Table of Contents

• How To Choose A Mutual Fund
• What About Recommendations?
• Comparing Performance
• Comparing Costs
• Comparing Investment Philosophy
• Comparing Customer Service
• Risk Factors In General
• Summary
• Recommended Reading
• Government and Non-Profit Agencies
• Computer Programs

Mutual funds are an excellent way to invest in stocks, bonds and other securities. They are a good choice of investment because:

• They are managed by professional money managers, so most of the investment research is done for you (most investors don't have the time or know-how to do all the necessary research).
• You diversify your investment risk by owning shares in a mutual fund, instead of buying individual stocks or bonds directly.
• Transaction costs are often lower than what you would pay if you invested in individual securities (the mutual fund buys and sells large amounts of securities at a time).

Before getting into our discussion of mutual funds, there are three important points to keep in mind:

1. Past performance is not a reliable indicator of future performance. Beware of dazzling performance claims. Many publications recommend mutual funds based only on past performance.
2. Mutual funds are not guaranteed or insured by any bank or government agency. Even if you buy through a bank and the fund carries the bank's name, there is no guarantee. You can lose your investment.
3. All mutual funds have costs that lower your investment returns. Thus, even an index fund that mirrors a broad market index cannot perform as well as its mirror index, since the fund has transaction and operating costs that the index does not.

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How To Choose A Mutual Fund

Once you determine your asset allocation model, you can implement the recommended portfolio with mutual funds. You need only six to ten funds to achieve diversification and your asset allocation objectives, as opposed to having to buy many more individual securities to achieve the same results.

Once you identify the asset classes that will be represented in your portfolio, it's time to select specific funds in those categories-i.e., funds that meet your investment goals. To choose wisely, it's necessary to assess:

• A fund's risk/reward history and characteristics, which should match your own financial profile;
• A fund's philosophy and investment style, which should match your own investment goals;
• A fund's costs, including loads and ongoing expenses; and
• The customer service available from the fund.

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What About Recommendations?

Most sources of mutual fund recommendations are inadequate. They either depend solely on past performance or fail to take into account your particular needs. Newsletters and magazines, for example, often simply recommend last year's hot fund-which, even though it may remain hot for the current year, may be totally wrong for you.

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Comparing Performance

A fund's past performance is not as important as you might think. Advertisements, rankings, and ratings tell you how well a fund has performed in the past. But studies show that the future is often different. This year's "No. 1" fund can easily become next year's dog.

Here are some tips for comparing fund performances:

• Check the fund's total return. You will find it in the Financial Highlights of the prospectus (near the front). Total return measures increases and decreases in the value of the investment over time, after subtracting costs. This is just one of many return measures.
• Find out how the fund ranked in its investment category class. There are various rating systems available to show how a fund ranked among its peers.
• See how the total return has varied over the years. The Financial Highlights in the prospectus show yearly total return for the most recent 10-year period. An impressive 10-year total return may be based on one spectacular year followed by many average years. Looking at year-to-year changes in total return is a good way to see how stable the fund's returns have been.
• Check the fund's Sharpe ratio. The Sharpe ratio is intended to give investors an understanding of the fund's performance relative to the risk. The Sharpe ratio is calculated by subtracting the average monthly return of the 90-day Treasury Bill-basically a risk-free return-from the average monthly return of the fund. The difference-the "excess" return- is then annualized and divided by the fund's annual standard deviation (a common measure of volatility).

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Comparing Costs

Costs are important because they lower your returns. A fund that has a sales load and high expenses will have to perform better than a low-cost fund, just to stay even.

Find the fee table near the front of the fund's prospectus, where the fund's costs are laid out. You can use the fee table to compare the costs of different funds.

The fee table breaks costs into two main categories:

• Sales loads and transaction fees (paid when you buy, sell or exchange your shares) and
• Ongoing expenses (paid while you remain invested in the fund).

Sales Loads

The first part of the fee table will tell you if the fund charges any sales loads. No-load funds by definition, do not charge sales loads. There are no-load funds in every major fund category. Even no-load funds have ongoing expenses, however, such as management fees.

A sales load usually pays for commissions to the brokers who sell the fund's shares to you, as well as other marketing costs. Sales loads buy you a broker's services and advice; they do not assure superior performance.

Front-end load: A front-end load is a sales charge you pay when you buy shares. This type of load, which by law cannot be higher than 8.5 percent of your investment-although in practice are often much less-reduces the amount of your investment in the fund.

Back-end load: A back-end load (also called a deferred load) is a sales charge you pay when you sell or exchange your shares. It usually starts out at 5 or 6 percent for the first year and gets smaller each year after that until it reaches zero say, in year six or seven year of your investment.

