Fund of Hedge Fund and its benefits

What is a Fund of Hedge Funds?

-A diversified portfolio of generally uncorrelated hedge funds.
-May be widely diversified, or sector or geographically focused.
-Seeks to deliver more consistent returns than stock portfolios, mutual funds, unit trusts or individual hedge funds.
-Preferred investment of choice for many pension funds, endowments, insurance companies, private banks and high-net-worth families and individuals.
-Provides access to a broad range of investment styles, strategies and hedge fund managers for one easy-to-administer investment.
-Provides more predictable returns than traditional investment funds.
-Provides effective diversification for investment portfolios.

Benefits of a Hedge Fund of Funds

-Provides an investment portfolio with lower levels of risk and can deliver returns uncorrelated with the performance of the stock market.
-Delivers more stable returns under most market conditions due to the fund-of-fund manager’s ability and understanding of the various hedge strategies.
-Significantly reduces individual fund and manager risk.
-Eliminates the need for time-consuming due diligence otherwise required for making hedge fund investment decisions.
-Allows for easier administration of widely diversified investments across a large variety of hedge funds.
-Allows access to a broader spectrum of leading hedge funds that may otherwise be unavailable due to high minimum investment requirements.
-Is an ideal way to gain access to a wide variety of hedge fund strategies, managed by many of the world’s premier investment professionals, for a relatively modest investment.

Hedge Fund Styles

The predictability of future results shows a strong correlation with the volatility of each strategy. Future performance of strategies with high volatility is far less predictable than future performance from strategies experiencing low or moderate volatility.

Aggressive Growth: Invests in equities expected to experience acceleration in growth of earnings per share. Generally high P/E ratios, low or no dividends; often smaller and micro cap stocks which are expected to experience rapid growth. Includes sector specialist funds such as technology, banking, or biotechnology. Hedges by shorting equities where earnings disappointment is expected or by shorting stock indexes. Tends to be "long-biased." Expected Volatility: High

Distressed Securities: Buys equity, debt, or trade claims at deep discounts of companies in or facing bankruptcy or reorganization. Profits from the market's lack of understanding of the true value of the deeply discounted securities and because the majority of institutional investors cannot own below investment grade securities. (This selling pressure creates the deep discount.) Results generally not dependent on the direction of the markets. Expected Volatility: Low - Moderate

Emerging Markets: Invests in equity or debt of emerging (less mature) markets that tend to have higher inflation and volatile growth. Short selling is not permitted in many emerging markets, and, therefore, effective hedging is often not available, although Brady debt can be partially hedged via U.S. Treasury futures and currency markets. Expected Volatility: Very High

Funds of Hedge Funds: Mix and match hedge funds and other pooled investment vehicles. This blending of different strategies and asset classes aims to provide a more stable long-term investment return than any of the individual funds. Returns, risk, and volatility can be controlled by the mix of underlying strategies and funds. Capital preservation is generally an important consideration. Volatility depends on the mix and ratio of strategies employed. Expected Volatility: Low - Moderate - High

Income: Invests with primary focus on yield or current income rather than solely on capital gains. May utilize leverage to buy bonds and sometimes fixed income derivatives in order to profit from principal appreciation and interest income. Expected Volatility: Low

Macro: Aims to profit from changes in global economies, typically brought about by shifts in government policy that impact interest rates, in turn affecting currency, stock, and bond markets. Participates in all major markets -- equities, bonds, currencies and commodities -- though not always at the same time. Uses leverage and derivatives to accentuate the impact of market moves. Utilizes hedging, but the leveraged directional investments tend to make the largest impact on performance. Expected Volatility: Very High

Market Neutral - Arbitrage: Attempts to hedge out most market risk by taking offsetting positions, often in different securities of the same issuer. For example, can be long convertible bonds and short the underlying issuers equity. May also use futures to hedge out interest rate risk. Focuses on obtaining returns with low or no correlation to both the equity and bond markets. These relative value strategies include fixed income arbitrage, mortgage backed securities, capital structure arbitrage, and closed-end fund arbitrage. Expected Volatility: Low

Market Neutral - Securities Hedging: Invests equally in long and short equity portfolios generally in the same sectors of the market. Market risk is greatly reduced, but effective stock analysis and stock picking is essential to obtaining meaningful results. Leverage may be used to enhance returns. Usually low or no correlation to the market. Sometimes uses market index futures to hedge out systematic (market) risk. Relative benchmark index usually T-bills. Expected Volatility: Low

