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Date:    Thu, 3 Mar 1994 10:09:00 EST
From:    Wayne Marr <MARRM@CLEMSON.BITNET>
Subject: Mutual Fund FAQ

Found by kwsowel@clemson.clemson.edu


  From: abcham@engin.umich.edu (Abbot Chambers)
  Newsgroups: misc.invest.funds


  >From timlee@netcom.com  Ukn Dec 13 20:58:58 1993
  To: abcham@umich.edu

  Mutual Fund FAQ

  Author: Timothy Lee

  Disclaimer:  This question and answer list is given in the hope
  that it is useful, but with no express or implied warranty for
  accuracy, usefulness, up-to-date-ness, or anything else.  Use the
  information contained in this list at your own risk.  This list
  applies to mutual funds in the USA; most things are likely to differ
  elsewhere.



  TABLE OF CONTENTS

  1:  What is a mutual fund?
  2:  Why do people use mutual funds?
  3:  Are there any disadvantages to using a mutual fund?
  4:  What is a "closed-end fund" vs. an "open-end fund"?
  5:  What is "net asset value"?
  6:  A fund is "closed".  Is that the same as a closed-end fund?
  7:  What expenses are there for a mutual fund?
  8:  What are typical expenses of a mutual fund?
  9:  Can mutual fund performance be guaranteed?
  10: What is a "prospectus"?
  11: What is a "statement of additional information"?
  12: What is a "signature guarantee"?
  13: What are "dividend distributions"?
  14: What are "capital gain distributions"?
  15: What else is there to know about distributions?
  16: What do mutual funds invest in?
  17: What is a "socially responsible" fund?
  18: Where can I get comparative information on mutual funds?
  19: How does buying funds directly compare with buying through a broker?
  20: What does family of funds do compared to a single fund?
  21: What are the tax implications of mutual funds for individuals?
  22: How do I put mutual funds in an IRA?

  Appendix:  How to get a copy of the "Guide to Personal Finance Resources
          on the Internet".



  1:  What is a mutual fund?

  A:  A mutual fund, or investment company, is a corporation or partnership
      which makes investments and passes gains, losses, and taxability
      through to its shareholders or partners.

  2:  Why do people use mutual funds?

  A:  (1) Mutual funds provide diversification, since a fund typically
          owns a few dozen to hundreds of securities.
      (2) Mutual funds, by pooling funds from many investors, can hire
          investment managers less expensively, since it does not cost
          twice as much (in research, brokerage fees, etc.) to run a
          fund that is twice as large.
      (3) Mutual fund investment managers are subject to frequent reviews
        by various publications.  This means that information useful
          for selecting a mutual fund is easier to find than information
        useful for selecting one's own investment manager.

  3:  Are there any disadvantages to using a mutual fund?

  A:  (1) All mutual funds charge management, brokerage, and marketing
        expenses.  These expenses vary from fund to fund.
      (2) Buying mutual fund shares at the wrong time can subject the
        buyer to earlier than normal payment of taxes.

  4:  What is a "closed-end fund" vs. an "open-end fund"?

  A:  A closed-end fund has a fixed number of shares outstanding and is
      traded just like other stocks on an exchange or over the counter.
      The more common open-end funds sell and redeem shares at any time
      directly to shareholders.  Sales and redemption prices of open-end
      funds are fixed by the sponsor based on the fund's net asset value;
      closed-end funds may trade a discount (usually) or premium to
      net asset value.

  5:  What is "net asset value"?

  A:  The net asset value (NAV) is the value of the fund's underlying
      securities.  It is calculated at the end of the trading day.
      Any open-end fund buy or sell order received on that day is traded
      based on the net asset value calculated at the end of the day.
      A few funds calculate net asset value at more frequent intervals
      and process trades at those values.

  6:  A fund is "closed".  Is that the same as a closed-end fund?

  A:  No.  Some open-end funds are closed to new investors because the
      fund manager feels that it cannot be as effective with a very
      large amount of money.  This typically happens with funds that
      invest in small companies.  The open-end format remains the same,
      but investments are not accepted from those who do not already
      have accounts.

  7:  What expenses are there for a mutual fund?

