Mutual Fund Terms: Don’t Guess the Flavor Edition

Last month, a chance conversation with my dad showed me that a lot of folks really don’t understand basic investment terms.

I put together a quick reference, and asked, “What’s missing?”

Gary from Super Savings Tips suggested I add a little on Growth and Value funds.

That’s a pretty good suggestion. After all, most investors start by choosing between mutual funds, if only because they are the main component of most 401(k) plans. How can you choose the right mutual fund for you if you don’t understand mutual fund terms? 

What the heck is a growth fund, anyway?

If you don’t know, then picking a mutual fund can be like eating Bertie Bott’s Every Flavor Beans. You might pick the exact thing you want….or not.

Like Bertie Botts, mutual funds come in a vast array of flavors, from deliciously profitable to…well, earwax. The funds you pick can vary by the investments they hold (stocks or bonds), the amount of risk they take on, the management philosophy (active vs passive) and the fee structure. And if you don’t know the basic terms, then you’ve turned your investments into a guessing game. 

No one likes ending up with the earwax-flavored beans. But to be able to pick out the toffee-flavored bean, you need to know the terms well enough to recognize the right investment for you when you see it.

Basic Mutual Fund Types

Mutual Fund: An investment that is structured so that a single share includes a group of stocks and/or bonds. A good way of diversifying your portfolio even if you don’t have a ton of money to invest.

Money Market Funds: Cash and cash equivalents. Think of it as a savings account. It pays you a little interest. You won’t lose money (except to inflation), but you won’t get much in the way of earnings either.

Bond Funds: Mutual funds that invest in bonds (company or government debt). Bonds pay interest, so the interest rate on the bond matters. If interest rates go up, the value of older low-interest bonds goes down. That means bond fund holdings are worth less, and their price drops. If interest rates go down, the value of older higher interest bonds goes up. That means bond fund holdings are worth more, and their prices rise.

Equity Funds: Mutual funds that invest in stocks.

Balanced Funds: Mutual funds that invest in both stocks and bonds. Most target-date funds are balanced funds.

ETF: Exchange-Traded Fund. An ETF holds multiple investments, like a mutual fund, but is traded on the stock exchange where mutual funds are not. While there are several differences, the key ones include 1) an ETF can be bought or sold any time of day, where mutual fund transactions take place at the end of the trading day. 2) you can buy a single share of an ETF where mutual funds usually have minimum investments.

What You Invest In: Stocks

Large Cap/Mid Cap/Small Cap: Cap means capitalization or the amount of money invested in a company’s outstanding shares of stock. Large Cap companies are the big dogs (Think Apple, Coca-Cola) and have more than $10 billion in shares outstanding. Small Cap companies tend toward start-ups, but basically any company with less than $2 billion in shares outstanding. That leaves mid-cap stocks….in the middle.

Growth Funds: Mutual funds that invest in companies whose stock price is expected to grow significantly. The companies rarely pay dividends and invest spare cash into expansion or research. Growth funds tend to be a little riskier than some approaches…the companies may not become more valuable, but if they do there can be big rewards. They can be good holdings for taxable accounts because you’d only have to pay income taxes on gains, and only when you sold your holdings. This strategy works best if you can hold for a while.

Value Funds: Mutual funds that invest in companies that they deem undervalued. These companies are generally older and often pay dividends.

Income Funds: Mutual funds that invest in dividend-producing stocks or interest-bearing bonds, rather than investments that are expected to become more valuable over time. This strategy works well for retirees since it creates cash flow while they maintain their holdings.

Sector Funds: Mutual funds that invest in one line of business, like energy or health care. Different sectors tend to move with or against the total market, depending on condition. For instance, the market as a whole tend to be priced high, but energy stocks tend to have fallen due to lower oil prices, so you might invest in an energy sector fund.

International Funds; Mutual funds that invest only outside their own country.

Global Funds: Mutual funds that invest both at home and abroad.

What You Invest In: Bonds

Government/Treasury Bond Fund: Funds that invest in the debt of the federal government. Considered the safest bonds, and therefore pay the lowest interest rates.