Market Timing: Allocates assets among different asset classes depending on the manager's view of the economic or market outlook. Portfolio emphasis may swing widely between asset classes. Unpredictability of market movements and the difficulty of timing entry and exit from markets add to the volatility of this strategy. Expected Volatility: High

Opportunistic: Investment theme changes from strategy to strategy as opportunities arise to profit from events such as IPOs, sudden price changes often caused by an interim earnings disappointment, hostile bids, and other event-driven opportunities. May utilize several of these investing styles at a given time and is not restricted to any particular investment approach or asset class. Expected Volatility: Variable

Multi Strategy: Investment approach is diversified by employing various strategies simultaneously to realize short- and long-term gains. Other strategies may include systems trading such as trend following and various diversified technical strategies. This style of investing allows the manager to overweight or underweight different strategies to best capitalize on current investment opportunities. Expected Volatility: Variable

Short Selling: Sells securities short in anticipation of being able to rebuy them at a future date at a lower price due to the manager's assessment of the overvaluation of the securities, or the market, or in anticipation of earnings disappointments often due to accounting irregularities, new competition, change of management, etc. Often used as a hedge to offset long-only portfolios and by those who feel the market is approaching a bearish cycle. High risk. Expected Volatility: Very High

Special Situations: Invests in event-driven situations such as mergers, hostile takeovers, reorganizations, or leveraged buyouts. May involve simultaneous purchase of stock in companies being acquired, and the sale of stock in its acquirer, hoping to profit from the spread between the current market price and the ultimate purchase price of the company. May also utilize derivatives to leverage returns and to hedge out interest rate and/or market risk. Results generally not dependent on direction of market. Expected Volatility: Moderate

Value: Invests in securities perceived to be selling at deep discounts to their intrinsic or potential worth. Such securities may be out of favor or underfollowed by analysts. Long-term holding, patience, and strong discipline are often required until the ultimate value is recognized by the market. Expected Volatility: Low - Moderate

Benefits of Hedge Funds

Many hedge fund strategies have the ability to generate positive returns in both rising and falling equity and bond markets.

-Inclusion of hedge funds in a balanced portfolio reduces overall portfolio risk and volatility and increases returns.

-Huge variety of hedge fund investment styles – many uncorrelated with each other provides investors with a wide choice of hedge fund strategies to meet their investment objectives.

-Academic research proves hedge funds have higher returns and lower overall risk than traditional investment funds.

-Hedge funds provide an ideal long-term investment solution, eliminating the need to correctly time entry and exit from markets.

-Adding hedge funds to an investment portfolio provides diversification not otherwise available in traditional investing.

Hedging Strategies

A wide range of hedging strategies are available to hedge funds. For example:

-selling short - selling shares without owning them, hoping to buy them back at a future date at a lower price in the expectation that their price will drop.
-using arbitrage - seeking to exploit pricing inefficiencies between related securities - for example, can be long convertible bonds and short the underlying issuers equity.
-trading options or derivatives - contracts whose values are based on the performance of any underlying financial asset, index or other investment.
-investing in anticipation of a specific event - merger transaction, hostile takeover, spin-off, exiting of bankruptcy proceedings, etc.
-investing in deeply discounted securities - of companies about to enter or exit financial distress or bankruptcy, often below liquidation value.
Many of the strategies used by hedge funds benefit from being non-correlated to the direction of equity markets

Facts About the Hedge Fund Industry

-Estimated to be a $1 trillion industry and growing at about 20% per year with approximately 8350 active hedge funds.
-Includes a variety of investment strategies, some of which use leverage and derivatives while others are more conservative and employ little or no leverage. Many hedge fund strategies seek to reduce market risk specifically by shorting equities or through the use of derivatives.
-Most hedge funds are highly specialized, relying on the specific expertise of the manager or management team.
-Performance of many hedge fund strategies, particularly relative value strategies, is not dependent on the direction of the bond or equity markets -- unlike conventional equity or mutual funds (unit trusts), which are generally 100% exposed to market risk.
-Many hedge fund strategies, particularly arbitrage strategies, are limited as to how much capital they can successfully employ before returns diminish. As a result, many successful hedge fund managers limit the amount of capital they will accept.
-Hedge fund managers are generally highly professional, disciplined and diligent.
-Their returns over a sustained period of time have outperformed standard equity and bond indexes with less volatility and less risk of loss than equities.
-Beyond the averages, there are some truly outstanding performers.
-Investing in hedge funds tends to be favored by more sophisticated investors, including many Swiss and other private banks, that have lived through, and understand the consequences of, major stock market corrections.
-An increasing number of endowments and pension funds allocate assets to hedge funds.

