Since the creation of the first modern-day mutual fund, the Massachusetts Investors Trust, in 1924, there has been a steady growth of mutual funds. Today there are over 8,000 mutual funds.1 Because of their convenience and flexibility, you might want to consider including mutual funds in your investment portfolio.
A mutual fund is a collection of stocks, bonds, and other securities that is purchased and professionally managed by an investment company with the capital from a group of investors. When you invest in a mutual fund, the investment company pools your money with that of other investors that is invested to pursue the objectives stated in the mutual fund prospectus.
As a mutual fund shareholder, you gain an equity position in the fund and, therefore, in all of the underlying securities. You share in any gains and/or losses of the fund. The mutual fund manager trades securities, incurring capital gains or losses, and generates dividend or interest income. Some mutual funds hold securities that offer the potential for capital appreciation. When these securities are sold by the fund, it distributes the profits from the sale to its shareholders in the form of capital gains. Most mutual funds will automatically reinvest your dividends and capital gains in additional shares, if you’d like.
You can redeem your mutual fund shares at any time for their current market value. The value of mutual fund shares is determined daily, based on the total value of the fund divided by the number of shares purchased. The return and principal value of mutual fund shares fluctuate with market conditions; shares, when redeemed, may be worth more or less than their original cost.
Purchasing shares in a mutual fund can give you access to a diversified portfolio, often without having to spend a large chunk of money and time deciding which types of individual securities to purchase on your own. In addition, you benefit from having your investment managed by a financial professional. Diversification is a method to help manage investment risk, but it does not guarantee a profit or protect against investment loss.
Mutual funds are sold by prospectus. Please consider the investment objectives, risks, charges, and expenses carefully before investing. The prospectus, which contains this and other information about the investment company, can be obtained from your financial professional. Be sure to read the prospectus carefully before deciding whether to invest.
Whether you’re a first-time stock investor or a seasoned veteran, you should understand what differentiates single stock investments from mutual fund investing.
First, Some Working Definitions
Picture a collection of stocks, bonds, or other securities that are purchased by a group of investors and then managed by an investment company. That’s a mutual fund.
When you buy a share in a fund, you’re really buying a piece of a large, diverse portfolio. Conversely, stocks are shares of a single company.
Stocks vs. Funds:
The Management
When it comes to managing an investment, some investors prefer leaving those details and skills to someone else.
They like having a professional manager oversee the day-to-day decisions that a changing stock investment involves and see that as a distinct advantage. A good manager, they might argue, has access to information that would cost them an exorbitant amount, even if they had the time and inclination to do the work themselves.
On the other hand, some investors would never surrender control of their investments. Part of the thrill of investing is knowing that when they succeed it was due to their own decisions, these investors might say.
Individual comfort level plays a big part in your investment choice.
Diversifying Matters
When one security in a fund drops, an insightful fund manager may have included stocks that could cushion or offset that loss. Diversification is a big selling factor for mutual funds.
But that’s not to say that an investor couldn’t diversify via his or her own stock selections. Diversification does not guarantee a profit or protect against investment loss; it is a method used to help manage investment risk.
Liquidity
Fund investors can cash in on any business day.
When you sell a stock, you must wait three business days before the trade settles and your money is released.
The Issue of Red Tape
Mutual fund investors often cite transaction ease as an inviting factor. And it is hard to beat the convenience of having records and transactions handled for you, while periodically receiving a detailed statement of your holdings.
Transacting business with stocks can be a more complicated experience. Placing buy orders, selling shares, or dictating any number of orders can be time-consuming. To some, however, that’s just part of the experience.
In summary, fund investors are often attracted by the overall convenience. By way of contrast, stock investors may tend to be more comfortable with their own investing skills.
Remember the value of both mutual funds and stocks will fluctuate with changes in market conditions, and when sold the investor may receive back more or less than their original investment amount.
Mutual funds are sold by prospectus. Please consider the investment objectives, risks, charges, and expenses carefully before investing. The prospectus, which contains this and other information about the investment company, can be obtained from your financial professional. Be sure to read the prospectus carefully before deciding whether to invest.