  A:  (1) Closed-end funds charge annual expenses for research and
        trading expenses.  To buy and sell closed-end fund shares,
        the investor must usually pay additional brokerage fees, unless
        the investor finds someone to buy from or sell to directly.
      (2) Open-end funds charge annual expenses for research and trading
        expenses.  In addition, they sometimes charge the following:
        (a) A front end load or sales charge.  These vary from 1% to
            8.5% subtracted from the amount paid and are usually used
              to pay commissions to brokers and financial advisors who
              sell the funds.  Very large investors can sometimes get
              discounts on the front end loads.  Currently, fund sponsors
              determine loads, but the SEC is proposing a rule to allow
              brokers and other salespeople to discount loads.
        (b) A redemption fee, deferred sales charge, or back end load.
            These work the same way as front end loads, but are charged
            when you redeem shares.  In many cases, they decline or
              disappear after a long enough holding period.
        (c) A Rule 12b-1 fee.  Used to pay marketing expenses, which
            means either commissions or advertising expenses.  This is
            a fee that adds to the annual expenses; it may be as large
            as 1.25% per year.  Declining back end loads are common
              in funds with large 12b-1 fees.
        A mutual fund that has neither (a) nor (b) is generally referred
        to as a no-load fund.  No-load funds are generally not sold
        through brokers or financial advisors, but are sold directly to
        investors.  Many advertise in business and financial periodicals.
        All of the above expenses for open-end funds are described on
        the first or second page of the prospectus in a standardized
        form.  Brokerage fees paid by the fund in its trading activity
          are _not_ normally included in such expense tables as they are
          usually accounted for in the cost of securities bought.

  8:  What are typical expenses of a mutual fund?

  A:  Stock funds tend to be the most expensive, with annual expenses
      ranging from 0.2% to 3.0% with most between 1.0% and 1.5%.  Small
      company and international funds tend to be more expensive.  Bond
      fund expenses range from 0.2% to 2.0%, with most around 1.0%.  Money
      market funds tend to be the least expensive, ranging from about
      0.2% to 1.0%.  See a later answer for a more detailed description
      of these funds.  Note that some funds, particularly money market
      funds, waive expenses for a limited time to boost yield (and make
      good ad copy).  About one half of stock and bond funds have loads
      (front or back end), but money market funds do not normally have
      loads, though some have 12b-1 fees.

  9:  Can mutual fund performance be guaranteed?

  A:  No.  As many funds state, past performance is no guarantee of
      future results, and the fund shares are not backed or guaranteed
      by the FDIC or other government agency.  Note that while some
      funds buy government backed securities, that is not the same as
      backing the market value of the fund shares.

  10: What is a "prospectus"?

  A:  It is a document which an open-end fund, or newly issued closed-end
      fund, is required to provide to investors.  Funds say that investors
      should read it carefully before investing or sending money.  A
      prospectus contains descriptions of:
      (1)  fees, in a standardized format
      (2)  investment objective
      (3)  some financial data
      (4)  investment methods, risk description
      (5)  investment manager and compensation
      (6)  how to buy shares
      (7)  how to sell shares, including signature guarantee requirements
      (8)  dividend and capital gain distributions
      (9)  other services

  11: What is a "statement of additional information"?

  A:  It is a document that is designed to be read along with the
      prospectus; however, it is not required to be given to investors
      before or after they invest (i.e. investors have to ask for it).
      It contains information such as brokerage selection, description
      of the fund's investment adviser, etc.

  12: What is a "signature guarantee"?

  A:  It is a guarantee by a financial institution that your signature
      is genuine and the financial institution accepts liability for any
      forgery.  It is typically required for large or unusual redemptions
      of open-end mutual funds, though some funds require it for all
      redemptions.  At many funds, the guarantor must be a commercial
      bank or NYSE member brokerage firm; some funds accept savings and
      loan associations or credit unions (be careful, some savings and
      loan associations have bank-like names).

  13: What are "dividend distributions"?

  A:  A mutual fund may receive dividend or interest income from the
      securities it owns; it is required to pay out this income to its
      investors.  Most open-end funds offer an option to purchase
      additional shares with the distributions.  Dividend distributions
      are often made monthy or quarterly, though many funds make
      distributions only yearly.

  14: What are "capital gain distributions"?

