What You Should Know About Mutual Fund Investment

Mutual fund investing requires you to put your faith in professional money managers who will select investments on your behalf, meaning it is essential that you feel comfortable with the risk involved.

Before selecting a fund, it is important to identify your financial goals, timelines and risk tolerance so you can determine how much risk to take on.

Costs

Mutual funds impose fees and charges that vary from fund to fund, with these costs ultimately passed onto investors and having an effect on performance over time. A fund with higher fees must earn more than its low-cost counterpart to provide similar returns to investors.

Fees typically appear as an annual expense ratio in a fund’s prospectus and encompass management fees, 12b-1 fees and other expenses; however it can sometimes be hard to identify exactly which fees fall under this expense ratio.

Some funds charge initial buyers sales commissions, or loads, when purchasing shares for the first time. This fee is designed to compensate the broker who sold you these shares for his or her professional services and advice; other fees could include redemption charges, exchange charges or account service charges.

One mutual fund may provide multiple share classes with differing combinations of front-end loads and back-end loads as well as distribution and service fees, which ultimately reflect in its net asset value and lead to significantly different performance results over time.

Fees

Fees associated with mutual funds can be significant and significantly impact your rate of return. They’re usually known upfront and should be taken into account when comparing funds.

Sales loads are one-time fees paid to brokers when investing in fund shares, which aren’t factored into its total expense ratio. Some funds also impose back-end loads when selling shares back out through breakpoints; this fee may be known as contingent deferred sales charge (CDSC), and you’ll find more information in its prospectus.

Fund expenses also include distribution charges, which is part of the overall management fee and used to pay for marketing and distribution of shares of the fund. Other operating expenses include legal, customer service, office supplies and filing fees. Some funds also charge account fees that cover their account management services for investors.

Taxes

Mutual funds pool the money of many investors into one pooled portfolio to purchase securities. Professional managers oversee this investment strategy and decide when and how often securities should be purchased and sold, with profits distributed back out as capital gains or income to shareholders.

Investors receive dividends proportional to the number of unit shares they own and any distributions are subject to income taxes, regardless of whether they are reinvested back into the fund or not.

Mutual funds also often realize capital gains beyond regular dividend payments, typically after selling certain holdings at higher prices than when purchased. Capital gains taxation rates depend on how long a fund owns the shares it gains from.

To accurately calculate your taxes, you will require detailed records of your purchases and sales of mutual fund shares. Your fund company should provide this documentation; additionally, be sure to keep copies of IRS Form 1099s or account statements from time-to-time.

Distributions

Distributions from mutual funds play a vital role in their returns, providing dividends, interest income, capital gains and withholding taxes to investors. Long-term capital gains tend to be taxed at lower rates than regular income and investors may opt to receive their distributions in cash or reinvested them back into shares.

Most mutual funds make yearly distributions of income and capital gains to investors in order to meet excise tax requirements, yet these distributions may cause portfolio dilution.

Distribution amounts are calculated by subtracting sales loads and fees from a fund’s net asset value, with sales loads used to compensate outside brokers that sell its shares, while back-end loads may also be deducted from redemption proceeds. Investors should understand which share classes charge which sales loads, as this helps them compare various funds; front-end loads generally decrease as more money is invested into each mutual fund.