There are a variety of types of investment funds that can be used by the investor to build wealth across time. To the new investor the plethora of investment alternatives can be staggering. One area of confusion are funds. There are many types of funds available for purchase and each has different objectives. Lets look at the three main types.
Mutual funds generally invest in stocks, bonds or a mix of the two. Stock funds can be general funds investing in a wide variety of companies, index funds tied to a specific benchmark such as the S&P 500, or sector funds specializing in specific industries or countries. Hybrids exist such as world funds that are general funds that invest only in the stocks of foreign companies in many countries. Funds can have specific goals such as growth, capital appreciation, or income. Such goals will define and limit the type of stocks the fund can invest in
Bond funds invest in debt instruments of various sorts. These can be government bonds, corporate bonds and foreign bonds. Usually these funds will be specialized in a specific type of security, such as tax free municipal bonds, long term treasuries, or high yield risky junky bonds, etc.
Mutual funds may be free to purchase or have an upfront commission, paid to the seller. These are called no load and load funds. There is no evidence that load funds perform better than no load funds and you should concentrate on looking for no load funds. Many brokers now offer both load and no load funds. If you are working with a full service broker be sure you know what you are getting. If you are working with an online broker this information should be readily available in the broker’s listings. Fund companies also sell no load funds directly to the public.
Mutual funds are bought and sold on the basis of their net asset value. This is computed at the end of each business day by dividing the total asset value of the fund by it’s number of shares, giving a net asset value or share price. All buy and sell orders received that day are then executed at this price.
Closed End Funds
Closed end funds start life by offering a limited number of shares at a set price for sale through a broker.They are then listed like a stock on a stock exchange. The money is then invested according to the mandate of the fund. Closed end funds, like their mutual fund cousins, can be geared toward a wide variety of stocks and bonds with a wide variety of goals. There are several differences between closed end funds and mutual funds. Closed end funds always have a fixed number of shares. The net asset value of the shares is computed in the same fashion for both types of funds. The closed end funds, though, are bought and sold throughout the trading day. The price for the fund is actually set by market forces, by supply and demand, rather than by the net asset value. As a result closed end funds usually sell at a discount to the value of the held securities.
Exchange Traded Funds
These are a recent development in the fund world. They, like closed end funds, are sold on stock exchanges during the trading day. Most are geared to stocks rather than bonds. Highly specialized funds may invest in other assets such as precious metals, agricultural prices, and various indices. Quite often these funds aren’t investing in stocks directly but rather in investment instruments expected to move along with the target securities the fund is replicating. As a result there are many funds that are leveraged and seek to double or even triple the performance of a given benchmark. Leveraged ETFs go up quickly and down quickly and hence have higher risk. Exchange traded funds are more popular with traders than long term investors.
Before investing in any fund get the prospectus. This is a summary of all the information in detail you need to know for making an investment decision. Remember that past performance of a fund does not guarantee future results. First read the investment objectives and make sure they are in line with your own. Next look at the section on investment risks. The first rule of investing is that you have to be able to sleep at night. If the fund takes chances you’re not comfortable with, don’t invest. Look at the expense ratio of the fund. This is the percentage of your investment that goes into operational expenses such as stock trading. For a stock fund a ratio around 1% is good. Over 1.5 % is getting up there. An exception to this rule of thumb are foreign stock funds. Foreign stock trading is more expensive for a variety of reasons. It’s not unusual to see expense ratio for this type of fund hit 2%. Index funds engage in a simple buy and hold strategy. Expense ratios for this type of fund should be close to zero.
Prospectuses can be obtained through a broker, the fund company itself, and often online at the click of a button. The Wall Street Journal and Barrons offer a service to obtain prospectuses for a wide variety of funds as well as stocks. A simple call can get dozens sent to your door.
Performance information on all types of funds is published daily in the Wall Street Journal. Closed end funds receive a more detailed treatment in Barrons on the weekend. Barrons will give you the net asset value, closing price, per cent premium or discount and past year performance in a special section devoted to this type of fund.