  A:  A mutual fund may, in the process of trading, realize capital
      gains.  These must be distributed to investors.  As with dividends,
      there is usually the option to reinvest in additional fund shares.
      Capital gain distributions generally occur late in the year, but
      some funds make additional distributions at other times.  Funds
      with high turnover of securities often make significant capital
      gain distributions every year, while funds with low jurnover of
      securities may accumulate unrealized gains for several years before
      making a large capital gain distribution.  Also, funds that are
      increasing in size tend to make smaller capital gain distributions
      because they buy more than they sell, while funds decreasing in size
      tend to make larger capital gain distributions because they sell
      more than they buy.

  15: What else is there to know about distributions?

  A:  A distribution lowers the net asset value of the fund by the
      amount of the distribution.  The shareholder does not actually
      lose money because of the distribution, since s/he gets cash or
      additional shares to compensate for the lower net asset value.
      Distributions have important tax consequences as detailed later.

  16: What do mutual funds invest in?

  A:  Almost anything.  There are funds that invest in almost anything
      an investor could want to invest in.  The most common types are
      described below.
      (1) Money market funds:  these try to maintain a constant (usually
          $1) NAV per share (though they cannot guarantee that), while
        yielding dividends from their investments in short term debt
        securities.  They offer very low risk, but usually low long
        term return.  Most restrict investments to the top two (out
        of four) Moody's and Standard and Poor ratings for short term
        debt; some (including national government only funds) restrict
        themselves to only the top rating, providing a bit of extra
        credit safety, usually at a slightly lower yield.  Most also
        invest in repurchase agreements (repos) collateralized by short
        term debt securities; these are subject to credit or fraud risk
        of the other party in the repo (regardless of the credit risk
        of the securities being repoed).  Their market value is NOT
        insured by the FDIC or other government agency.  Enough defaults
        in the fund's securities can cause it to be unable to maintain
        its constant NAV.
        (a) Regular funds:  invest in short term debt of all types.
        (b) Government funds:  invest only in national government or
            government agency debt or repos involving such debt.
            Slightly lower credit risk than regular funds.
        (c) Treasury funds:  invest only in direct obligations of the
            national government or repos involving these securities.
            Lowest credit risk and dividend distributions are exempt
            from state income taxes in most states.
        (d) Municipal funds:  invest only in debt of state or local
            governments.  For most individuals, dividend distributions
            are exempt from national income taxes.
        (e) Single state municipal funds:  invest only in debt of
            one state or its political subdivisions.  For most individuals,
            dividend distributions are exempt from national income
            taxes and that state's income taxes.  Note that a single
            state fund is usually less diversified than a regular municipal
            fund and might be considered riskier for this reason.
      (2) Bond funds.  These invest in longer term debt securities.
        Thus the short term risk is greater than the infinitesmal
        risk of the money market.  But returns are usually higher.
        Their NAVs may fluctuate due to both interest rate risk and
        defaults.  Unlike individual bonds, most bond funds do not
        mature; they trade to maintain their stated future maturity.
        The types of debt are similar to those of money funds (but
        longer term); however, futures and options are sometimes used
        for hedging purposes.  The other classifications are described
        below:
        Time to maturity, interest rate risk:
        (a) Short term:  usually less than 5 years maturity.  Interest
            rate risk is low.
        (b) Long term:  up to 30 year average maturity.  Interest rate
            risk is high.
        (c) Mortgage backed:  has some unusual interest rate risks.
            When interest rates rise, they lose value like other bonds.
            When interest rates fall, homebuyers refinance, causing them
            to prepay old mortgages, which in turn causes bonds backed
            by these mortgages to be called.
        (d) Adjustable rate:  this type of fund is like other mortgage
            backed funds, but it invests in adjustable rate mortages.
            Therefore, the two sided interest rate risk faced by fixed
            rate mortgage backed bonds in considerably reduced.  However,
            the interest income will fluctuate widely, even though the
            principal value is more stable.  Since most adjustable rate
            mortgages have caps on how high the rate can go (typical
            limits are a 2% increase during a year and 6% increase during
            the life of the load), risk increases if interest rates
            increase quickly or by a large amount.
        (e) Target maturity:  the few funds in this category buy only
            bonds of the given maturity date.  Thus one can actually
            hold these to maturity.