What is a Hedge Fund?

A hedge fund is a fund that can take both long and short positions, use arbitrage, buy and sell undervalued securities, trade options or bonds, and invest in almost any opportunity in any market where it foresees impressive gains at reduced risk. Hedge fund strategies vary enormously -- many hedge against downturns in the markets -- especially important today with volatility and anticipation of corrections in overheated stock markets. The primary aim of most hedge funds is to reduce volatility and risk while attempting to preserve capital and deliver positive returns under all market conditions.

There are approximately 14 distinct investment strategies used by hedge funds, each offering different degrees of risk and return. A macro hedge fund, for example, invests in stock and bond markets and other investment opportunities, such as currencies, in hopes of profiting on significant shifts in such things as global interest rates and countries’ economic policies. A macro hedge fund is more volatile but potentially faster growing than a distressed-securities hedge fund that buys the equity or debt of companies about to enter or exit financial distress. An equity hedge fund may be global or country specific, hedging against downturns in equity markets by shorting overvalued stocks or stock indexes. A relative value hedge fund takes advantage of price or spread inefficiencies. Knowing and understanding the characteristics of the many different hedge fund strategies is essential to capitalizing on their variety of investment opportunities.

It is important to understand the differences between the various hedge fund strategies because all hedge funds are not the same -- investment returns, volatility, and risk vary enormously among the different hedge fund strategies. Some strategies which are not correlated to equity markets are able to deliver consistent returns with extremely low risk of loss, while others may be as or more volatile than mutual funds. A successful fund of funds recognizes these differences and blends various strategies and asset classes together to create more stable long-term investment returns than any of the individual funds.

       >Hedge fund strategies vary enormously – many, but not all, hedge against market downturns – especially important today with volatility and anticipation of corrections in overheated stock markets.
      >The primary aim of most hedge funds is to reduce volatility and risk while attempting to preserve capital and deliver positive (absolute) returns under all market conditions.
     >The popular misconception is that all hedge funds are volatile -- that they all use global macro strategies and place large directional bets on stocks, currencies, bonds, commodities or gold, while using lots of leverage. In reality, less than 5% of hedge funds are global macro funds. Most hedge funds use derivatives only for hedging or don’t use derivatives at all, and many use no leverage.

Key Characteristics of Hedge Funds

-Hedge funds utilize a variety of financial instruments to reduce risk, enhance returns and minimize the correlation with equity and bond markets. Many hedge funds are flexible in their investment options (can use short selling, leverage, derivatives such as puts, calls, options, futures, etc.).

-Hedge funds vary enormously in terms of investment returns, volatility and risk. Many, but not all, hedge fund strategies tend to hedge against downturns in the markets being traded.

-Many hedge funds have the ability to deliver non-market correlated returns.

-Many hedge funds have as an objective consistency of returns and capital preservation rather than magnitude of returns.

-Most hedge funds are managed by experienced investment professionals who are generally disciplined and diligent.

-Pension funds, endowments, insurance companies, private banks and high net worth individuals and families invest in hedge funds to minimize overall portfolio volatility and enhance returns.

-Most hedge fund managers are highly specialized and trade only within their area of expertise and competitive advantage.

-Hedge funds benefit by heavily weighting hedge fund managers’ remuneration towards performance incentives, thus attracting the best brains in the investment business. In addition, hedge fund managers usually have their own money invested in their fund.

Hedge Funds

An aggressively managed portfolio of investments that uses advanced investment strategies such as leverage, long, short and derivative positions in both domestic and international markets with the goal of generating high returns (either in an absolute sense or over a specified market benchmark).

Legally, hedge funds are most often set up as private investment partnerships that are open to a limited number of investors and require a very large initial minimum investment. Investments in hedge funds are illiquid as they often require investors keep their money in the fund for at least one year.