Ongoing Expenses

The second part of the fee table tells you the kinds of ongoing expenses you will pay while you remain invested in the fund. It shows expenses as a percentage of the fund's assets, generally for the most recent fiscal year. Here, the table will tell you the management fee for managing the fund's portfolio, along with any other fees and expenses.

High expenses do not assure superior performance. Higher-expense funds do not, on average, perform better than lower-expense funds. But there may be circumstances in which you decide it is appropriate to pay higher expenses. For example, you can expect to pay higher expenses for certain types of funds that require extra work by managers, such as international stock funds, which require sophisticated research.

A difference in expenses that may look small to you can make a big difference in the value of your investment over time.

Rule 12b-1 fee: One type of ongoing fee that is taken out of fund assets has come to be known as a Rule 12b-1 fee. It most often is used to pay commissions to brokers and other salespersons, and occasionally to pay for advertising and other costs of promoting the fund to investors. It usually is between 0.25 percent and 1.00 percent of assets annually.

Funds with back-end loads usually have higher Rule 12b-1 fees. If you are considering whether to pay a front-end load or a back-end load, think about how long you plan to stay in the fund. If you plan to stay in for six years or more, a back-end load will usually cost less than a front-end load.

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Comparing Investment Philosophy

Here are some suggestions for examining a fund's approach to investing.

1. Determine the fund's overall investment objectives.

2. Determine whether the fund's portfolio matches its stated investment objectives. The fund should fully reveal how it invests.

3. Determine whether the fund invests overseas.

4. For an equity fund, determine the industry sectors in which it's invested.

5. For a bond fund, determine the years to maturity of its holdings and whether it holds any tax-exempt bonds.

6. Find out how long the fund's management has been in place and whether one particular manager has been responsible for the success of the fund.

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Comparing Customer Service

You'll want to find out what services the fund offers. Among the questions you should ask are:

1. How long does it take to reach a representative?
2. Which account options does the fund offer?
3. How quickly are questions about returns or investments answered?

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Risk Factors In General

You take risks when you invest in any mutual fund. You may lose some or all of the money you invest (your principal) because the securities held by a fund go up and down in value. What you earn on your investment (dividends and interest) also may go up or down. The various types of risk are:

• Volatility: The unpredictability of changes in stock prices.
• Interest-rate risk: The fluctuation in bond prices due to interest rate changes.
• Credit risk: The likelihood that payments of bond interest and principal will not be made as promised.
• Inflation risk: The risk that the lowered purchasing power of the dollar will erode your return.

Each kind of mutual fund has different risks and rewards. Generally, the higher the potential return, the higher the risk of loss. The following discussion of risk for the various types of funds is intended to aid you in choosing a fund that meets your requirements as an investor.

Money Market Fund Risks

Money market funds are relatively low risk compared to other mutual funds. They are limited by law to certain high-quality, short-term investments. They try to keep their net asset value (NAV) at a stable $1.00 per share.

• A money market fund is a type of mutual fund. It is not guaranteed, and comes with a prospectus.
• A money market deposit account is a bank deposit. It is guaranteed, and comes with a "Truth in Savings" form.

Bond Fund Risks

Bond funds (also called fixed-income funds) have higher risks than money market funds, but usually pay higher yields. Unlike money market funds, bond funds are not restricted to high-quality or short-term investments. Because there are many different types of bonds, bond funds can vary dramatically in their risks and rewards.

Most bond funds have credit risk, the risk that companies or other issuers whose bonds are owned by the fund may fail to pay their bond holders. Some funds have little credit risk, however, such as those that invest in insured bonds or U.S. Treasury bonds. Keep in mind that nearly all bond funds have interest rate risk, which means that the market value of their bonds will go down when interest rates go up. Because of this, you can lose money in any bond fund, including those that invest only in insured bonds or Treasury bonds. Long-term bond funds invest in bonds with longer maturities (the length of time until the final payout). The net asset values (NAVs) of long-term bond funds can go up or down more rapidly than those of shorter-term bond funds.

Summary

There are a number of sources of information that you should explore before investing in mutual funds. The most important of these is the prospectus, which is the fund's selling document and contains information about costs, risks, past performance and the fund's investment goals. Request the prospectus from the fund or from a financial professional if you are using one. Read the prospectus, and exercise your judgment carefully, before you invest.

Read the sections of the prospectus that discuss the risks, investment goals and investment policies of the fund you are considering. Funds of the same type can have significantly different risks, objectives and policies.

All mutual funds must prepare a Statement of Additional Information (SAI, also called Part B of the prospectus). It explains a fund's operations in greater detail than the prospectus. If you ask, the fund must send you an SAI.

You can get a clearer picture of a fund's investment goals and policies by reading its annual and semi-annual reports to shareholders. If you ask, the fund will send you these reports. You can also research funds at most libraries or by using an on-line service.

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Government and Non-Profit Agencies