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The Investment FAQ (part 9 of 20)

( Part1 - Part2 - Part3 - Part4 - Part5 - Part6 - Part7 - Part8 - Part9 - Part10 - Part11 - Part12 - Part13 - Part14 - Part15 - Part16 - Part17 - Part18 - Part19 - Part20 )
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Archive-name: investment-faq/general/part9
Version: $Id: part09,v 1.61 2003/03/17 02:44:30 lott Exp lott $
Compiler: Christopher Lott

See reader questions & answers on this topic! - Help others by sharing your knowledge
The Investment FAQ is a collection of frequently asked questions and
answers about investments and personal finance.  This is a plain-text
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compiler nor contributors will be liable to any user or anyone else
for any inaccuracy, error or omission, regardless of cause, in The
Investment FAQ or for any damages (whether direct or indirect,
consequential, punitive or exemplary) resulting therefrom.  

Rules, regulations, laws, conditions, rates, and such information
discussed in this FAQ all change quite rapidly.  Information given
here was current at the time of writing but is almost guaranteed to be
out of date by the time you read it.  Mention of a product does not
constitute an endorsement. Answers to questions sometimes rely on
information given in other answers.  Readers outside the USA can reach
US-800 telephone numbers, for a charge, using a service such as MCI's
Call USA.  All prices are listed in US dollars unless otherwise
Please send comments and new submissions to the compiler.

--------------------Check for updates------------------

Subject: Mutual Funds - Distributions and Tax Implications

Last-Revised: 27 Jan 1998
Contributed-By: Chris Lott ( contact me ), S.  Jaguiar, Art Kamlet
(artkamlet at, R.  Kalia

This article gives a brief summary of the issues surrounding
distributions made by mutual funds, the tax liability of shareholders
who recieve these distributions, and the consequences of buying or
selling shares of a mutual fund shortly before or after such a

Investment management companies (i.e., mutual funds) periodically
distribute money to their shareholders that they made by trading in the
shares they hold.  These are called dividends or distributions, and the
shareholder must pay taxes on these payments.  Why do they distribute
the gains instead of reinvesting them? Well, a mutual fund, under The
Investment Company Act of 1940, is allowed to make the decision to
distribute substantially all earnings to shareholders at least annually
and thereby avoid paying taxes on those earnings.  And, of course, they
do.  In general, equity funds distribute dividends quarterly, and
distribute capital gains annually or semi-annually.  In general, bond
funds distribute dividends monthly, and distribute capital gains
annually or semi-annually. 

When a distribution is made, the net asset value (NAV) goes down by the
same amount.  Suppose the NAV is $8 when you bought and has grown to $10
by some date, we'll pick Dec.  21.  On paper you have a profit of $2. 
Then, a $1 distribution is made on Dec.  21.  As a result of this
distribution, the NAV goes down to $9 on Dec.  22 (ignoring any other
market activity that might happen).  Since you received a $1 payment and
your shares are still worth $9, you still have the $10.  However, you
also have a tax liability for that $1 payment. 

Mutual funds commonly make distributions late in the year.  Because of
this, many advise mutual fund investors to be wary of buying into a
mutual fund very late in the year (i.e., shortly before a distribution). 
Essentially what happens to a person who buys shortly before a
distribution is that a portion of the investment is immediately returned
to the investor along with a tax bill.  In the short term it essentially
means a loss for the investor.  If the investor had bought in January
(for example), and had seen the NAV rise nicely over the year, then
receiving the distribution and tax bill would not be so bad.  But when a
person essentially increases their tax bill with a fund purchase, it is
like seeing the value of the fund drop by the amount owed to the tax
man.  This is the main reason for checking with a mutual fund for
planned distributions when making an investment, especially late in the

But let's look at the issue a different way.  The decision of buying
shortly before a distribution all comes down to whether or not you feel
that the fund is going to go up more in value than the total taxable
event will be to you.  For instance let's say that a fund is going to
distribute 6% in income at the end of December.  You will have to pay
tax on that 6% gain, even though your account value won't go up by 6%
(that's the law).  Assuming that you are in a 33% tax bracket, a third
of that gain (2% of your account value) will be paid in taxes.  So it
comes down to asking yourself the question of whether or not you feel
that the fund will appreciate by 2% or more between now and the time
that the income will be distributed.  If the fund went up in value by
10% between the time of purchase and the distribution, then in the above
example you would miss out on a 8% after-tax gain by not investing.  If
the fund didn't go up in value by at least 2% then you would take a loss
and would have been better off waiting.  So how clear is your crystal

For someone to make the claim that it is always patently better to wait
until the end of the year to invest so as to avoid capital gains tax is
ridiculous.  Sometimes it is and sometimes it isn't.  Investing is a
most empirical process and every new situation should be looked at

And it's important not to lose sight of the big picture.  For a mutual
fund investor who saw the value of their investment appreciate nicely
between the time of purchase and the distribution, a distribution just
means more taxes this year but less tax when the shares are sold.  Of
course it is better to postpone paying taxes, but it's not as though the
profits would be tax-free if no distribution were made.  For those who
move their investments around every few months or years, the whole issue
is irrelevant.  In my view, people spend too much time trying to beat
the tax man instead of trying to make more money.  This is made worse by
ratings that measure 'tax efficiency' on the basis of current tax
liability (distributions) while ignoring future tax liability
(unrealized capital gains that may not be paid out each year but they
are still taxed when you sell). 

