What are some important points to consider before investing in a mutual fund?
According to the SEC, there are some key considerations before you invest in a mutual fund. It is good to look at the fund’s service charges, fees, and loads, as well as the fund’s expenses, to see how it compares to other similar funds. Funds with higher expenses will have to perform much better in order to generate a good return on their investments than lower-cost funds of the same type and return.
It is important to note that even small differences in a fund’s expenses may translate into many thousands of dollars in costs, that in turn may affect the return an investor desires. It is also important to note how a mutual fund may affect your tax bill at the end of the year, as a mutual fund must distribute capital gains to shareholders if it sells a stock at a profit that cannot be offset by a loss. And you must pay taxes on any capital gains, even if the fund’s return has been negative since you began investing in it. One way around this is to contact the prospective fund to find out when capital gains will be distributed, so you may avoid this burden immediately upon investing.
It is also important to consider the size and age of the fund. A “newly created” fund with a relatively small number of companies in its portfolio may show a higher return in the short term than other similar funds, and may still be small enough to generate quick profits. Over the long term, however, the results may be considerably different as the fund expands, and has more years of results to analyze. The SEC also notes that potential investors should look at a portfolio’s turnover rate, the frequency with which the fund buys and sells securities. Each time a mutual fund buys and sells securities it generates capital gains and losses. This usually translates to higher costs for the investor in fees and in capital gains taxes.
You should also look at the volatility of a fund, since two funds may record the same average return over a long period of time, but one may have many years of losses offset by a few stellar years. This makes the fund more volatile than a more stable fund that may, year-over-year post smaller, more stable, and thus relatively less volatile gains. As mentioned above, it is important to read prospectuses to understand the risks of each fund choice, and understand that funds with very high rates of return may, in fact, be engaging in relatively riskier investments. You should also consider the management of the fund, whether there have been any changes, and how long the managers have been in place before investing.
Last, you should see how investing in such a fund affects the overall diversity of your portfolio. For example, if you have heard about a new small company or international fund, but already have a large percentage of your portfolio invested in this type, you should consider what may happen (both good and bad) if you increase our concentration in this fund type. You need to consider the overall diversification of your investments before you invest.