with several benefits - especially if they are thinking about investing their money slowly - just to test the waters. The 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 involved here is that 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 is a risk that all stocks are exposed to because it involves factors that are more macro-economic in nature. 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 to which they are exposed through diversification. This is one reason they are so 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've got to learn how to pick a good fund. Choosing the right fund is going to take a bit of research, but 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.
We've chosen to define some of the more common and important terms your 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 your mutual fund to cover expenses of a fund associated with sales and marketing.
Annual Report
An annual report is a report detailing performance of a mutual fund over the last year.
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, taking into account factors such as dividend payments, capital gains, and the reinvestments 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 those 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 income 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 mutual funds.
Fund Advisor
The person or entity responsible for making the actual mutual fund investments is called a fund advisor. The fund advisor can also be an organization hired by the mutual fund to provide advice on the find's investments and assets management approach.
Management Fees
The fees paid to those responsible for managing the mutual fund.
Net Asset Value
The net asset value, or NAV, of a mutual fund is the value of each share of your 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 the information that the Securities and Exchange Commission believes that you need to make an informed investment decision for a mutual fund.
Risk
Risk is simply the chance an investor takes that an undesired outcome will result for an investment. When investing in mutual funds, you want to make sure that risk is 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 also includes the reinvestment of all distributions.
Up Next Researching Mutual Funds
So far 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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