So what are the tax implications based on the timing of any sale?
Actually, for most people there are none.  If you sell your shares on
Dec.  21, you have $2 in taxable capital gains ($1 from the distribution
and $1 from the growth from 8 to 9).  If you sell on Dec.  22, you have
$1 in taxable capital gains and $1 in taxable distributions.  This can
make a small difference in some tax brackets, but no difference at all
in others. 

--------------------Check for updates------------------

Subject: Mutual Funds - Fees and Expenses

Last-Revised: 28 Jun 1997
Contributed-By: Chris Lott ( contact me )

Investors who put money into a mutual fund gain the benefits of a
professional investment management company.  Like any professional,
using an investment manager results in some costs.  These costs are
recovered from a mutual fund's investors either through sales charges or
operation expenses . 

Sales charges for an open-end mutual fund include front-end loads and
back-end loads (redemption fees).  A front-end load is a fee paid by an
investor when purchasing shares in the mutual fund, and is expressed as
a percentage of the amount to be invested.  These loads may be 0% (for a
no-load fund), around 2% (for a so-called low-load fund), or as high as
8% (ouch).  A back-end load (or redemption fee) is paid by an investor
when selling shares in the mutual fund.  Unlike front-end loads, a
back-end load may be a flat fee, or it may be expressed as a sliding
scale.  A sliding-scale means that the redemption fee is high if the
investor sells shares within the first year of buying them, but declines
to little or nothing after 3, 4, or 5 years.  A sliding-scale fee is
usually implemented to discourage investors from switching rapidly among
funds.  Loads are used to pay the sales force.  The only good thing
about sales charges is that investors only pay them once. 

A closed-end mutual fund is traded like a common stock, so investors
must pay commissions to purchase shares in the fund.  An article
elsewhere in this FAQ about discount brokers offers information about
minimizing commissions. 

To keep the dollars rolling in over the years, investment management
companies may impose fees for operating expenses.  The total fee load
charged annually is usually reported as the expense ratio .  All annual
fees are charged against the net value of an investment.  Operating
expenses include the fund manager's salary and bonuses (management
fees), keeping the books and mailing statements every month (accounting
fees), legal fees, etc.  The total expense ratio ranges from 0% to as
much as 2% annually.  Of course, 0% is a fiction; the investment company
is simply trying to make their returns look especially good by charging
no fees for some period of time.  According to SEC rules, operating
expenses may also include marketing expenses.  Fees charged to investors
that cover marketing expenses are called "12b-1 Plan fees." Obviously an
investor pays fees to cover operating expenses for as long as he or she
owns shares in the fund.  Operating fees are usually calculated and
accrued on a daily basis, and will be deducted from the account on a
regular basis, probably monthly. 

Other expenses that may apply to an investment in a mutual fund include
account maintenance fees, exchange (switching) fees, and transaction
fees.  An investor who has a small amount in a mutual fund, maybe under
$2500, may be forced to pay an annual account maintenance fee.  An
exchange or switching fee refers to any fee paid by an investor when
switching money within one investment management company from one of the
company's mutual funds to another mutual fund with that company. 
Finally, a transaction fee is a lot like a sales charge, but it goes to
the fund rather than to the sales force (as if that made paying this fee
any less painful). 

The best available way to compare fees for different funds, or different
classes of shares within the same fund, is to look at the prospectus of
a fund.  Near the front, there is a chart comparing expenses for each
class assuming a 5% return on a $1,000 investment.  The prospectus for
Franklin Mutual Shares, for example, shows that B investors (they call
it "Class II") pay less in expenses with a holding period of less than 5
years, but A investors ("Class I") come out ahead if they hold for
longer than 5 years. 

In closing, investors and prospective investors should examine the fee
structure of mutual funds closely.  These fees will diminish returns
over time.  Also, it's important to note that the traditional
price/quality curve doesn't seem to hold quite as well for mutual funds
as it does for consumer goods.  I mean, if you're in the market for a
good suit, you know about what you have to pay to get something that
meets your expectations.  But when investing in a mutual fund, you could
pay a huge sales charge and stiff operating expenses, and in return be
rewarded with negative returns.  Of course, you could also get lucky and
buy the next hot fund right before it explodes.  Caveat emptor. 

--------------------Check for updates------------------

Subject: Mutual Funds - Index Funds and Beating the Market

Last-Revised: 26 May 1999
Contributed-By: Chris Lott ( contact me )

This article discusses index funds and modern portfolio theory (MPT) as
espoused by Burton Malkiel, but first makes a digression into the topic
of "beating the market."

Investors and prospective investors regularly encounter the phrase
"beating the market" or sometimes "beating the S&P 500." What does this

Somehow I'm reminded of the way Garrison Keillor used to start his show
on Minnesota Public Radio, "Greetings from Lake Woebegon, where all the
women are beautiful and all the children are above average" ..  but I

To answer the second question first: The S&P 500 is a broad market
index.  Saying that you "beat the S&P" means that for some period of
time, the returns on your investments were greater than the returns on
the S&P index (although you have to ask careful questions about whether
dividends paid out were counted, or only the capital appreciation
measured by the rise in stock prices). 

Now, the harder question: Is this always the best indicator? This is
slightly more involved. 

Everyone, most especially a mutual fund manager, wants to beat "the
market".  The problem lies in deciding how "the market" did.  Let's
limit things to the universe of stocks traded on U.S.  exchanges..  even
that market is enormous .  So how does an aspiring mutual fund manager
measure his or her performance? By comparing the fund's returns to some
measure of the market.  And now the $64,000 question: What market is the
most appropriate comparison?