In 1884, Charles Henry Dow averaged the closing prices of 11 stocks he considered representative of the strength of the U.S. economy in a paper that preceded The Wall Street Journal. By 1896, The Wall Street Journal was publishing this average on a regular basis, and the most famous indicator of stock market performance was born: the Dow Jones Industrial Average (DJIA or Dow).
Most people have heard of the Dow, as well as a few other well-known stock indexes that track the overall direction of the market. Indexes and averages serve as useful benchmarks against which investors can measure the performance of their own portfolios. Depending on its makeup, a stock index can give investors some idea about the state of the market as a whole or a certain sector of the market. Conceptually, a shift in the price of an index represents an equitable change in the stocks included in the index.
Basically, indexes are imaginary portfolios of securities that represent a particular market or section of the market. Each index has its own method of calculating a change in its base value, often expressed as a percentage change. Thus, you might hear that an index has risen or fallen by a certain percentage. Although you can’t invest directly in an unmanaged index, you can invest in an index mutual fund that attempts to mirror a particular index by investing in the securities that comprise the index. The performance of an unmanaged index is not indicative of the performance of any specific investment.
Mutual funds are sold by prospectus. Please consider the investment objectives, risks, charges, and expenses carefully before investing. The prospectus, which contains this and other information about the investment company, can be obtained from your financial professional. Be sure to read the prospectus carefully before deciding whether to invest.
All the stocks in an index typically have at least one element in common. They might trade on the same stock market exchange, belong to the same industry, or have similar market capitalizations. Some of the more widely known indexes are the Dow, the S&P 500, the Nasdaq Composite, the Wilshire 5000, and the Russell 2000.
The Dow Jones Industrial Average
The Dow is an index of widely held “blue-chip” stocks that is used as an indicator of the performance of U.S. industrial stocks. Unlike most other major indexes, the stocks in the Dow are unweighted by market capitalization. The 30 stocks included in the Dow are all major factors in their industries. Many have become household names: American Express, Boeing, Coca-Cola, General Electric, Hewlett-Packard, IBM, Intel, Johnson & Johnson, McDonald’s, Microsoft, Procter & Gamble, Walt Disney, and Wal-Mart.
S&P 500
The Standard & Poor’s 500 is an index of 500 of the most widely held stocks — leading companies from all sectors of the economy — chosen for their market size, liquidity, and industry group representation. Because some stocks influence the market more than others, each stock is given a different weight when the calculations are made. This is called “market-capitalization weighting,” which is the type of weighting used for the Nasdaq Composite, the Wilshire 5000, and the Russell 2000. Over 80% of all U.S. equity is tracked by the S&P 500.
Nasdaq Composite Index
The National Association of Securities Dealers Automated Quotation system, or NASDAQ, represents all domestic and non-U.S. based common stocks traded on The NASDAQ Stock Market. It includes over 3,000 companies — more than most other stock indexes —many of which are in the technological field. Of course, The NASDAQ Stock Market isn’t restricted to technology issues. Many other well-known companies, such as Starbucks and Amgen, are listed there. The NASDAQ Stock Exchange was established in 1971 as the world’s first electronic stock market.
Wilshire 5000
Probably the most broadly based market index is the Wilshire 5000 Total Market Index. Originally comprising 5,000 stocks, the Wilshire 5000 now uses more than 5000 market capitalization–weighted security returns to adjust the index. The index tracks the overall performance of stocks actively traded on the American stock exchanges; the companies are all headquartered in the United States.
Russell 2000
Started in 1972, the Russell 2000 Index gauges the performance of 2,000 “small cap” stocks that are often omitted from large indexes. This market capitalization–weighted index serves as a benchmark for small-cap U.S. stocks and could be useful for tracking small companies with growth potential.
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Market indexes are useful for assessing the historical performance of investment portfolios over time, but they don’t reveal important details about the companies they track. They also have certain biases inherent in their statistical calculations. Remember that past performance is not a guarantee of future results.
If your portfolio lags substantially behind a corresponding index, it may be time to reevaluate and reallocate assets. Be sure to select an appropriate index as your benchmark. For example, comparing a small-cap stock portfolio to the Dow Jones Industrial Average may not be very meaningful; comparing it to the Russell 2000 Index would be more appropriate. When selecting stocks, it’s prudent to keep an eye on long-term performance based on certain fundamentals that may or may not be subject to market trends.
