Mutual Funds: Popularity, Risk and Terminology
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 an investor will encounter.
Growing Popularity of Mutual Funds
The prospects of low interest rates on Certificates of Deposits and money market funds have caused investors to seek the higher returns on investment traditionally offered by the stock market. Unfortunately, picking individual stocks is a complex matter, and not very appealing to a lot of "beginner investors."
Fortunately, mutual funds provide such investors with several benefits, especially if they are cautious. They also offer the opportunity to create a bundle or portfolio of stocks, which helps to explain the popularity of these investments. In fact, according to the Investment Company Institute, the mutual fund market consisted of $25.2 trillion in assets under management worldwide (March 2020).
Mutual Fund Risks
Everyone that invests in the stock market assumes two types of risk:
- Individual Stock Risk: this is the risk that a single 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 consist of a portfolio of stocks, this diversification of investment dollars lowers the exposure to individual stock risk. This is one reason mutual funds are popular with individuals that are new to investing.
Mutual Fund Terms
Choosing the right fund is going to take research. Before going to that step, there needs to be a fundamental understanding of the terms encountered when researching a mutual fund. Listed below are some of the more common, and important, terms appearing on a website or in a prospectus.
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.
An annual report is a document detailing performance of a mutual fund over the last twelve months.
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 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 are the profits an investor realizes when securities are sold.
Closed End Funds
Closed-end funds 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 are usually dividends and capital gains paid by mutual fund companies directly to their shareholders.
Dividends are one form of profits that a mutual fund distributes to its shareholders.
A front-end load is a sales commission that an investor pays for the right to purchase shares of a mutual fund.
The person or entity responsible for making the actual mutual fund investment decisions is called a fund advisor. This can also be an organization hired by the mutual fund to provide advice on the fund's investments and asset management approach.
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.
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.
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 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?
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.
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 they're likely to encounter. Next up, we're going to explain how to start researching a mutual fund.
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