Of course there are many answers.  How about the large-cap market, for
which one widely known (but dubious value) index is the DJIA? What about
the market of large and mid-cap shares, for which one widely known index
is the S&P 500? And maybe you should use the small-cap market, for which
Wilshire maintains various indexes? And what about technology stocks,
which the NASDAQ composite index tracks somewhat?

As you can see, choosing the benchmark against which you will compare
yourself is not exactly simple.  That said, an awful lot of funds
compare themselves against the S&P.  The finance people say that the S&P
has some nice properties in the way it is computed.  Most market people
would say that because so much of the market's capitalization is tracked
by the S&P, it's an appropriate benchmark. 

You be the judge. 

The importance of indexes like the S&P500 is the debate between passive
investing and active investing.  There are funds called index funds that
follow a passive investment style.  They just hold the stocks in the
index.  That way you do as well as the overall market.  It's a
no-brainer.  The person who runs the index fund doesn't go around buying
and selling based on his or her staff's stock picks.  If the overall
market is good, you do well; if it is not so good, you don't do well. 
The main benefit is low overhead costs.  Although the fund manager must
buy and sell stocks when the index changes or to react to new
investments and redemptions, otherwise the manager has little to do. 
And of course there is no need to pay for some hotshot group of stock

However, even more important is the "efficient market theory" taught in
academia that says stock prices follow a random walk.  Translated into
English, this means that stock prices are essentially random and don't
have trends or patterns in the price movements.  This argument pretty
much attacks technical analysis head-on.  The theory also says that
prices react almost instantaneously to any information - making
fundamental analysis fairly useless too. 

Therefore, a passive investing approach like investing in an index fund
is supposedly the best idea.  John Bogle of the Vanguard fund is one of
the main proponents of a low-cost index fund. 

The people against the idea of the efficient market (including of course
all the stock brokers who want to make a commission, etc.) subscribe to
one of two camps - outright snake oil (weird stock picking methods,
bogus claims, etc.) or research in some camps that point out that the
market isn't totally efficient.  Of course academia is aware of various
anomalies like the January effect, etc.  Also "The Economist" magazine
did a cover story on the "new technology" a few years ago - things like
using Chaos Theory, Neural Nets, Genetic Algorithms, etc.  etc.  - a
resurgence in the idea that the market was beatable using new technology
- and proclaimed that the efficient market theory was on the ropes. 

However, many say that's an exaggeration.  If you look at the records,
there are very, very few funds and investors who consistently beat the
averages (the market - approximated by the S&P 500 which as I said is a
"no brainer investment approach").  What you see is that the majority of
the funds, etc.  don't even match the no-brainer approach to investing. 
Of the small amount who do (the winners), they tend to change from one
period to another.  One period or a couple of periods they are on top,
then they do much worse than the market.  The ones who stay on top for
years and years and years - like a Peter Lynch - are a very rare breed. 
That's why efficient market types say it's consistent with the random
nature of the market. 

Remember, index funds that track the S&P 500 are just taking advantage
of the concept of diversification.  The only risk they are left with
(depending on the fund) is whether the entire market goes up and down. 

People who pick and choose individual companies or a sector in the
market are taking on added risk since they are less diversified.  This
is completely consistent with the more risk = possibility of more return
and possibility of more loss principle.  It's just like taking longer
odds at the race track.  So when you choose a non-passive investment
approach you are either doing two things:
  1. Just gambling.  You realize the odds are against you just like they
     are at the tracks where you take longer odds, but you are willing
     to take that risk for the slim chance of beating the market. 
  2. You really believe in your own or a hired gun's stock picking
     talent to take on stocks that are classified as a higher risk with
     the possibility of greater return because you know something that
     nobody else knows that really makes the stock a low risk investment
     (secret method, inside information, etc.) Of course everyone thinks
     they belong in this camp even though they are really in the former
     camp, sometimes they win big, most of times they lose, with a few
     out of the zillion investors winning big over a fairly long period. 
     It's consistent with the notion that it's gambling. 

So you get this picture of active fund managers expending a lot of
energy on a tread mill running like crazy and staying in the same spot. 
Actually it's not even the same spot since most don't even match the S&P
500 due to the added risk they've taken on in their picks or the
transaction costs of buying and selling.  That's why market indexes like
the S&P 500 are the benchmark.  When you pick stocks on your own or pay
someone to manage your money in an active investment fund, you are
paying them to do better or hoping you will do better than doing the
no-brainer passive investment index fund approach that is a reasonable
expectation.  Just think of paying some guy who does worse than if he
just sat on his butt doing nothing!

The following list of resources will help you learn much, much more
about index mutual funds. 
   * An accessible book that covers investing approaches and academic
     theories on the market, especially modern portfolio theory (MPT)
     and the efficient market hypothesis, is this one (the link points
     to Amazon):
     Burton Malkiel
          A Random Walk Down Wall Street This book was written by a
     former Princeton Prof.  who also invested hands-on in the market. 
     It's a bestseller, written for the public and available in
   * offers much information about index mutual funds. 
     The site is edited by Will McClatchy and published by IndexFunds,
     Inc., of Austin, Texas.
   * The list of frequently asked questions about index mutual funds,
     which is maintained by Dale C.  Maley.

