Though still a bit uneasy, you understand the attractions of investing in mutual funds and think you have narrowed down the type of fund you want to purchase. You feel pretty confident knowing that mutual funds allow you to play the stock market and generate a respectable rate of return without having to pick the winners on your own. But with over 10,000 mutual funds to choose from, you can be sure that there are a significant number of "losers" out there. Before making any financial commitments review this checklist to make sure you’re really prepared.
Identify Your Goals
It goes without saying that until you understand your investment objectives, you should hold off on your purchase. While mutual funds present a convenient and cost effective strategy of diversifying investments, and don't necessarily demand your management, you need to understand your goals to choose the right mix if funds that can work to achieve them. Are you seeking aggressive growth, capital preservation, or something in between? Is this investment long term, or do you plan to use your earnings in the short term, possibly as a down payment, or for college tuition?
Buy a mutual fund that is in sync with your investment objectives, not because it has done well recently or you read about it in the paper. Or, that worst case scenario, your neighbor has been raving about it! For long term investment strategies, any track record less than five years just isn't that reliable. It’s generally not recommended that you focus exclusively on returns. Consider the fund’s performance over longer periods of time and compare it to peers or an index that represents the type of asset class the fund is in.
Read the Prospectus
A prospectus illustrates the mutual fund's fees and investment objectives, and includes relevant financial data such as investment methods and risk description. By law, this report must be presented to all investors. It should include information about the fund managers and compensation agreements, detail procedures for buying and selling shares, dividend and capital gain distributions, and other services related to the fund. Read the prospectus from cover to cover before making your investment.
Ask About Fees
Fees are displayed in the prospectus as well as on many mutual fund research sites. Look for funds with low expenses and avoid " 12-b fees ". A rule 12-b fee is one applied towards marketing expenses, which means either commissions or advertising expenses. This fee will add to your annual expenses and can be as high as 1.25% per year. Also avoid “loaded funds”; funds that carry front-end loads, back-end loads or deferred loads, which are basically sales charges. There are plenty of no-load funds out there to choose from.
Understand the Level of Risk
You should be pretty comfortable with the level of risk of the fund you are interested in. Of course, when you make an investment, there is always some degree of risk, but don't take any risk that you are not comfortable with and never take unnecessary risks.
Investigate the Fund Manager
What firm serves as the fund's adviser and who manages the fund? It might not be a bad idea to do some background checking to make sure it is a decent entity. The Securities Exchange Commission (SEC) is the official regulator for mutual funds and has information about each fund and its manager. Also look out for recent manager changes. Though a new fund manager may be just as good or better, it is important to realize that all the fund statistics from before may not be relevant, especially in an actively managed fund.
Know the Record Date?
The record date is a date set by the issuing company on which you already must own shares to receive a dividend or capital gains distribution. Before you buy, ask about the realized gains (profits) in the fund’s portfolio. If realized gains are more than 5% of the value of the fund’s underlying securities, and the record date of the next capital gain distribution is near, you may want to hold off on purchasing until the record date has passed. Otherwise you will “buy the dividend”, and will have to pay tax on the capital gains. This rule generally applies to one-time lump sum investments, verses continuing dividend reinvestments. In that case, it is better to buy the dividend then fail to invest.
There is so much to think about before your investment, but these items are a good start. Remember that fund performance is subject to frequent reviews by various publications and rating agencies, including Barron’s, Business Week, The Wall Street Journal, Money Magazine, only to a few, making it easier for you to conduct direct comparisons between funds. Spending the time to make comparisons is well worth the assurance that the money you put towards your investment is all going to work for you.
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