Municipal Bond Fund: Funds that invest in the debts of state and city government agencies. The interest from the funds is exempt from federal income tax and may be exempt from state income tax as well.

Corporate Bond Fund: Funds that invest in the debts of companies. These bonds tend to pay better interest rates than the government debt because they have a higher risk of default.

Short/Intermediate/Long Term: The time to maturity of the bonds a fund is trading. Short-term funds buy and sell bonds with maturities of less than 3 years, so there’s less risk. Intermediate funds buy and sell bonds with maturities 3-10 years away, and long-term funds buy and sell bonds with maturities more than 10 years away.

Credit Quality: The level of safety of your investment. Credit agencies rate bonds from AAA (safest) to C. The higher the grade, the safer.

Investment Grade Quality: AAA, AA, A and BBB rated bonds.

Junk Bonds: Bonds that are rated below investment grade quality. They have a greater risk of default, so they also offer higher interest rates.

Mutual Fund Terms: Don't Guess the Flavor Edition

What You Get: Income

Capital Gains/Losses: The difference between what you buy an investment for and what you sell an investment for. If you buy it for more than you sell it, you have a capital loss. If the sales price is higher than the buy price, you have a capital gain.

Unrealized Gains/Losses: The difference between what you bought an investment for and what you could have potentially sold it for at a given point in time had you chosen to sell. So if you buy a mutual fund at $40 a share, and it’s now worth $50 a share, you have an unrealized gain of $10 a share if you don’t sell or a capital gain of $10 a share if you sell.

Capital Gains Distribution: The profits that a mutual fund makes from buy/sell transactions that are distributed to shareholders.

Dividend: The portion of profits paid to shareholders for being owners.

Interest: Money paid to bondholders for lending their money to the institution.Taxable income to shareholders.

Accrued Interest: Interest owed that has not yet been paid.

Distribution: Money paid out of a qualified retirement or savings plan.

Fund Management

Actively Managed Fund: A mutual fund where the managers buy and sell investments to try to maximize profits.

Index Fund: A mutual fund where managers buy and sell investments proportionately to reflect the performance of an index. Usually cheaper to run and to hold than an actively managed fund, and statistically, they perform better than most actively managed funds.

Management Fee: The amount a mutual fund charges investors for holding and investing their funds.

Distribution Fee (also known as a 12b-1 Fee): Fee charged for advertising and other expenses, like creating prospectuses and answering shareholder questions.

Total Expense Ratio: A fundholder’s total expense to hold shares in a mutual fund. It includes the management fees, but also distribution fees and other expenses.

Loads: Transaction fees paid to the broker on buying or selling a mutual fund. Front-end loads charge you a fee to buy. Back-end loads charge a fee to sell your shares, though the fee may drop the longer you hold the fund. No-load funds have neither.

Purchase/Redemption Fees: Fees paid to the mutual fund company upon buying/selling a mutual fund.

Prospectus: Formal document, filed with the SEC, describing a mutual fund (or other investment). Most importantly, the prospectus should describe the fund’s objective and investing philosophy and the fund fees.

Don’t Get BeanBoozled

No one can be a perfect wizard when it comes to picking the right investment, and you’ll have to take your own risk tolerance and investment horizon into account to pick the right investment for you.

That said, you need to understand your options, and to do that, you need to be able to understand mutual fund terms to make sure you’re choosing your investments wisely. 

I’d hate for you to get stuck with one of the gross ones.

 

Once again, what am I missing here, guys? Any major mutual fund terms that I need to clarify or add?

*Part of Financially Savvy Saturdays on brokeGIRLrich.*

26 Responses to “Mutual Fund Terms: Don’t Guess the Flavor Edition”
  1. Jay 05/09/2017
    • Emily Jividen 05/09/2017
  2. Brian 05/09/2017
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  3. Mrs. Groovy 05/09/2017
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  5. Fruclassity (Ruth) 05/11/2017
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  6. Femme Frugality 05/13/2017
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