For the most part, hedge funds (unlike mutual funds) are unregulated because they cater to sophisticated investors. In the U.S., laws require that the majority of investors in the fund be accredited. That is, they must earn a minimum amount of money annually and have a net worth of more than $1 million, along with a significant amount of investment knowledge. You can think of hedge funds as mutual funds for the super rich. They are similar to mutual funds in that investments are pooled and professionally managed, but differ in that the fund has far more flexibility in its investment strategies.

It is important to note that hedging is actually the practice of attempting to reduce risk, but the goal of most hedge funds is to maximize return on investment. The name is mostly historical, as the first hedge funds tried to hedge against the downside risk of a bear market by shorting the market (mutual funds generally can't enter into short positions as one of their primary goals). Nowadays, hedge funds use dozens of different strategies, so it isn't accurate to say that hedge funds just "hedge risk". In fact, because hedge fund managers make speculative investments, these funds can carry more risk than the overall market.

Common money market instruments

Bankers' acceptance - A draft issued by a bank that will be accepted for payment, effectively the same as a cashier's check.
Certificate of deposit - A time deposit at a bank with a specific maturity date; large-denomination certificates of deposits can be sold before maturity.
Repurchase agreements - Short-term loans—normally for less than two weeks and frequently for one day—arranged by selling securities to an investor with an agreement to repurchase them at a fixed price on a fixed date.
Commercial paper - An unsecured promissory notes with a fixed maturity of one to 270 days; usually sold at a discount from face value.
Eurodollar deposit - Deposits made in U.S. dollars at a bank or bank branch located outside the United States.
Federal Agency Short-Term Securities - (in the US). Short-term securities issued by government sponsored enterprises such as the Farm Credit System, the Federal Home Loan Banks and the Federal National Mortgage Association.
Federal funds - (in the US). Interest-bearing deposits held by banks and other depository institutions at the Federal Reserve; these are immediately available funds that institutions borrow or lend, usually on an overnight basis. They are lent for the federal funds rate.
Municipal notes - (in the US). Short-term notes issued by municipalities in anticipation of tax receipts or other revenues.
Treasury bills - Short-term debt obligations of a national government that are issued to mature in 3 to 12 months. For the U.S., see Treasury bills.
Money market mutual funds - Pooled short maturity, high quality investments which buy money market securities on behalf of retail or institutional investors.
Foreign Exchange Swaps - Exchanging a set of currencies in spot date and the reversal of the exchange of currencies at a predetermined time in the future.

Unit Investment Trusts (UITs)

A"unit investment trust," commonly referred to as a "UIT," is one of three basic types of investment company. The other two types are mutual funds and closed-end funds.

Here are some of the traditional and distinguishing characteristics of UITs:

A UIT typically issues redeemable securities (or "units"), like a mutual fund, which means that the UIT will buy back an investor’s "units," at the investor’s request, at their approximate net asset value (or NAV) . Some exchange-traded funds (ETFs) are structured as UITs. Under SEC exemptive orders, shares of ETFs are only redeemable in very large blocks (blocks of 50,000 shares, for example) and are traded on a secondary market.

A UIT typically will make a one-time "public offering" of only a specific, fixed number of units (like closed-end funds). Many UIT sponsors, however, will maintain a secondary market, which allows owners of UIT units to sell them back to the sponsors and allows other investors to buy UIT units from the sponsors.

A UIT will have a termination date (a date when the UIT will terminate and dissolve) that is established when the UIT is created (although some may terminate more than fifty years after they are created). In the case of a UIT investing in bonds, for example, the termination date may be determined by the maturity date of the bond investments. When a UIT terminates, any remaining investment portfolio securities are sold and the proceeds are paid to the investors.

A UIT does not actively trade its investment portfolio. That is, a UIT buys a relatively fixed portfolio of securities (for example, five, ten, or twenty specific stocks or bonds), and holds them with little or no change for the life of the UIT. Because the investment portfolio of a UIT generally is fixed, investors know more or less what they are investing in for the duration of their investment. Investors will find the portfolio securities held by the UIT listed in its prospectus.

