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One of the main advantages when investing in mutual funds is that it allows individual investors access to a managed and diversified portfolio of assets within the capital markets, which would otherwise be difficult to do with a small investment. Furthermore, each investor can share in the gain and/or loss of the fund. Mutual funds have different fee structures and can be back ended or front ended and open or closed.
Mutual funds can be held within 401(k)s and IRAs, and investors should take full advantage of the benefits from these tax-sheltered retirement accounts. In a regular brokerage account, certain mutual funds can generate substantial tax bills from capital gain distributions and/or dividends. These are typically the more active funds, namely high yield junk bonds, corporate bond funds and REIT funds, or actively managed stock funds.
There are two types of mutual fund sales commissions, called loads, paid to brokers for purchasing or selling shares in a mutual fund: front-end sales loads and back end sales loads.
It is important to note that how mutual funds are traded depends on if it’s an open-end fund or closed-end fund. With open-end funds, they only trade at the end of the day because you trade mutual funds based on their net asset value (NAV), which is very different than stocks which can be traded anytime during market hours. The NAV is only calculated after market close. If it’s a closed-end fund it must be bought through a broker and you can watch the price change during the day.
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Selling a mutual fund is much like buying a mutual fund in the sense that if it’s a closed-end fund you have to use a broker, but if it’s an open-end fund you deal directly with the fund through your trading account. Mutual fund shares in open-end funds are bought from the mutual fund and sold back to the fund.
The alternative, which represents the majority of mutual funds, consists of open-ended funds. This fund does not have a set number of shares; instead, whenever an investor decides to purchase that mutual fund, the fund will issue new shares to the investor based upon the current net asset value, and redeem the shares when the investor decides to sell. Open-ended funds always reflect the net asset value of the fund because the shares are created to satisfy any demand.
Once the risk tolerance is determined, then take a look at a mutual fund’s past five to 10 year performance, management experience, and expense ratios. Past performance is not a good indicator of future performance, but by familiarizing oneself with the investment returns, management experience, and expenses of the fund, an investor can determine for himself or herself if it is worth the risk.
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In fact, strong performance can also be a negative indicator, because strong performance over a long period of time is rarely sustainable. Watch for mutual funds with non-abnormal returns that boast a proven track record over a long period of time with a low expense ratio. Good fund managers usually close funds to future investors as well; the more money they have to manage the harder it is to navigate the markets.
As with any investment decision, potential investors should do the due diligence in regards to investment performance, fees, asset classes, and amount they want to dedicate to the investment. By following these guidelines, you will increase your chances of success over the long-haul.
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