Mutual Fund Basics
Mutual funds have become an increasingly popular investment alternative for today’s investor because they offer a convenient cost effective way to invest in the financial markets.
In the simplest of terms a mutual fund is a company that brings together a group of people and invests their money in investment vehicles such as bonds, stocks, money market instruments and other securities. Each investor in the fund owns shares, which represents their portion of the holdings of the fund.
It is important for any investor exploring the option of buying into a mutual fund to understand what some of the common terms associated with mutual fund investing mean.
Net Asset Value (NAV) – To a mutual fund investor the performance of their investment depends on what happens to the funds per share value or its NAV. This is the current market worth of a mutual fund share calculated daily or weekly by taking the funds total assets deducting any liabilities and dividing by the number of shares outstanding.
Ask/Offer Price – This is the price at which mutual funds shares can be purchased. It is based on the current NAV per share plus any sales charges.
Bid/Sell Price – The price at which mutual funds shares can be redeemed i.e. bought back by the fund. It is the current NAV less any redemption fees.
Capital Gain – This is any profit that results when the price of a security held in a mutual fund rises above its purchase price. A capital loss on the other hand is the reverse.
Contingent Deferred Sales Charge (CDSC) – This is a fee imposed by certain funds on shares redeemed within a specific time period following purchase.
Expense Ratio – This is the total expense to net assets of the fund. Expenses include operating costs such as management and administration fees. This ratio is expressed as a percentage of a funds average net assets for a given time period.
Load – A sales charge added to the purchase of a mutual fund to cover selling costs. It is usually stated as a percentage or portion of the funds offering price.
Total Return - This measures the performance of an investment including yield (interest, dividends and capital gains) as well as any changes in share price, calculated over a designated period of time. Assume for example that your shares are now worth $10,000.00 and the initial investment was $6,000.00 the total return would then be;
10,000 – 6,000/6,000 X 100 = 66.7%
Beta Value – The beta value is a measure of a funds volatility or risk. The lower the beta value the less risky the fund.
Distributions – This includes any dividends, income or capital gains paid by a mutual fund to its shareholders.
Having decided to invest in a fund the investor faces the task of choosing the fund that is suitable for them. In order to do this they must ask the following questions.
What is my investment objective?
There are several reasons why people invest. Some may be saving to buy their dream house, finance their children’s college education or for retirement. Whatever the answer is to this question it helps the investor to focus on what it is they are trying to achieve and leads to the next question.
What is my investment time horizon?
For example the investor saving to buy his dream house may want to do so in two years a relatively short investing time period. On the other hand the investor saving for retirement in say the next 25 years has a longer investment time horizon.
How much risk am I willing to take?
In assessing your risk level you must consider your time horizon as discussed above. The shorter your investment horizon the less risk you are willing to take but an investor with a longer time horizon may be willing to ride out the periodic ups and downs of the market.
Other factors to consider when assessing how much risk to assume include the age, income level, expenses and liquidity needs of the investor.
Choosing the Fund
After answering the above questions the investor should now choose a mutual fund that matches his/her objective. It is wise to consult with your financial advisor to guide you comfortably through the process.