A UIT does not have a board of directors, corporate officers, or an investment adviser to render advice during the life of the trust.
Keep in mind that just because a UIT had excellent performance last year does not necessarily mean that it will duplicate that performance. For example, market conditions can change, and this year’s winning UIT could be next year’s loser. To understand the factors you should consider before investing in a mutual fund, read Mutual Fund Investing: Look at More Than a Mutual Fund's Past Performance. In addition, before investing in a UIT, you should carefully read all of the UIT’s available information, including its prospectus.

UITs are regulated primarily under the Investment Company Act of 1940 and the rules adopted under that Act, in particular Section 4 and Section 26.

http://www.sec.gov/answers/uit.htm

Net Asset Value

"Net asset value," or "NAV," of an investment company is the company’s total assets minus its total liabilities. For example, if an investment company has securities and other assets worth $100 million and has liabilities of $10 million, the investment company’s NAV will be $90 million. Because an investment company’s assets and liabilities change daily, NAV will also change daily. NAV might be $90 million one day, $100 million the next, and $80 million the day after.

Mutual funds and Unit Investment Trusts (UITs) generally must calculate their NAV at least once every business day, typically after the major U.S. exchanges close. A closed-end fund, whose shares generally are not "redeemable"—that is, not required to be repurchased by the fund—is not subject to this requirement.

An investment company calculates the NAV of a single share (or the "per share NAV") by dividing its NAV by the number of shares that are outstanding. For example, if a mutual fund has an NAV of $100 million, and investors own 10,000,000 of the fund’s shares, the fund’s per share NAV will be $10. Because per share NAV is based on NAV, which changes daily, and on the number of shares held by investors, which also changes daily, per share NAV also will change daily. Most mutual funds publish their per share NAVs in the daily newspapers.

The share price of mutual funds and traditional UITs is based on their NAV. That is, the price that investors pay to purchase mutual fund and most UIT shares is the approximate per share NAV, plus any fees that the fund imposes at purchase (such as sales loads or purchase fees). The price that investors receive on redemptions is the approximate per share NAV at redemption, minus any fees that the fund deducts at that time (such as deferred sales loads or redemption fees).

For the statutory and regulatory provisions relating to NAV, refer to the Investment Company Act of 1940 and the rules adopted under that Act, in particular Section 2(a)(41), and Rules 2a-4 and 22c-1.

http://www.sec.gov/answers/nav.htm

Money Market Funds

A money market fund is a type of mutual fund that is required by law to invest in low-risk securities. These funds have relatively low risks compared to other mutual funds and pay dividends that generally reflect short-term interest rates. Unlike a "money market deposit account" at a bank, money market funds are not federally insured.

Money market funds typically invest in government securities, certificates of deposits, commercial paper of companies, and other highly liquid and low-risk securities. They attempt to keep their net asset value (NAV) at a constant $1.00 per share—only the yield goes up and down. But a money market’s per share NAV may fall below $1.00 if the investments perform poorly. While investor losses in money market funds have been rare, they are possible.

Before investing in a money market fund, you should carefully read all of the fund’s available information, including its prospectus, or profile if the fund has one, and its most recent shareholder report.

Money market funds are regulated primarily under the Investment Company Act of 1940 and the rules adopted under that Act, particularly Rule 2a-7 under the Act.

http://www.sec.gov/answers/mfmmkt.htm

Required minimum distributions

An account owner must begin making distributions from their accounts at least no later than the year after the year the account owner turns 70½ unless the account owner is still employed at the company sponsoring the 401(k) plan. The amount of distributions is based on life expectancy according to the relevant factors from the appropriate IRS tables. The only exception to minimum distribution are for people still working once they reach that age, and the exception only applies to the current plan they are participating in. Required minimum distributions apply to both pre-tax and after-tax Roth contributions. Only a Roth IRA is not subject to minimum distribution rules. Other than the exception for continuing to work after age 70½ differs from the rules for IRA minimum distributions. The same penalty applies to the failure to make the minimum distribution. The penalty is 50% of the amount that should have been distributed, one of the most severe penalties the IRS applies.

Withdrawal of funds 401(k)

Virtually all employers impose severe restrictions on withdrawals while a person remains in service with the company and is under age 59½. Any withdrawal that is permitted before age 59½ is subject to an excise tax equal to twenty percent of the amount distributed, including withdrawals to pay expenses due to a hardship, except to the extent the distribution does not exceed the amount allowable as a deduction under Internal Revenue Code section 213 to the employee for amounts paid during the taxable year for medical care (determined without regard to whether the employee itemizes deductions for such taxable year).

