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Types of Investments — Mutual Funds

What they are

A mutual fund is an investment company that pools money from many investors and invests the combined holdings in a single portfolio of securities including stocks, bonds, other securities and cash and cash alternatives, such as Treasury Bills, certificates of deposit and money market funds.  It is professionally managed according to stated investment objectives found in the fund’s prospectus.

Mutual funds are sold by prospectus only. The prospectus is a legal document which contains information on the fund’s investment objectives or goals, principal strategies for achieving those goals, principal risks of investing in the fund, fees, charges and expenses, past performance and other important information you should consider before investing.

How they work

Mutual funds generally offer broad diversification across different asset classes. Some mutual funds, such as target date or asset allocation funds, invest in other funds. These types of mutual funds offer diversification across hundreds or even thousands of securities.

Diversification is an investment strategy used to manage risk. By spreading your investments across different asset classes, industry sectors and types of investments the fund seeks to reduce risk from any one investment. Although diversification can help manage risk it cannot guarantee a profit or protect against loss.

Types:

As of late 2014, there were more than 8,000 mutual funds falling into three broad categories: equity, fixed income (bond), and money market. Popular funds within these categories include target date, asset allocation, global/international, and specialty.

Most can be purchased through a brokerage account. You can also purchase mutual funds directly from the fund company or through a workplace retirement plan such as a 401(k), 403(b), or 457 plan.

Advantages and disadvantages

When you buy any investment, it's important to understand both its advantages and disadvantages. In the case of mutual funds, if its advantages outweigh its disadvantages, it's quite possible that it may be something to consider.

Advantages

  • Reduced risk through diversification. A diversified portfolio has the potential to provide more consistent returns through lowered volatility than investing in individual asset classes. Mutual funds are professionally managed portfolios that generally offer broad diversification in an effort to spread risk across a large number of securities, different asset classes, sectors, industries, and investment styles.
  • Professional management. Mutual funds are professionally managed, which means a fund manager selects the fund’s investments, monitors performance, and rebalances when necessary. In this respect, the fund maintains proper diversification so you don’t have to.
  • Investment growth. Mutual funds allow you to reinvest any interest or dividends earned automatically in additional shares of the fund. The option to reinvest earnings or income provides a large base on which earnings can accumulate, thus providing the potential to generate greater earnings on your investment.
  • Convenience. Mutual funds are common and can generally be bought with a low initial investment.  You can sell your shares at any time the market is open at the fund’s current net asset value (NAV), which is usually set at 4:00 p.m. Eastern Time or after the New York Stock Exchange closes.

Disadvantages

  • No guaranteed return. Mutual funds cannot guarantee returns. Your shares, when sold, may be worth more or less than their original cost. Also, mutual funds are not guaranteed or issued by the Federal Deposit Insurance Corporation (FDIC) or any other government agency. Unlike a bank deposit, which is insured by the FDIC up to applicable limits, mutual funds have no such guarantee.
  • Market risk. Mutual funds are subject to market risk. The securities within the fund may fluctuate in response to general economic and market conditions and the perception of individual issuers. Some funds may experience greater volatility than others. It is important to understand the fund’s level of volatility and your tolerance for market swings before investing.
  • Some have high expense ratios and fees. Some mutual funds have expense ratios that many experts consider high, as well as costly advertising fees and sales charges. You may also pay transaction costs, which include commission fees and other sales charges.
  • Lack of control. Because you don’t pick the investments in a mutual fund, you don’t have influence over which securities the fund manager buys and sells. You also can’t pick the timing or level of capital gains, if any, the fund will realize.

Ways to manage risk

Know what you own. Reading a fund’s prospectus is a good way to learn about the fund, its goals, and fees. You can also use the Wells Fargo Advisors Mutual Fund Screener tool to research mutual funds.

Don’t rely on market news. While it may be tempting to buy a fund you’ve heard good things about, try to avoid buying a fund solely based on past performance. Keep in mind that markets are cyclical — which means they go up, peak, and go down again. Buying or selling investments following market news may leave you one step behind the markets.

A carefully considered investment plan designed for long-term investing and based on your target asset allocation strategy can help you reach your long-term goals. An asset allocation strategy is an investment strategy that seeks to balance risk and reward by dividing your money among different asset categories, such as stocks, bonds, and cash. Your recommended asset allocation strategy is based on your individual investment goal, time frame, and risk tolerance.

Understand the fees. Pay close attention to a fund’s annual fund operating expenses, (also known as its expense ratio) when selecting a mutual fund, as mutual fund expense ratios vary widely. Operating a mutual fund involves costs, which is why every mutual fund charges an expense ratio. The fund’s expense ratio includes the fund’s management, marketing, and distribution fees, as well as other expenses such as administrative services that are stated as a percentage, and are deducted from the fund’s assets annually, regardless of the fund’s performance.

A fund’s operating expenses can sometimes take a large amount of the fund’s returns over time. The fund’s prospectus lists all fees and expenses associated with an investment in the fund. Investors can use websites such as Morningstar.com to see how a fund's expenses compare to other funds in the same Morningstar category. The Financial Industry Regulatory Authority (FINRA) offers a Fund Analyzer with information and analysis on more than 18,000 mutual funds.

Monitor their performance. If you diversify your own portfolio using individual stocks and bonds, ensure you routinely monitor the performance, pricing, and creditworthiness of each investment. Investing in an all-in-one mutual fund, such as a target date fund or an asset allocation fund can save you time and help you stay on track to meet your goal.

A target date fund is a mutual fund that invests in other mutual funds rather than individual stocks and bonds with a target retirement year in mind. With this type of fund, the fund’s investments become more conservative as the “target retirement year” approaches, which generally means the fund invests more in bonds and cash than in stocks.

An asset allocation fund is a mutual fund that invests in other mutual funds rather than individual stocks, bonds and cash that seeks to maintain a certain allocation in the primary asset categories through its investments in underlying funds based on a set investment objective.

Risk Considerations:

All investing involves some degree of risk, whether it is associated with market volatility, purchasing power or a specific security. There is no assurance any investment strategy will be successful or that a fund will meet its investment objectives.  Investing in mutual funds involves risk, including the possible loss of principal. An investment in a mutual fund will fluctuate and, shares, when sold, may be worth more or less than their original cost. Each fund is subject to its own specific risks which are detailed in the prospectus. Before investing, you should read the prospectus for a complete description of the investment objectives, risks, charges and expenses associated with an investment in a specific fund.

Asset Allocation Funds are subject to the risks of the underlying funds in which they invest. These funds are also indirectly subject to the underlying fund expenses as well as the expenses of the portfolio and the cost of this type of investment may be higher than a mutual fund that only invests in stocks or bonds.

Target Date Funds are subject to the risks associated with the underlying funds in which they invest. These risks change over time as the fund’s asset allocation strategy adjusts as it approaches its target date. There is no assurance any target date fund will achieve its investment objective. The principal value of an investment in a target date fund is not guaranteed at any time including at its target date. Most target date funds invest in a combination of equity, fixed income and short-term funds and the cost of this type of investment may be higher than a mutual fund that only invests in stocks or bonds.

Investing internationally entails special risks such as currency, political, economic, and market risks. These risks are heightened in emerging markets. Specialty funds may involve more volatility than other funds because of their narrow focus.

How you can invest