Questions to Ask Before Investing in Mutual Funds - dummies

Questions to Ask Before Investing in Mutual Funds

By Amine Bouchentouf

Before you invest in a mutual fund, you need to gather as much information as possible about the fund itself, as well as about the mechanics of investing in the fund. You can get answers to these questions directly from the fund manager or the fund’s prospectus.

Call the mutual fund company directly and ask for a prospectus. A prospectus contains a wealth of information regarding how the fund is managed, the strategies the fund managers use, and details on fees and expenses. It’s a great way to start gathering information on a prospective fund. Best of all, mutual funds send you their prospectus for free!

Some useful questions can help you zero in on the key points of mutual fund investing:

  • What is the fund’s investment objective? Different funds have radically different investment objectives. One may focus on capital gains, where the purpose is price appreciation, whereas another may specialize in income investing by buying assets, such as bonds, that generate an income stream. Knowing the fund’s objective is one of the first pieces of information to look for.

  • What securities does the fund invest in? This may seem like an obvious question when you’re looking at commodities funds, but a number of funds claim that their main investment products are commodities, when in reality, only a small percentage of the fund is commodities related.

  • Who manages the fund? You want to know as much as possible about the individuals who will be managing your hard-earned money. Most money managers in the United States have to be registered with the National Association of Securities Dealers (NASD). You can get information on a manager’s personal background by checking the NASD website. Look for these key points:

    • Experience: How long has he been a manager?

    • Track record: What kind of returns has the manager achieved for his clients in the past?

    • Disciplinary actions: Has this manager been disciplined for a past action? If so, find out more.

    • Registrations and certifications: Does this manager have all the required registrations with the appropriate financial authorities to trade and invest on behalf of clients?

  • What kind of strategy does the fund use? A fund’s strategy relies on a number of factors, including the investing style of the portfolio managers, the fund’s objective, and the securities it chooses to invest in. Some funds follow low-risk, steady-income strategies, while others have a more aggressive strategy that uses a lot of leverage. Identifying the fund’s strategy right away is critical.

  • What is the profile of the typical investor in this fund? The fund caters to the profile of its investors, which can be anywhere from highly conservative to extremely aggressive. You need to know what kind of individual is likely to invest in this fund and determine whether your risk tolerance squares with that of the other investors.

  • What are the main risks of investing in this fund? Whenever you invest, you take on a certain degree of risk: interest rate risk, credit risk, risk of loss of principal, liquidity risk, hedging risk, and geopolitical risk.

  • What is the fund’s track record? Although past performance doesn’t guarantee future results, it’s always important to examine the fund’s track record, to get a sense of the kinds of returns the managers have achieved for their investors in the past. Most funds post their performance over a number of years; in particular, look at the key periods of the past three, five, and ten years.

  • What is the fund’s after-tax performance? Pay close attention to after-tax returns when looking at historical performance; they’re a more accurate measure of the fund’s performance — and how much money you get to keep after you pay Uncle Sam. Many funds use big, bold charts to advertise their performance before taxes, but these can be misleading because a significant portion of these returns ends up in the government’s coffers after taxes are taken out.

  • What are the fund’s fees and expenses? Fees and expenses always cut into how much money you can get out of the fund. Look for funds that have lower expenses and fees. This information is available in the prospectus.

  • What is the minimum capital an investor must commit? A number of mutual funds require investing a minimum amount of money, ranging anywhere from $500 to $10,000 or more. The minimum requirement may also vary according to the type of investor. Someone investing in an IRA, for example, may have to put up less money up front than someone investing through a brokerage account. Finally, many funds also require minimum incremental amounts after the initial investment amount. So you may invest $1,000 up front but then be required to increase your investment by at least $100 each subsequent time you want to invest in the fund.

  • Are there different classes of shares? Most mutual funds offer more than one class of shares to investors. The different classes are based on several factors, including sales charges, deferred sales charges, redemption fees, and investor availability. Examine each class of shares closely to determine which is best for you.

  • What are the tax implications of investing in this fund? Talk to your accountant to determine the tax consequences of any investment you make.

As with almost everything else in finance, investing in commodity mutual funds requires mastering specific terminology. These technical terms can help you talk the talk:

  • Expense ratio: The expense ratio is the percentage of the fund’s total assets earmarked for general operational expenses. This is the amount used to run the fund, and it generally lowers total fund returns.

  • Sales load: Some mutual funds sell their shares through brokerage houses and other financial intermediaries. A sales load is the commission the mutual fund pays to brokers who sell their shares to the general public. The investor pays the sales load. Some funds don’t have sales load; they’re called no-load funds.

  • Sales charge: A sales charge, sometimes referred to as a deferred sales charge, is a fee that the mutual fund investor pays when she sells her mutual fund shares. This charge is also known as a back-end charge because you pay a fee after you sell your shares.

  • Net asset value (NAV): A fund’s net asset value (NAV) is its total assets minus total liabilities. Mutual funds calculate NAV on a per-share basis at the end of each trading day by dividing the difference between total assets and liabilities by the number of shares outstanding. A mutual fund’s NAV is similar to a publicly traded company’s stock price on a per-share basis.