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The ABCs of mutual funds

Mutual funds are one of the most popular investment and savings vehicles for one very simple reason; they’re easy to understand and accessible for individuals managing their own money, but versatile enough for professionals.

Whether you manage your own money or rely on an investment professional, it probably doesn’t hurt to brush up on mutual fund basics.

Before we get into some of things you should know about mutual funds, however, let’s start with a simple definition.

A good way to understand mutual funds is to consider them a basket of investments. When you are buying a mutual fund, you are not buying a particular stock or bond; you are buying a basket of stocks or bonds (or sometimes a combination of both). Mutual funds are usually managed by a fund manager. A fund manager executes a fund’s investing strategy and manages its day-to-day operations. You could just invest your money yourself, but most people do not have the time, expertise, or resources. Professional managers have a full-time commitment to their investment responsibilities, a wealth of financial research, economic information from various resources, and the experience and skill to identify, select, and manage their portfolios. The manager gets paid a management fee, which is part of the expense ratio.

Fund classifications

Here are some of general categories of mutual funds.

  • Bond funds are pooled amounts of money invested in debt issued by companies or governments.
  • Stock funds invest in corporate equities categorized by market capitalization usually in three basic sizes; small-cap, mid-cap, and large-cap.
  • International funds invest in companies headquartered outside the U.S.
  • Emerging markets funds invest in companies of a single or group of developing countries.
  • Global funds invest in stocks or bonds throughout the world, including the U.S.
  • Sector funds invest in one particular sector of the economy; technology, banking or oil and gas, for example.
  • Index funds seek to match the shareholdings of a target index such as the S&P 500.

Note: All investments involve risk, including loss of principal invested. Investments in small- and mid-cap companies involve a higher degree of risk and volatility than investments in larger, more established companies. Investments in international and global companies involve risks in addition to those ordinarily associated with investing in domestic securities, including the potentially negative effects of currency fluctuations, political and economic developments, foreign taxation and differences in auditing and other financial standards. These risks are magnified in emerging markets. Investments in certain sector funds may be concentrated in a limited number of industries and issuers, and this potential concentration may involve substantial risk. Note, an investor cannot invest directly in an index.

Investments in bonds (debt securities) are subject to credit risk, which is possibility that the issuer of a security will be unable to make interest payments and repay the principal on its debt. All bonds are subject to interest rate risk. As rates rise, the price of bonds falls.

The dos and don’ts of mutual funds

Once you’ve educated yourself on the type(s) of mutual funds in the market, here are some additional things you should keep in mind before you select the actual fund. Your decisions should be based on your investment objective, risk tolerance, time horizon and your unique circumstances.

  • Find the right fit. Pick the right balance between how much safety you are willing to risk for a possible higher yield. Some funds buy conservative government bonds, for example, while others seek higher return by investing in more volatile equities such as emerging markets.
  • Avoid unnecessary charges. Mutual fund charges come in various stripes, also known as loads. There might be a charge for buying into the fund (a front-end load) or selling the fund (back-end loads or redemption fees). Whenever possible, seek out funds with few, if any, charges.
  • Look for a low expense ratio. Expense ratios represent the annual fees charged by all funds, including the management fee, the administrative costs, distribution fees, and other operating expenses. Look for a ratio below one percent.
  • Seek low turnover. Turnover measures how long a fund holds on to stocks it buys. The longer it holds on to a stock the less trading the fund does, the lower the turnover will be. Since a fund incurs expenses every time it buys and sell stocks, the lower the turnover, the lower the transaction costs incurred by the fund.
  • Check out the consistency of the returns. You should be looking for funds that not only have had good returns overall, but ones that do so on a consistent basis, rather than having a great year followed by a poor one. Of course, past performance in no guarantee of future results.
  • Consider your tax situation. Tax-free funds could be a better bet than taxable ones if you’re looking to hold a fund outside a tax-protected retirement account, such as a 401(k), and your income puts you into a high tax bracket.
  • Diversify and don’t chase short-term performance. If you buy into more than one fund, as with any investment it is important to diversify your holdings to mitigate risk and to think long-term. However, diversification does not assure a profit or protect against market loss.

The devil is in the details

A mutual fund prospectus looks daunting. But, whether you are buying into one on your own or through a properly licensed Registered Representative of a broker-dealer, it is important to read it. Some of the essential questions you want answered are:

  • What is the fund’s investment objective and the strategy?
  • Fees and expenses – How much is the fund going to make from managing your money?
  • What kinds of returns has the fund delivered in the past, and what does it invest in to seek positive results?
  • What are the investment risks?
  • It is very important that you read the prospectus very carefully before investing. Many fund companies now provide what is called the summary prospectus which is significantly shorter and contains the “nuts and bolts” of a Fund. If undertaking a full prospectus is too daunting at first, you may start with the summary prospectus. However, you should read the full prospectus before making any purchase decision.

    Learn about the mutual funds offered by New York Life.

    Mutual funds are sold by prospectus. Investors should consider a fund's investment objectives, risks, charges and expenses carefully before investing. The prospectus contains this and other information about a fund. To obtain a free prospectus, please contact your investment professional or go to the fund’s website. An investor should read the prospectus carefully before investing.

    This material is for informational purposes only. Securities are offered through NYLIFE Securities LLC (Member FINRA/SIPC ), a wholly owned subsidiary of New York Life Insurance Company, 51 Madison Avenue, NY. NY 10010.

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