Although global exposure to equities can provide substantial diversification for a portfolio, many investors are content to stay within the confines of the U.S. when it comes to investing. But this still represents a vast market that is beyond the scope of most people to analyze and understand. Domestic stock funds offer several key advantages for those in this category and are often the vehicle of choice for investors who wish to profit from the American economy.
Domestic Stock Fund Overview
The stock market in America has risen steadily over time despite the corrections and bear markets that periodically appear. Its progress is measured with several different benchmark indices, including the Dow, the Standard & Poor’s 500, the Russell 2000 and 3000 and the Wilshire 5000. The domestic stock market encompasses many different sectors that have provided competitive long-term growth as well as dividend income from larger companies.
Domestic stock funds offer all of the standard benefits that come with any type of mutual fund, such as broad diversification, professional management and liquidity that is packaged into a convenient vehicle that makes it accessible to even the smallest investors. Some funds invest in companies of a specific size, such as small, mid or large cap while others focus on a single sector in the economy, such as technology, utilities or healthcare. Some funds also seek more specialized corporate issues such as preferred stocks or convertible bonds that can be traded in for a specific number of company shares.
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Domestic stock funds can also have several different investment objectives, such as capital growth, income or some combination thereof. Some funds also seek to achieve one or more of these objectives (usually growth) in a tax-efficient manner. These funds can be held either inside or outside of an IRA or employer-sponsored qualified plan, and many of them are also offered as subaccount options in variable annuity contracts.
Home Country Bias
Many investors choose to purchase domestic stock funds simply because they are familiar with a large percentage of the companies in which they are ultimately investing. The S&P 500 Index contains a long list of household names such as Microsoft, Wal-Mart, McDonald’s and other companies whose products are used by Americans on a daily basis. Those who purchase funds that invest in this index therefore have a reasonably clear picture of what these companies do and why they are successful. It is also easier for them to see why their funds may be rising or falling based on the economic news that influences the share price.
Of course, this bias is not always rational; most asset managers strongly recommend that investors keep a portion of their holdings in foreign companies in order to provide additional diversification and reduce their overall risk. Most domestic stocks funds will move at least somewhat in unison during periods of strong market movement in either direction, although the severity of their reaction does of course differ depending upon the type of fund.
But research is beginning to show that global investing does not provide quite the same level of diversification that it once did, because many foreign markets have matured to the point that they now move much more in tandem with the U.S. indices. Investors seeking foreign holdings that fall outside this category have therefore begun to seek opportunities in the frontier markets, which exposes them to considerably higher political risk and substantial volatility.
Nevertheless, overseas holdings can still do very well when domestic markets are down, and those who overlook this area can miss out on valuable opportunities. But fear of the unknown often prevents investors from venturing outside their borders, and this bias can ultimately lead to lower returns with greater overall risk.
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Domestic mutual funds are taxed in the same manner as all other types of funds. They typically post capital gains distributions every year around November and then issue the appropriate tax forms to their shareholders sometime around February of the following year. 1099-B Forms are issued for those who realized long and/or short-term capital gains. Form 1099-D is sent to those who received ordinary dividends, and Form 1099-R is sent to shareholders who liquidated their domestic funds and received the proceeds as IRA or retirement plan distributions.
Unfortunately, qualified dividends are no longer eligible for capital gains treatment, so all dividends of any kind are now taxed as ordinary income. But shareholders of domestic stock funds will not have to worry about reporting foreign dividends or gains of any kind.
Examples of Domestic Stock Funds
There are thousands of domestic stock funds available to investors today. Virtually every major mutual fund company offers one or more of these funds to its customers. Here are a few examples of funds in this category:
- Vanguard S&P 500 Index VFINX – This fund purchases all of the stocks in the Standard & Poor’s 500 Index and charges one of the lowest expense ratios in the industry. Thousands of investors who wish to simply purchase the market have accomplished their objective with this fund.
- Fidelity Mid-Cap Value Fund (FSMVX) – This fund seeks to provide capital appreciation by investing in stocks of companies with a middle capitalization rating that the managers feel are currently trading below their real value. Morningstar has assigned this fund a five-star rating as of 09/30/2014.
- T. Rowe Price Equity Income Fund PRFDX – This fund seeks to provide a stream of income superior to that of guaranteed instruments like CDs or Treasury securities by purchasing equities that produce above-average dividend income. Long-term capital growth is a secondary objective. Morningstar has assigned a 3-star rating to this fund as of 9/30/2014.
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The Bottom Line
Mutual funds that invest in domestic stocks can satisfy several different investment objectives, including conservative, moderate and aggressive capital growth, tax efficiency and current income. Although international exposure can provide greater diversification and greater potential for long-term growth, many investors prefer to keep their money within the confines of their own borders.