Bond ratings gauge a bond issuer’s financial ability to repay its promised principal and interest payments. Ratings are based on an analysis of the issuer’s financial condition and creditworthiness. In essence, the higher the rating, the more likely it is that a bondholder will receive his or her principal again when the bond matures.
Credit rating agencies assess the risks of certain bonds, issuing grades that reflect the issuer’s ability to meet the promised principal and interest payments. The best-known independent rating services are Standard & Poor’s, Moody’s Investors Service, and Fitch Ratings. The following are the rating scales for each agency, ranging from the highest quality to the lowest (and possibly default). They are rated in descending alphabetic order from A to D.
Standard & Poor’s: AAA, AA+, AA, AA–, A+, A, A–, BBB+, BBB, BBB–, BB+, BB, BB–, B+, B, B–, CCC+, CCC, CCC–, D
A credit rating is not a recommendation to purchase a particular bond. Bonds with higher ratings typically have a lower yield. Bonds with lower ratings generally offer higher yields, but the risk that the issuer will default is greater. You should carefully weigh the risks of investing in these bonds.
In addition to credit risks, bonds are subject to interest rate and inflation risks, and they have different maturities. The principal value of bonds fluctuates with changes in market conditions. If sold prior to maturity, a bond may be worth more or less than its original value.
When you invest in bonds, you are investing in the debt of a government entity or a corporation. A bond is simply evidence of a debt and represents a long-term IOU.
Bonds are issued by federal, state, and local governments; agencies of the U.S. government; and corporations. By selling debt with a promise to pay it back with interest, the issuing agency can raise capital to finance its operations.
The issuing company or government entity will outline how much money it would like to borrow, for what length of time, and the interest it is willing to pay. Investors who buy bonds are lending their money to the issuer and thus become the issuer’s creditors. Bonds are sold at “par” or “face” value, which is the price at which the bond is issued, usually in denominations of $1,000 or $5,000.
By purchasing a bond, you are lending the debtor money. In exchange, you receive a note stating the amount loaned, the interest rate (the “coupon” or “coupon rate”), how often the interest will be paid, and the term of the loan.
The principal (the amount initially paid for the bond) must be repaid on the stipulated maturity date. Before that date, you (as lender) receive regular interest, usually every six months. The interest payments on a bond are usually fixed.
Before 1983, bondholders would receive coupons that they would clip and mail in semi-annually to receive the interest payments. Presently, all bonds are issued electronically in book-entry form only.
If you are considering buying a bond, remember that the market value of a bond is at risk when interest rates fluctuate. As interest rates rise, the value of existing bonds typically falls because the interest rate on new bonds would be higher. The opposite can also happen as well. Of course, this phenomenon applies only if you decide to sell a bond before it reaches maturity. If you hold a bond to maturity, you will receive the interest payments due plus your original principal, barring default by the issuer. Additional considerations are a bond’s maturity date and credit quality. Investments seeking to achieve higher yields also involve a higher degree of risk.
Bonds are issued by federal, state, and local governments; agencies of the U.S. government; and corporations. There are three basic types of bonds: U.S. Treasury, municipal, and corporate.
Treasury Securities
Bonds, bills, and note issued by the U.S. government are generally called “Treasuries” and are the highest-quality securities available. They are issued by the U.S. Department of the Treasury through the Bureau of Public Debt. All treasury securities are liquid and traded on the secondary market. They are differentiated by their maturity dates, which range from 30 days to 30 years. One major advantage of Treasuries is that the interest earned is exempt from state and local taxes. Treasuries are backed by the full faith and credit of the U.S. government as to the timely payment of principal and interest, so there is little risk of default.
Treasury bills (T-bills) are short-term securities that mature in less than one year. They are sold at a discount from their face value and thus don’t pay interest prior to maturity.
Treasury note (T-note) earn a fixed rate of interest every six months and have maturities ranging from one year to 10 years. The 10-year Treasury note is one of the most quoted when discussing the performance of the U.S. government bond market and is also used as a benchmark by the mortgage market.
