A Guide to Mutual Fund Investing

Special Considerations & Risks

Before investing in a mutual fund, investors need to understand and evaluate some of the special considerations and risks associated with mutual funds.

Distributions

By law, mutual funds must declare distributions each year, which are a transmission to shareholders earnings from dividends, interest and other income earned from the securities in which it invests. Dividend distributions are made on regular, scheduled intervals after a fund deducts its expenses from the investment income. Capital gains, which are profits the fund makes from selling underlying securities at a higher price than it paid, are typically paid at year end.

Even in years with negative returns, mutual funds can pay out distributions. Regardless of the fund's overall performance, the fund must pay a distribution for transactions on which it made a capital gain, creating a taxable event for the shareholder. Since the fund's underlying securities can pay out dividends regardless of fund performance, income distributions are also not dependent on positive fund returns.

Duration

Duration is an important concept to consider when investing in mutual funds with exposure to bonds. Duration is a basic measure of interest rate risk. It can help predict the likely change in the price of a bond, given a change in interest rates. For example, the shorter a bond's maturity, the shorter its duration because it takes less time to receive full payment. Duration allows for the effective comparison of bonds with different maturities and coupon rates.

Market Risk

As with any security, the price of a fund's shares will fluctuate with market conditions and other factors more specific to a given security. Mutual funds can decline in value and are not insured by the Federal Deposit Insurance Corporation. Mutual fund shares are designed for long-term investors and should not be treated as trading vehicles.

Interest Rate Risk

An adjustment to interest rates can affect all types of securities. Generally, bonds will decrease in value when interest rates rise, while stocks tend to increase in value. The net asset value of a fund will fluctuate if interest rate changes alter the value of its portfolio holdings.

Credit Risk

Lower-rated bonds carry a greater degree of risk that the issuer will lose its ability to make interest and principal payments. This could impact a fixed income fund's net asset value and dividend payout.

Fees

Shareholders pay annual fees for investment management services, sales-related expenses and administrative services. The investment management portion is applied to investment costs, which include technology, research costs and compensation for investment managers. The sales component is paid when buying shares in a mutual fund with the assistance of a financial advisor. Though they are not free, mutual funds remain a bargain compared to what it would cost to replicate the depth of research and trading capabilities that are shared when investors pool their assets.

Automatic Reinvestment

Both dividends and fund distributions can be automatically reinvested to purchase additional fund shares. Funds generally offer a systematic reinvestment option. Separately, shareholders may participate in an automatic investment plan, whereby fund shares are purchased regularly from funds drawn electronically from a checking account. This can make saving easier, and by regularly purchasing securities, reduce the risk of buying securities when their value is the highest. Investing regularly, sometimes called dollar-cost averaging, enables investors to buy more shares when the price is low and fewer when the price is high.

Tax-Deferred Investing

Mutual funds held in tax-deferred accounts such as 401(k) plans, IRAs or variable annuities are not subject to annual taxes. Only the withdrawals are subject to tax. The tax deferral offered by 401(k) and IRA accounts is designed to give greater incentive to save for retirement, and participation in these can significantly postpone or grow investments without tax on gains, saving investors from a considerable amount of taxes over the long term.