        Credit risk:
        (a) Investment grade:  restricted only to bonds with low to
            medium-low credit risk (national government bonds are
            usually considered lowest risk).  This generally means the
            fourth highest Standard and Poor's or Moody's rating
            (S&P BBB or Moody's Baa).  Some funds have higher standards.
        (b) High yield or junk:  buys bonds of any credit rating,
            seeking maximum interest yield at a greater risk of default.
      (3) Stock funds.  These invest in common and/or preferred stocks.
        Stocks usually have higher short term risk than bonds, but
          have historically produced the best long term returns.
        Stock funds often hold small amounts of money market investments
        to meet redemptions; some hold larger amounts of money market
        investments when they cannot find any stock worth investing in
        or if they believe the market is about to head downward.
        Some of the possible investment goals are described below.
        They are not necessarily mutually exclusive.
        (a) Growth.  These funds seek maximum growth of earnings and
            share price, with little regard for dividends.  Usually
            tend to be volatile.
        (b) Aggressive growth.  Similar to growth funds, but even more
            aggressive; tend to be the most volatile.
        (c) Equity income.  These funds are more conservative and seek
            maximum dividends.
        (d) Growth and income.  In between growth funds and income funds,
            they seek both growth and a reasonable amount of income.
        (e) Small company.  Focuses on smaller companies.  Usually of the
            growth or aggressive growth variety, since smaller companies
            usually don't pay much dividends.
        (f) International.  Focuses on stocks outside the USA, generally
            investing in many nations' companies.
        (g) Country or regional funds.  These funds buy stocks primarily
            in the designated country or region.
        (h) Index funds.  These funds do no management, but just buy some
            index, like the Standard and Poor 500.  Some index funds,
            particularly those emulating indices with large numbers of
            stocks such as the Wilshire 4500 or Russell 2000, emulate
            the index by buying a subset with similar industry mix,
            capitalization, price/earnings ratio, etc.  Expenses are
            usually very low.
        (i) Sector funds.  These funds buy stocks only in one industry.
            Usually considered among the riskiest stock funds, though
            different sectors tend to have different levels and types
            of risk.
      (4) Balanced funds.  By mixing stocks and bonds (and sometimes other
        types of assets) a balanced fund is likely to give a return
        between the return of stocks and bonds, usually at a lower
        risk than investing in either alone, since different types of
        assets rise and fall at different times.  An investor can create
        his/her own balanced fund by buying shares of his/her favorite
        stock fund(s) and his/her favorite bond fund(s) (and other funds,
        if desired) in the desired allocation.
          (a) Regular balanced funds:  These funds usually hold a fixed
            or rarely changed allocation between stocks and bonds.
        (b) Asset allocation funds:  These funds may switch to any
            allocation, usually based on market timing to some degree.
      (5) Multifunds.  These funds buy primarily other mutual funds.
        They choose other funds based on one or more of the investment
        goals outlined above.
        (a) No-management funds:  These funds hold fixed proportions
            of other funds.  They are offered by fund companies as
            cheap balanced funds -- the underlying funds are other
            funds managed by the same company.  There are generally
            little or no expenses other than those of the underlying
            funds.
        (b) Managed funds:  In these funds, a manager picks which other
            funds s/he believes are managed well.  Sometimes these
            funds are market timing funds which prefer to leave the
            stock picking to other managers.  These funds have
            expenses above and beyond those of the underlying funds.

  17: What is a "socially responsible" fund?

  A:  In addition to the usual investment goals, these funds restrict
      their investments to whatever they define as socially responsible.
      Such criteria can include:  avoiding military, alcohol, tobacco,
      and gambling industries, avoiding South Africa, preferring companies
      that treat their employees and the environment well.  Different
      funds have different social and investment criteria.

  18: Where can I get comparative information on mutual funds?

  A:  Brokers and financial advisors offer information, but they
      usually give information only on load funds.  However, many
      periodicals (Barron's, Money, Forbes, Fortune, Business Week,
      etc.) have regular (often quarterly or annually) mutual fund
      review issues.  In addition, there are many books available on
      mutual fund investing.  Different periodicals and books use
      different criteria to rate funds.  These periodicals and books
      usually have phone numbers which you can call to get the fund's
      prospectus and other information.  Note that some ratings account
      for loads, while others do not.  Past performance is no guarantee
      of future results of either the fund or the securities markets
      in general.

