5 Things Investors Should Know About Mutual Funds

Many funds have loads, and some managers must follow strict guidelines.

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Mutual funds are one of the best ways to invest in the stock market. They are diversified, easy to trade, and come in virtually every size imaginable. But, there are factors you need to understand before you invest with this vehicle. Here are five things to consider before investing:

Many mutual funds have loads. A load is a fee paid to your broker or advisor for selling the fund to you. Loads can be charged in different ways: front (A shares), back (B shares), level (C shares), and no load. Front loads are charged up front and range between 3 and 6 percent. That up-front fee comes from your investment, and most of it is paid to your broker. Back-loads are not charged up front but are assessed if you take your money out of the fund prior to a certain period of time (typically four to seven years). Level-loaded funds usually carry a one percent additional internal expense paid to your broker. Many level-loaded funds also carry a 1 percent fee for liquidating the fund within the first year. Both back-loaded and level-loaded funds carry a higher internal expense ratio, which will be discussed below. No-load funds do not carry a fee. But remember, the reason no-load funds are cheaper is because no advises you. Therefore, no one needs to be paid.

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There are also inexpensive no-load institutional funds, but typically you must invest more than 1 million dollars with the fund family to qualify for this share class. Fee-based advisors generally use these funds for their clients.

All mutual funds have internal expenses. These are the fees associated with running the funds. They cover the accounting, legal, trading, and other expenses of the fund. Internal expenses cost investors anywhere from 0.25 percent to more than 2.5 percent. Remember, these fees come from your return. The lower the internal expense, the more of the fund's return you get to keep.

How mutual funds trade. Unlike a stock, open-end mutual funds do not trade on the market. When you buy and sell a fund, you buy and sell it from the fund company. Because of this trading method, the time at which you actually buy and sell that fund is meaningless. In other words, if you buy a fund on a Monday at 1:00 p.m., your fund is not actually traded or priced at 1:00 p.m.. It is priced at the market close. The same happens when you sell a fund. Funds do not trade throughout the day. They only trade and are priced at the end of the day.

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Mutual funds are not taxed like stocks. They are taxed based on the way the fund manager trades the securities within the fund. If a fund manager sells a stock within the portfolio today and it has a gain, the tax on that gain is passed on to shareholders. This may be fine for those who bought the fund last year when the manager first purchased the stock, but not so positive for an investor that just invested in the fund, did not realize the gain, but still had to pay the tax. Mutual funds can be tax-inefficient.

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Managers must follow strict investing guidelines. Knowing that your fund manager can only invest in a particular type of stock helps you know what you are invested in, but it can also significantly hurt you if that particular asset class is in a downward trend. For example, if you invested in a technology fund in 1999, you probably did fairly well into early 2000s, but after that your fund probably lost a significant amount. By charter, objective, and prospectus, your fund's manager was required to invest most of the fund's assets in technology securities. Just keep in mind that it was not necessarily the fund manager's fault. He was just doing his job. He had no choice, and your fund had nowhere to go but down. According to the Investment Company Act of 1940, which provides rules for open-end mutual funds, those funds must invest at least 80 percent of their assets in the associated asset class.

There are pluses and minuses when you invest in a mutual fund. The most important thing you can do is to be aware of them.

Good luck and happy investing.

Kelly Campbell , Certified Financial Planner and Accredited Investment Fiduciary, is founder of Campbell Wealth Management, a Registered Investment Advisor in Fairfax, Va. Campbell is also the author of Fire Your Broker, a controversial look at the broker industry written as an empathetic response to the trials and tribulations many investors have faced as the stock market cratered and their advisors abandoned their responsibilities to help them weather the storm.