--------------------Check for updates------------------

Subject: Mutual Funds - Money-Market Funds

Last-Revised: 16 Aug 1998
Contributed-By: Chris Lott ( contact me ), Rich Carreiro (rlcarr at

A money-market fund (MMF) is a mutual fund, although a very special type
of one.  The goal of a money-market fund is to preserve principal while
yielding a modest return.  These funds try very, very, very hard to
maintain a net asset value (NAV) of exactly $1.00.  Basically, the
companies try to make these feel like a high-yield bank account,
although one should never forget that the money-market fund has no
insurance against loss. 

The NAV stays at $1 for (at least) three reasons:
  1. The underlying securities in a MMF are very short-term money market
     instruments.  Usually maturing in 60 days or less, but always less
     than 180 days.  They suffer very little price fluctuation. 
  2. To the extent that they do fluctuate, the fund plays some (legal)
     accounting games (which are available because the securities are so
     close to maturity and because they fluctuate fairly little) with
     how the securities are valued, making it easier to maintain the NAV
     at $1. 
  3. MMFs declare dividends daily, though they are only paid out
     monthly.  If you totally cash in your MMF in the middle of the
     month, you'll receive the cumulative declared dividends from the
     1st of the month to when you sold out.  If you only partially
     redeem, the dividends declared on the sold shares will simply be
     part of what you see at the end of the month.  This is part of why
     the fund's interest income doesn't raise the NAV. 

MMFs remaining at a $1 NAV is not advantageous in the sense that it
reduces your taxes (in fact, it's the opposite), it's advantageous in
the sense that it saves you from having to track your basis and compute
and report your gain/loss every single time you redeem MMF shares, which
would be a huge pain, since many (most?) people use MMFs as checking
accounts of a sort.  The $1 NAV has nothing to do with being able to
redeem shares quickly.  The shareholders of an MMF could deposit money
and never touch it again, and it would have no effect on the ability of
the MMF to maintain a $1 NAV. 

Like any other mutual fund, a money-market fund has professional
management, has some expenses, etc.  The return is usually slightly more
than banks pay on demand deposits, and perhaps a bit less than a bank
will pay on a 6-month CD.  Money-market funds invest in short-term
(e.g., 30-day) securities from companies or governments that are highly
liquid and low risk.  If you have a cash balance with a brokerage house,
it's most likely stashed in a money-market fund. 

--------------------Check for updates------------------

Subject: Mutual Funds - Reading a Prospectus

Last-Revised: 9 Aug 1999
Contributed-By: Chris Stallman (chris at

Ok, so you just went to a mutual fund family's (e.g., Fidelity) web site
and requested your first prospectus.  As you anxiously wait for it to
arrive in the mail, you start to wonder what information will be in it
and how you'll manage to understand it.  Understanding a prospectus is
crucial to investing in a mutual fund once you know a few key points. 

When you request information on a mutual fund, they usually send you a
letter mentioning how great the fund is, the necessary forms you will
have to fill out to invest in the fund, and a prospectus.  You can
usually just throw away the letter because it is often more of an
advertisement than anything else.  But you should definitely read the
prospectus because it has all the information you need about the mutual

The prospectus is usually broken up into different sections so we'll go
over what each section's purpose is and what you should look for in it. 

Objective Statement
     Usually near the front of a prospectus is a small summary or
     statement that explains the mutual fund.  This short section tells
     what the goals of the mutual fund are and how it plans to reach
     these goals. 
     The objective statement is really important in choosing your fund. 
     When you choose a fund, it is important to choose one based on your
     investment objective and risk tolerance.  The objective statement
     should agree with how you want your money managed because, after
     all, it is your money.  For example, if you wanted to reduce your
     exposure to risk and invest for the long-term, you wouldn't want to
     put your money in a fund that invests in technology stocks or other
     risky stocks. 
     The performance section usually gives you information on how the
     mutual fund has performed.  There is often a table that gives you
     the fund's performance over the last year, three years, five years,
     and sometimes ten years. 
     The fund's performance usually helps you see how the fund might
     perform but you should not use this to decide if you are going to
     invest in it or not.  Funds that do well one year don't always do
     well the next. 
     It's often wise to compare the fund's performance with that of the
     index.  If a fund consistently under performs the index by 5% or
     more, it may not be a fund that you want to invest in for the
     long-term because that difference can mean the difference of
     retiring with $200,000 and retiring with $1.5 million. 
     Usually in the performance section, there is a small part where
     they show how a $10,000 investment would perform over time.  This
     helps give you an idea of how your money would do if you invested
     in it but this number generally doesn't include taxes and inflation
     so your portfolio would probably not return as much as the
     prospectus says. 
Fees and Expenses
     Like most things in life, a mutual fund doesn't operate for free. 
     It costs a mutual fund family a lot of money to manage everyone's
     money so they put in some little fees that the investors pay in
     order to make up for the fund's expenses. 
     One fee that you will come across is a management fee, which all
     funds charge.  Mutual funds charge this fee so that the fund can be
     run.  The money collected from the shareholders from this fee is
     used to pay for the expenses incurred from buying and selling large
     amounts of shares in stocks.  This fee usually ranges from about
     0.5% up to over 2%. 
     Another fee that you're likely to encounter is a 12b-1 fee.  The
     money collected from charging this fee is usually used for
     marketing and advertising the fund.  This fee usually ranges
     between 0.25-0.75%.  However, not all funds charge a 12b-1 fee. 
     One fee that is a little less common but still exists in many funds
     is a deferred sales load.  Frequent buying and selling of shares in
     a mutual fund costs the mutual fund money so they created a
     deferred sales charge to discourage this activity.  This fee
     sometimes disappears after a certain period and can range from 0.5%
     up to 5%. 
     When you are looking through a prospectus, be sure that you look
     over these fees because even if a mutual fund performs well, its
     growth may be limited by high expenses. 
How to Purchase and Redeem Shares