Treasury bonds (T-bonds) have maturities ranging from 10 to 30 years. Like T-note, they also have a coupon payment every six months.
Treasury Inflation-Protected Securities (TIPS) are inflation-indexed bonds. The principal of TIPS is adjusted by changes in the Consumer Price Index. They are typically offered in maturities ranging from five years to 20 years.
In addition to these treasury securities, certain federal agencies also issue bonds. The Government National Mortgage Association (Ginnie Mae), the Federal National Mortgage Association (Fannie Mae), and the Federal Home Loan Mortgage Corp. (Freddie Mac) issue bonds for specific purposes, mostly related to funding home purchases. These bonds are also backed by the full faith and credit of the U.S. government.
Municipal Bonds
Municipal bonds (“munis”) are issued by state and local governments to fund the construction of schools, highways, housing, sewer systems, and other important public projects. These bonds tend to be exempt from federal income taxes and, in some cases, from state and local taxes for investors who live in the jurisdiction where the bond is issued. Munis tend to offer competitive rates but with additional risk because local governments can go bankrupt.
Note that, in some states, investors will have to pay state income tax if they purchase shares of a municipal bond fund that invests in bonds issued by states other than the one in which they pay taxes. In addition, although some municipal bonds in the fund may not be subject to ordinary income taxes, they may be subject to federal, state, or local alternative minimum tax. If an investor sells a tax-exempt bond fund at a profit, there are capital gains taxes to consider.
There are two basic types of municipal bonds. General obligation bonds are secured by the full faith and credit of the issuer and supported by the issuer’s taxing power. Revenue bonds are repaid using revenue generated by the individual project the bond was issued to fund.
Corporate Bonds
Corporations may issue bonds to fund a large capital investment or a business expansion. Corporate bonds tend to carry a higher level of risk than government bonds, but they generally are associated with higher potential yields. The value and risk associated with corporate bonds depend in large part on the financial outlook and reputation of the company issuing the bond.
Bonds issued by companies with low credit quality are high-yield bonds, also called junk bonds. Investments in high-yield bonds offer different rewards and risks than investing in investment-grade securities, including higher volatility, greater credit risk, and the more speculative nature of the issuer. Variations on corporate bonds include convertible bonds, which can be converted into company stock under certain conditions.
Zero-Coupon Bonds
This type of bond (also called an “accrual bond”) doesn’t make coupon payments but is issued at a steep discount. The bond is redeemed for its full value at maturity. Zero-coupon bonds tend to fluctuate in price more than coupon bonds. They can be issued by the U.S. Treasury, corporations, and state and local government entities and generally have long maturity dates.
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Bonds are subject to interest-rate, inflation, and credit risks, and they have different maturities. As interest rates rise, bond prices typically fall. The return and principal value of bonds fluctuate with changes in market conditions. If not held to maturity, bonds may be worth more or less than their original cost. Bond funds are subject to the same inflation, interest-rate, and credit risks associated with their underlying bonds. As interest rates rise, bond prices typically fall, which can adversely affect a bond fund’s performance.
Mutual funds are sold by prospectus. Please consider the investment objectives, risks, charges, and expenses carefully before investing. The prospectus, which contains this and other information about the investment company, can be obtained from your financial professional. Be sure to read the prospectus carefully before deciding whether to invest.
Virtually every investment has some type of risk associated with it. The stock market rises and falls. An increase in interest rates can cause a decline in the bond market. No matter what you decide to invest in, risk is something you must consider.
One key to successful investing is managing risk while maintaining the potential for adequate returns on your investments. One of the most effective ways to help manage your investment risk is to diversify. Diversification is an investment strategy aimed at managing risk by spreading your money across a variety of investments such as stocks, bonds, real estate, and cash alternatives; but diversification does not guarantee a profit or protect against loss.
The main philosophy behind diversification is really quite simple: “Don’t put all your eggs in one basket.” Spreading the risk among a number of different investment categories, as well as over several different industries, can help offset a loss in any one investment.
Likewise, the power of diversification may help smooth your returns over time. As one investment increases, it may offset the decreases in another. This may allow your portfolio to ride out market fluctuations, providing a more steady performance under various economic conditions. By potentially reducing the impact of market ups and downs, diversification could go far in enhancing your comfort level with investing.