  19: How does buying funds directly compare with buying through a broker?

  A:  A load fund usually costs the same whether bought directly or
      through a broker.  However, a proposed SEC rule change would
      allow more latitude in brokers discounting loads.  A no-load
      fund can be bought directly at no charge; most brokers will
      charge a commission to buy a no-load fund.  Holding funds in
      a broker may make it easier to trade from one fund to another,
      however.  Closed-end funds usually need to be traded through
      a broker, like regular stocks.

  20: What does family of funds do compared to a single fund?

  A:  Families of funds sometimes offer additional services, such as
      telephone switching from one fund to another within the family.
      With load fund families, switching from one load fund to another
      is sometimes allowed without paying a second load.  Some families
      may make bookkeeping easier by listing all of an investor's
      different funds on one statement.  Others reduce expenses by
      sharing services which realize economies of scale.  Note, however,
      that the good advertised performance of one fund in a family
      may or may not be shared by others.

  21: What are the tax implications of mutual funds for individuals?

  A:  Like shares of any stock, selling mutual fund shares may cause you to
      realize a capital gain or loss.  Mutual funds also distribute dividends
      received and their own realized capital gains, usually at the end
      of the year; these distributions, whether taken in cash or reinvested,
      are taxable (note that the nontaxability of municipal bond funds
      applies only to dividend distributions; capital gain distributions
      are always taxable).  Thus it is often a bad idea to buy a mutual
      fund just before the distribution date, since part of your investment
      will be immediately returned to you as a taxable distribution, resulting
      in you paying taxes much earlier than if you bought just after the
      distribution.  Although the distribution lowers the net asset value
      of your shares, allowing you to "deduct" it when you sell the shares,
      paying taxes sooner rather than later prevents you from gaining
      investment income on the amount that is taxed.  Note that reinvesting
      is considered identical to taking the distribution in cash and
      sending the same amount into the fund as a new investment, so don't
      forget about it when calculating the basis in your account.  When
      selling, it is best to know the different methods of calculating
      the basis of shares sold ahead of time, since some methods require
      that you designate which shares are to be sold.  For more information,
      call 1-800-TAX-FORM and ask for publications 544, 550, and 564, and
      schedules B and D.

  22: How do I put mutual funds in an IRA?

  A:  Most funds have a bank or trust company arranged to be an IRA custodian
      for any IRA shareholders.  If you buy the fund directly, using this
      custodian, you must use a different application available from the fund
      company.  The custodian usually charges $10 to $15 per fund account
      per year.  This is a significant expense for small accounts, not too
      significant for larger accounts.  Alternatively, you can open a
      brokerage account IRA and purchase mutual funds within that.  This
      would be similar to using a broker to buy funds normally, but incurs
      a single IRA custodian fee (usually $25 to $50).  Custodian fees,
      but not loads or commissions, may be paid separately from the
      contribution, and may be separately tax deductible.  Call 1-800-TAX-FORM
      and ask for publication 590 and form 8606 for general IRS information
      about IRAs.  Note that the tax issues of distributions as detailed
      previously don't affect IRA accounts.


  ========================================================================

  Further information on personal finance material on the Internet is
  available from the "Guide to Personal Finance Resources on the
  Internet" by Abbot Chambers and Catherine Kummer.

  Access to the Personal Finance Guide:

        anonymous ftp:
                host:   una.hh.lib.umich.edu
                path:    /inetdirsstacks
                file name:  persfin:chamkummer

        Gopher:
                via U. of Minnesota list of Gophers (Other Gophers)
                menus:  => North America
                                => Michigan
                                => Clearinghouse for Subject-Oriented...
                                => All Guides
                                => Personal Finance

        URL for WorldWideWeb/Mosaic:
                gopher://una.hh.lib.umich.edu/00/inetdirsstacks
                /persfin:chamkummer


  ---Direct questions or comments to:

                        Abbot Chambers
                        University of Michigan SILS
                        abcham@sils.umich.edu

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End of AFA-PERS Digest - 2 Mar 1994 to 3 Mar 1994
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