     This section provides information on how you can get your money
     into the mutual fund and how you can sell shares when you need the
     money out of the fund.  These methods are usually the same in every
     The most common method to invest in a fund once you are in it is to
     simply fill out investment forms and write a check to the mutual
     fund family.  This is probably the easiest but it often takes a few
     days or even a week to have the funds credited to your account. 
     Another method that is common is automatic withdrawals.  These
     allow you to have a certain amount which you choose to be deducted
     from your bank account each month.  These are excellent for getting
     into the habit of investing on a regular basis. 
     Wire transfers are also possible if you want to have your money
     invested quickly.  However, most funds charge you a small fee for
     doing this and some do not allow you to wire any funds if you do
     not meet their minimum amount. 
     The fund will also provide information on how you can redeem your
     shares.  One common way is to request a redemption by filling out a
     form or writing a letter to the mutual fund family.  This is the
     most common method but it isn't the only one. 
     You can also request to redeem your shares by calling the mutual
     fund itself.  This option saves you a few days but you have to make
     sure the fund has this option open to the shareholders. 
     You can also request to have your investment wired into your bank
     account.  This is a very fast method for redeeming shares but you
     usually have to pay a fee for doing this.  And like redeeming
     shares over the phone, you have to make sure the mutual fund offers
     this option. 

Now that you understand the basics of a prospectus, you're one step
closer to getting started in mutual funds.  So when you finally receive
the information you requested on a mutual fund, look it over carefully
and make an educated decision if it is right for you. 

For more insights from Chris Stallman, visit

--------------------Check for updates------------------

Subject: Mutual Funds - Redemptions

Last-Revised: 5 May 1997
Contributed-By: A.  Chowdhury

On the stock markets, every time someone sells a share, someone buys it,
or in other words, equal numbers of opposing bets on the future are
placed each day.  However, in the case of open-end mutual funds, every
dollar redeemed in a day isn't necessarily replaced by an invested
dollar, and every dollar invested in a day doesn't go to someone
redeeming shares.  Still, although mutual fund shares are not sold
directly by one investor to another investor, the underlying situation
is the same as stocks. 

If a mutual fund has no cash, any redemption requires the fund manager
to sell an appropriate amount of shares to cover the redemption; i.e.,
someone would have to be found to buy those shares.  Similarly, any new
investment would require the manager to find someone to sell shares so
the new investment can be put to work.  So the manager acts somewhat
like the fund investor's representative in buying/selling shares. 

A typical mutual fund has some cash to use as a buffer, which confuses
the issue but doesn't fundamentally change it.  Some money comes in, and
some flows out, much of it cancels each other out.  If there is a small
imbalance, it can be covered from the fund's cash position, but not if
there is a big imbalance.  If the manager covers your sale from the
fund's cash, he/she is reducing the fund's cash and so increasing the
fund's stock exposure (%), in other words he/she is betting on the
market at the same time as you are betting against it.  Of course if
there is a large imbalance between money coming in and out, exceeding
the cash on hand, then the manager has to go to the stock market to
buy/sell.  And so forth. 

--------------------Check for updates------------------

Subject: Mutual Funds - Types of Funds

Last-Revised: 12 Aug 1999
Contributed-By: Chris Lott ( contact me )

This article lists the most common investment fund types.  A type of
fund is typically characterized by its investment strategy (i.e., its
goals).  For example, a fund manager might set a goal of generating
income, or growing the capital, or just about anything.  (Of course they
don't usually set a goal of losing money, even though that might be one
of the easist goals to achieve :-).  If you understand the types of
funds, you will have a decent grasp on how funds invest their money. 

When choosing a fund, it's important to make sure that the fund's goals
align well with your own.  Your selection will depend on your investment
strategy, tax situation, and many other factors. 