Diversification is one of the main reasons why mutual funds may be so attractive for both experienced and novice investors. Many non-institutional investors have a limited investment budget and may find it challenging to construct a portfolio that is sufficiently diversified.
For a modest initial investment, you can purchase shares in a diversified portfolio of securities. You have “built-in” diversification. Depending on the objectives of the fund, it may contain a variety of stocks, bonds, and cash vehicles, or a combination of them.
Whether you are investing in mutual funds or are putting together your own combination of stocks, bonds, and other investment vehicles, it is a good idea to keep in mind the importance of diversifying. The value of stocks, bonds, and mutual funds fluctuate with market conditions. Shares, when sold, may be worth more or less than their original cost.
Mutual funds are sold by prospectus. Please consider the investment objectives, risks, charges, and expenses carefully before investing. The prospectus, which contains this and other information about the investment company, can be obtained from your financial professional. Be sure to read the prospectus carefully before deciding whether to invest.
Zero-coupon bonds (“zeros”) represent a type of bond that does not pay interest during the life of the bond. Instead, investors buy these bonds at a steep discount from the “face value” (the amount a bond will be worth when it matures). When the bond matures, investors will receive single payments equal to their initial investments plus the accrued interest.
Available in the secondary market and issued by the U.S. Treasury, corporations, and state and local government entities, zeros typically have long maturity dates, such as 10, 15, or more years. The initial price of a zero depends on the number of years to maturity, current interest rates, and the risk involved. For example, a zero-coupon bond with a face value of $5,000, a maturity date of 20 years, and a 5% interest rate might cost only a few hundred dollars. When the bond matures, the bondholder receives the face value of the bond ($5,000 in this case), barring default.
The value of zero-coupon bonds is subject to market fluctuations. Because these bonds do not pay interest until maturity, their prices tend to be more volatile than are bonds that make regular interest payments. Interest income is subject to ordinary income tax each year, even though the investor does not receive any interest until the bonds mature.
The return and principal value of bonds fluctuate with changes in market conditions. If sold prior to maturity, a bond may be worth more or less than its original cost.
Most people know something about the stock market, but many investors who see stock as a way to get rich quick might not understand exactly what stock is and how it works. Before jumping feet-first into investing in stocks, it is important to understand some of the basics and the risks involved in owning stocks.
A company can raise money by “going public” and selling a portion of the company by issuing stock; this is called equity financing. The advantage to the company is that it doesn’t have to pay back the money or pay interest right away, as it would to a bank if it borrowed the money it needed. The advantage to the shareholder is the potential to make money through dividends and/or capital appreciation.
Dividends are taxable payments to shareholders from the company’s earnings. They are generally paid quarterly in cash, but there is no guarantee that dividends will continue to be paid. Capital appreciation is the difference between the amount paid for a stock and its current value. Shareholders also have the ability to trade their stocks on an exchange at any time.
Stock is quite simply a share in the ownership of a company, which is why stockholders are called shareholders. When you buy stock, you are actually buying a piece of the company it represents; you have a claim on part of the corporation’s assets and earnings.
As a partial owner of the company, you therefore take on the potential risks and benefits of that position, but you don’t have to put any effort into running it. Your ownership is determined by the number of shares you own divided by the total number of shares sold by the company. For example, if a company has issued 1,000 shares and you have 10, you own 1 percent of the company. Of course, if you own 10 shares of a large company that has issued millions of shares, your equity in the company is quite small.
If a company is profitable, it may decide to pay dividends to shareholders from its earnings. On the other hand, some companies may decide to reinvest profits back into their businesses rather than pay dividends. Investors have the potential to make money from dividends as well as from appreciation in the value of stock shares on the open market. Thus, stockholders have the potential to make money if the company does well and the potential to lose money if the company does poorly. The return and principal value of stocks fluctuate with changes in market conditions. Shares, when sold, may be worth more or less than their original cost.
Shareholders of common stock often have voting rights on major issues at annual meetings, usually electing a board of directors. In this way, shareholders have a say in the way the company is run. Owners of preferred stock usually don’t have voting rights but have a higher claim on the company’s assets and earnings than common stockholders do. If a company pays dividends, preferred stockholders receive theirs before common stockholders.