Money-market funds
     Goal: preserve principal while yielding a modest return.  These
     funds are a very special sort of mutual fund.  They invest in
     short-term securities that pay a modest rate of interest and are
     very safe.  See the article on money-market funds elsewhere in this
     FAQ for an explanation of the $1.00 share price, etc. 
Balanced Funds
     Goal: grow the principal and generate income.  These funds buy both
     stocks and bonds.  Because the investments are highly diversified,
     investors reduce their market risk (see the article on risk
     elsewhere in this FAQ). 
Index funds
     Goal: match the performance of the markets.  An index fund
     essentially sinks its money into the market in a way determined by
     some market index and does almost no further trading.  This might
     be a bond or a stock index.  For example, a stock index fund based
     on the Dow Jones Industrial Average would buy shares in the 30
     stocks that make up the Dow, only buying or selling shares as
     needed to invest new money or to cash out investors.  The advantage
     of an index fund is the very low expenses.  After all, it doesn't
     cost much to run one.  See the article on index funds elsewhere in
     this FAQ. 
Pure bond funds
     Bond funds buy bonds issued by many different types of companies. 
     A few varieties are listed here, but please note that the
     boundaries are rarely as cut-and-dried as I've listed here. 
     Bond (or "Income") funds
          Goal: generate income while preserving principal as much as
          possible.  These funds invest in medium- to long-term bonds
          issued by corporations and governments.  Variations on this
          type of fund include corporate bond funds and government bond
          funds.  See the article on bond basics elsewhere in this FAQ. 
          Holding long-term bonds opens the owner to the risk that
          interest rates may increase, dropping the value of the bond. 
     Tax-free Bond Funds (aka Tax-Free Income or Municipal Bond Funds)
          Goal: generate tax-free income while preserving principal as
          much as possible.  These funds buy bonds issued by
          municipalities.  Income from these securities are not subject
          to US federal income tax. 
     Junk (or "High-yield") bond funds
          Goal: generate as much income as possible.  These funds buy
          bonds with ratings that are quite a bit lower than
          high-quality corporate and government bonds, hence the common
          name "junk." Because the risk of default on junk bonds is high
          when compared to high-quality bonds, these funds have an added
          degree of volatility and risk. 
Pure stock funds
     Stock funds buy shares in many different types of companies.  A few
     varieties are listed here, but please note that the boundaries are
     rarely as cut-and-dried as I've listed here. 
     Aggressive growth funds
          Goal: capital growth; dividend income is neglected.  These
          funds buy shares in companies that have the potential for
          explosive growth (these companies never pay dividends).  Of
          course such shares also have the potential to go bankrupt
          suddenly, so these funds tend to have high price volatility. 
          For example, an actively managed aggressive-growth stock fund
          might seek to buy the initial offerings of small companies,
          possibly selling them again very quickly for big profits. 
     Growth funds
          Goal: capital growth, but consider some dividend income. 
          These funds buy shares in companies that are growing rapidly
          but are probably not going to go out of business too quickly. 
     Growth and Income funds
          Goal: Grow the principal and generate some income.  These
          funds buy shares in companies that have modest prospect for
          growth and pay nice dividend yields.  The canonical example of
          a company that pays a fat dividend without growing much was a
          utility company, but with the onset of deregulation and
          competition, I'm not sure of a good example anymore. 
     Sector funds
          Goal: Invest in a specific industry (e.g.,
          telecommunications).  These funds allow the small investor to
          invest in a highly select industry.  The funds usually aim for
     Another way of categorizing stock funds is by the size of the
     companies they invest in, as measured by the market capitalization,
     usually abbreviated as market cap.  (Also see the article in the
     FAQ about market caps .) The three main categories:
     Small cap stock funds
          These funds buy shares of small companies.  Think new IPOs. 
          The stock prices for these companies tend to be highly
          volatile, and the companies never (ever) pay a dividend.  You
          may also find funds called micro cap, which invest in the
          smallest of publically traded companies. 
     Mid cap stock funds
          These funds buy shares of medium-size companies.  The stock
          prices for these companies are less volatile than the small
          cap companies, but more volatile (and with greater potential
          for growth) than the large cap companies. 
     Large cap stock funds
          These funds buy shares of big companies.  Think IBM.  The
          stock prices for these companies tend to be relatively stable,
          and the companies may pay a decent dividend. 
International Funds
     Goal: Invest in stocks or bonds of companies located outside the
     investor's home country.  There are many variations here.  As a
     rule of thumb, a fund labeled "international" will buy only foreign
     securities.  A "global" fund will likely spread its investments
     across domestic and foreign securities.  A "regional" fund will
     concentrate on markets in one part of the world.  And you might see
     "emerging" funds, which focus on developing countries and the
     securities listed on exchanges in those countries. 
     In the discussion above, we pretty much assumed that the funds
     would be investing in securities issued by U.S.  companies.  Of
     course any of the strategies and goals mentioned above might be
     pursued in any market.  A risk in these funds that's absent from
     domestic investments is currency risk.  The exchange rate of the
     domestic currency to the foreign currency will fluctuate at the
     same time as the investment, which can easily increase -- or
     reverse -- substantial gains abroad. 
Another important distinction for stock and bond funds is the difference
between actively managed funds and index funds.  An actively managed
fund is run by an investment manager who seeks to "beat the market" by
making trades during the course of the year.  The debate over manged
versus index funds is every bit the equal of the debate over load versus
no-load funds.  YOU decide for yourself. 

--------------------Check for updates------------------

Subject: Mutual Funds - Versus Stocks

Last-Revised: 10 Aug 1999
Contributed-By: Maurice E.  Suhre, Chris Lott ( contact me )

This article discusses the relative advantages of stocks and mutual

Question: What advantages do mutual funds offer over stocks?

Here are some considerations. 
   * A mutual fund offers a great deal of diversification starting with
     the very first dollar invested, because a mutual fund may own tens
     or hundreds of different securities.  This diversification helps
     reduce the risk of loss because even if any one holding tanks, the
     overall value doesn't drop by much.  If you're buying individual
     stocks, you can't get much diversity unless you have $10K or so. 
   * Small sums of money get you much further in mutual funds than in
     stocks.  First, you can set up an automatic investment plan with
     many fund companies that lets you put in as little as $50 per
     month.  Second, the commissions for stock purchases will be higher
     than the cost of buying no-load funds :-) (Of course, the fund's
     various expenses like commissions are already taken out of the
     NAV).  Smaller sized purchases of stocks will have relatively high
     commissions on a percentage basis, although with the $10 trade
     becoming common, this is a bit less of a concern than it once was. 
   * You can exit a fund without getting caught on the bid/ask spread. 
   * Funds provide a cheap and easy method for reinvesting dividends. 
   * Last but most certainly not least, when you buy a fund you're in
     essence hiring a professional to manage your money for you.  That
     professional is (presumably) monitoring the economy and the markets
     to adjust the fund's holdings appropriately. 