There is always a risk when investing in stocks. Generally, the greater the risk, the greater the potential reward. You should determine your risk tolerance and financial goals before deciding to invest in stock investments.
Many people have heard the Benjamin Franklin quote, “In this world nothing is certain but death and taxes.” Mutual fund taxes can be onerous. However, if you understand the complexities of mutual fund taxes and are prepared when tax season comes around, you may be able to lessen the blow.
Dividends and Capital Gains
The first thing to remember is that you generally must report any mutual fund distributions as income. Even if you reinvest your profits, the federal government still views this as personal income. Your mutual fund will send you a Form 1099-DIV describing what earnings to report on your income tax return. There are two main ways that mutual funds are taxed: dividends and capital gains.
Dividends represent the net earnings of the fund and will be taxed at a 20% tax rate for qualified dividends for taxpayers in the 39.6% federal income tax bracket, at a 0% tax rate for individuals in the 10% and 15% federal income tax brackets, and at a 15% tax rate for all other tax brackets. Qualified dividends, with some exceptions, are dividends received from domestic and foreign corporations after 2002. Foreign dividends must be securities that are traded on U.S. exchanges or have IRS approval.
Capital gains are profits from investor trading or distributions given to shareholders after revenue is taken in from the fund manager’s sales of securities. Provisions in the tax law allow you to pay lower capital gains taxes on the sale of assets held more than one year. These are referred to as “long term” capital gains.
Long-term gains are profits on assets held longer than 12 months before they are sold. The American Taxpayer Relief Act of 2012 instituted a 20% long-term capital gains tax rate for taxpayers in the 39.6% income tax bracket and extended both the 0% capital gains tax rate for individuals in the 10% and 15% tax brackets and the 15% capital gains tax rate for all other tax brackets. Short-term gains — those resulting from the sale of assets held less than one year — are taxed at your ordinary income tax rate.
Higher-income taxpayers should be aware that they may be subject to an additional 3.8% Medicare unearned income tax on net investment income (unearned income includes dividends) if their adjusted gross income exceeds $200,000 (single filers) or $250,000 (married joint filers). This is an outcome of the Patient Protection and Affordable Care Act of 2010.
This means that if you’ve been buying shares in a stock or mutual fund over the years and are considering selling part of your holdings, your tax liability could be significantly impacted by the timing of your sale.
Tax-Exempt Funds
One way to potentially reduce the amount of mutual fund taxes you could pay is by utilizing a tax-exempt bond fund. Distributions from these types of funds are attributable to interest from state and local municipal bonds, so they are exempt from federal income tax (not necessarily state tax). If a bond was issued by a municipality outside the state in which you reside, the interest could be subject to state and local income taxes. Some municipal bond interest could be subject to the federal alternative minimum tax.
Investing in tax-exempt bond funds potentially could lessen the blow of taxes, but it’s important to remember that they may offer lower yields than comparable taxable funds. If you are in a high tax bracket, the tax benefits may make it advantageous for you to invest in lower-yielding tax-exempt funds. Bond funds are subject to the same inflation, interest-rate, and credit risks associated with their underlying bonds. As interest rates rise, bond prices typically fall, which can adversely affect a bond fund’s performance. If you sell a tax-exempt bond fund at a profit, you could incur capital gains taxes.
Mutual fund taxes can be cumbersome, but there may be ways to help you potentially pay as little as possible. Remember that there are tax-advantaged accounts that you possibly could utilize, such as IRAs or 401(k)s, to defer taxes until you withdraw funds in retirement. You may want to consider tax-deferred accounts for high-income funds that come with lofty tax rates. Regardless of how you handle your mutual funds, be sure to consult with a tax professional.
The return and principal value of mutual fund shares fluctuate with changes in market conditions. Shares, when redeemed, may be worth more or less than their original cost.
Mutual funds are sold by prospectus. Please consider the investment objectives, risks, charges, and expenses carefully before investing. The prospectus, which contains this and other information about the investment company, can be obtained from your financial professional. Be sure to read the prospectus carefully before deciding whether to invest.