Question: Do stocks have any advantages compared to mutual funds?

Here are some considerations that will help you judge. 
   * The opposite of the diversification issue: If you own just one
     stock and it doubles, you are up 100%.  If a mutual fund owns 50
     stocks and one doubles, it is up 2%.  On the other hand, if you own
     just one stock and it drops in half, you are down 50% but the
     mutual fund is down 1%.  Cuts both ways. 
   * If you hold your stocks several years, you aren't nicked a 1% or so
     management fee every year (although some brokerage firms charge if
     there aren't enough trades). 
   * You can take your profits when you want to and won't inadvertently
     buy a tax liability.  (This refers to the common practice among
     funds of distributing capital gains around November or December of
     each year.  See the article elsewhere in this FAQ for more
   * You can do a covered write option strategy.  (See the article on
     options on stocks for more details.)
   * You can structure your portfolio differently from any existing
     mutual fund portfolio.  (Although with the current universe of
     funds I'm not certain what could possibly be missing out there!)
   * You can buy smaller cap stocks which aren't suitable for mutual
     funds to invest in. 
   * You have a potential profit opportunity by shorting stocks.  (You
     cannot, in general, short mutual funds.)
   * The argument is offered that the funds have a "herd" mentality and
     they all end up owning the same stocks.  You may be able to pick
     stocks better. 

--------------------Check for updates------------------

Subject: Real Estate - 12 Steps to Buying a Home

Last-Revised: 19 Sep 1999
Contributed-By: Blanche Evans

Why do you want to make a change? Are you ready to start a family, plant
your own garden? Do you feel you've finally "arrived" at your company?
Maybe a raise, or a bonus, or a baby on the way has made you think about
living in a home of your own. 

Whatever the reason you are thinking about a home, there are 12 steps
you will inevitably take.  If you do them in the right order, you will
save yourself time, frustration, and money.  For example, if you start
shopping for homes on the Internet without knowing how much you can
spend, you will not only waste time looking at the wrong homes, but you
may ultimately be disappointed at what you can actually afford. 
     The first thing you need to do is figure out what kind of home you
     want to buy and how much you can afford to pay in monthly
     Keep in mind that the results of your calculations will only be an
     estimate.  Until you have chosen a home and the type of loan you
     want, and communicated with a lender, you can only use the
     calculated amount to help you determine a price range of homes you
     want to preview. 
     Either go to a mortgage broker or a direct lender and find out for
     certain the size of mortgage for which you can qualify.  The
     pre-approval letter the lender issues you will help you be taken
     more seriously by agents and sellers because they will recognize
     you as someone who is prepared to buy.  If you want a larger
     mortgage or better rate, investigate the government sites such as
     Using an agent can help you in numerous ways, especially because
     you are already paying for those services in the purchase price of
     the home.  Both the seller's agent and the buyer's agent are paid
     out of the transaction proceeds that are included in the marketing
     price of the home.  If you don't take advantage of an agent, you
     are paying for services you aren't getting.  If you are planning to
     buy a home available through foreclosure or a for-sale-by-owner
     (FSBO), you can still use the services of an agent.  Agents will
     negotiate with you on their fees and the amount of service you will
     receive for those fees, and you can arrange for them to be paid out
     of the transaction, not out of your pocket. 
     Start by narrowing the field.  If you are interested in a certain
     neighborhood in your town, find out who the experts are in that
     area of town.  They will be better informed and more attuned to the
     "grapevine," and are better positioned to network with other agents
     in the same area.  Contrary to popular belief only 20 percent of
     homes are actually sold through newspaper ads.  The other 80
     percent are sold through networking among agents.  If you are
     relocating to a new city, ask agents in your own town to refer you
     to agents in your new area.  They will be happy to do so, because
     if you buy a home from their referral, they will receive a referral
     fee, so they are motivated to make certain you find the right agent
     to assist you in buying a home. 
     Again, if you find an agent you like, go all the way and sign a
     buyer's representation agreement.  This agreement means that you
     will have one agent representing you as a buyer.  The agreement
     empowers the agent to not only search out the latest Multiple
     Listing Service list, but to seek alternative means of finding you
     a home, including searching foreclosures and homes for sale by
     owner.  With a signed agreement, the agent becomes a fiduciary and
     must act, by law, in your best interests. 
     As you shop for homes, keep in mind what you like and don't like
     and pass along your feelings to the agent.  You should feel
     comfortable looking at numerous homes, but neither you nor your
     agent is interested in wasting time on homes that aren't
     appropriate.  Like any relationship, your home will not be perfect. 
     If you are finding that most of your criteria is met, it shouldn't
     be long before you find the right home.  Think in terms of
     possibilities as well as what you see is what you get.  Perhaps a
     home isn't move-in perfect, but with a little work it could be the
     home for you.  Don't let cosmetic or minor remodeling problems
     discourage you.  Many remodeling jobs add tremendous value to a
     home.  If you remodel a kitchen, for example, you may receive as
     much as a 128 percent return on your investment.  Talk with your
     agent, friends, relatives, and contractors and find out what it
     will cost to remodel the home the way you want it. 
     When you find the home you want, you will write a contract, either
     through your agent or your attorney, or on your own.  Your offer
     should spell out what you are willing to pay for and what you are
     not, when you want to close, and when you want to take possession
     of the home.  Your contract should be contingent upon getting an
     inspection and evaluating the results.  If the inspection reveals a
     big problem, you and the seller can renegotiate the purchase price
     if you are still interested in buying. 
     As soon as the seller agrees to the contract, you must start
     following through on your loan.  Take the contract to the lender
     and let it start the loan process in earnest.  If you have been
     preapproved, much of the legwork has already been done and your
     loan will process more quickly. 
     The lender will arrange to have the home appraised, which may
     affect whether the loan is granted.  But the likelihood of a
     homeselling for more than a lender is willing to lend is slim.  The
     real estate industry not only keeps up with how quickly homes sell,
     but how much they sell for in an area.  Most lenders will have a
     ceiling on the amount of square feet per home they will lend in a
     certain neighborhood.  If a home is overpriced, it will quickly be
     obvious.  You can then go back to the seller and renegotiate. 
     In many markets, you will have the inspection after the contract is
     signed, rather than before.  This is a better protection for the
     buyer.  The inspection can reveal some nasty shocks, though.  Your
     inspector may find a major problem with the furnace or the
     foundation.  These are problems that must be fixed or the home
     cannot be conveyed.  The seller then has to arrange to pay for the
     repairs, or have the repairs paid for out of the contract proceeds
     via a mechanic's lien.  Before you can truly set the closing date,
     the repairs have to be made and approved by the buyer. 
     As you find a mover, pack your things, and arrange days off a work
     around the closing date, you will find that things can still
     change.  It is the most intense, nerve-wracking time of the
     transaction -- waiting for the other shoe to drop.  You think you
     may have addressed all the issues and closing will proceed without
     any other hitches, but negotiations still continue as you
     reevaluate the inspection report, or find out the chandelier you
     thought was included is actually excluded from the contract.  As
     you revisit the home to show your relatives, your hopes raise, even
     through your doubts that the home will ever be yours increase. 
     Until closing, and even during closing, anything can happen.  You
     find out that your closing costs are higher than you thought they
     would be because some additional service fees have been added by
     the lender.  A glitch could come out in your credit report that
     delays the sale; a problem the owner was supposed to fix wasn't
     repaired in time; the homeowner can decide that she or he doesn't
     want to pay for the home warranty after all; the appraisal may come
     in the day before closing and be short of the asking price of the
     home.  If so, the buyer, seller, and their agents have to figure
     out how to make up the shortfall.  Do they lower the price of the
     home? Do the agents pay for the difference out of their
     commissions? How will last-minute problems be handled? The
     negotiating table is an emotionally explosive place.  That is why
     closings are generally held in private rooms with the buyers and
     sellers separated. 
     It's all over.  The home is yours.  Congratulations. 

This article was excerpted from The Insider's Guide to
Buying and Selling Your Home Using the Internet , by Blanche Evans. 
Copyright 1999 by Dearborn Financial Publishing.  Reprinted by
permission of the publisher Dearborn, A Kaplan Professional Company. 

--------------------Check for updates------------------

Subject: Real Estate - Investment Trusts (REITs)

Last-Revised: 8 Dec 1995
Contributed-By: Braden Glett (glett at

A Real Estate Investment Trust (REIT) is a company that invests its
assets in real estate holdings.  You get a share of the earnings,
depreciation, etc.  from the portfolio of real estate holdings that the
REIT owns.  Thus, you get many of the same benefits of being a landlord
without too many of the hassles.  You also have a much more liquid
investment than you do when directly investing in real estate.  The
downsides are that you have no control over when the company will sell
its holdings or how it will manage them, like you would have if you
owned an apartment building on your own. 

Essentially, REITs are the same as stocks, only the business they are
engaged in is different than what is commonly referred to as "stocks" by
most folks.  Common stocks are ownership shares generally in
manufacturing or service businesses.  REITs shares on the other hand are
the same, just engaged in the holding of an asset for rental, rather
than producing a manufactured product.  In both cases, though, the
shareholder is paid what is left over after business expenses,
interest/principal, and preferred shareholders' dividends are paid. 
Common stockholders are always last in line, and their earnings are
highly variable because of this.  Also, because their returns are so
unpredictable, common shareholders demand a higher expected rate of
return than lenders (bondholders).  This is why equity financing is the
highest-cost form of financing for any corporation, whether the
corporation be a REIT or mfg firm. 

An interesting thing about REITs is that they are probably the best
inflation hedge around.  Far better than gold stocks, which give almost
no return over long periods of time.  Most of them yield 7-10% dividend
yield.  However, they almost always lack the potential for tremendous
price appreciation (and depreciation) that you get with most common
stocks.  There are exceptions, of course, but they are few and far

If you invest in them, pick several REITs instead of one.  They are
subject to ineptitude on the part of management just like any company's
stock, so diversification is important.  However, they are a rather
conservative investment, with long-term returns lower than common stocks
of other industries.  This is because rental revenues do net usually
vary as much as revenues at a mfg or service firm. 

REITNet, a full-service real estate information site, offers a
comprehensive guide to Real Estate Investment Trusts.

--------------------Check for updates------------------

Compilation Copyright (c) 2003 by Christopher Lott.

User Contributions:

Gerri Pisciotta
My employer accidentally advised the company handling the 401k investment that I had been terminated, when in fact I had not. As a result, withdrawals discontinued from my pay and I missed a couple years of contributions. Since I never withdrew from the plan, is my employer liable for making up these contributions? If I made a lump sum catchup contribution,could they do the same?
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