In any event any amounts are subject to normal taxation as ordinary income. Some employers may disallow one, several, or all of the previous hardship causes. Someone wishing to withdraw from such a 401(k) plan would have to resign from their employer. To maintain the tax advantage for income deferred into a 401(k), the law stipulates the restriction that unless an exception applies, money must be kept in the plan or an equivalent tax deferred plan until the employee reaches 59½ years of age. Money that is withdrawn prior to 59 ½ typically incurs a 10% penalty tax unless a further exception applies.[1] This penalty is of course on top of the "ordinary income" tax that has to be paid on such a withdrawal. The exceptions to the 10% penalty include: the employee's death, the employee's total and permanent disability, separation from service in or after the year the employee reached age 55, substantially equal periodic payments under section 72(t), a qualified domestic relations order, and for deductible medical expenses (exceeding the 7.5% floor). This does not apply to the similar 457 plan.

Many plans also allow employees to take loans from their 401(k) to be repaid with after-tax funds at pre-defined interest rates. The interest proceeds then become part of the 401(k) balance. The loan itself is not taxable income nor subject to the 10% penalty as long as it is paid back in accordance with section 72(p) of the Internal Revenue Code. This section requires, among other things, that the loan be for a term no longer than 5 years (except for the purchase of a primary residence), that a "reasonable" rate of interest be charged, and that substantially equal payments (with payments made at least every calendar quarter) be made over the life of the loan. Employers, of course, have the option to make their plan's loan provisions more restrictive. When an employee does not make payments in accordance with the plan or IRS regulations, the outstanding loan balance will be declared in "default". A defaulted loan, and possibly accrued interest on the loan balance, becomes a taxable distribution to the employee in the year of default with all the same tax penalties and implications of a withdrawal.

These loans have been described as tax-disadvantaged, on the theory that the 401(k) contains before-tax dollars, but the loan is repaid with after-tax dollars. This is not correct. The loan is repaid with after-tax dollars, but the loan itself is not a taxable event, so the "income" from the loan is tax-free. This treatment is identical to that of any other loan, as long as the balance is repaid on schedule. (A residential mortgage or home equity line of credit may have tax advantages over the 401(k) loan; but that is because the interest on home mortgages is deductible, and unrelated to the tax-deferred features of the 401(k).)

Tax Consequences on 401(k)

Most 401(k) contributions are on a pre-tax basis. Starting in the 2006 tax year employees can either contribute on a pre-tax basis or opt to utilize the Roth 401(k) provisions to contribute on an after tax basis and have similar tax effects of a Roth IRA. However, in order to do so, the plan sponsor must amend the plan to make those options available. With either pre-tax or after tax contributions, earnings from investments in a 401(k) account (in the form of interest, dividends, or capital gains) are not taxable events. The resulting compound interest without taxation can be a major benefit of the 401(k) plan over long periods of time.

For pre-tax contributions, the employee does not pay federal income tax on the amount of current income that he or she defers to a 401(k) account. For example, a worker who earns $50,000 in a particular year and defers $3,000 into a 401(k) account that year only recognizes $47,000 in income on that year's tax return. Currently this would represent a near term $750 savings in taxes for a single worker, assuming the worker remained in the 25% marginal tax bracket and there were no other adjustments (e.g. deductions). The employee ultimately pays taxes on the money as he or she withdraws the funds, generally during retirement. The character of any gains (including tax favored capital gains) are transformed into "ordinary income" at the time the money is withdrawn.

For after tax contributions to a designated Roth account (Roth 401(k)), qualified distributions can be made tax free. To qualify, distributions must be made more than 5 years after the first designated Roth contributions and not before the year in which the account owner turns age 59 and a half, unless an exception applies as detailed in IRS code section 72(t). In the case of designated Roth contributions, the contributions being made on an after tax basis means that the taxable income in the year of contribution is not decreased as it is with pre-tax contributions. Roth contributions are irrevocable and cannot be converted to pre-tax contributions at a later date. Administratively Roth contributions must be made to a separate account, and records must be kept that distinguish the amount of contribution that are to receive Roth treatment.

401(k) Introduction

The 401(k) plan is a type of employer-sponsored defined contribution retirement plan under section 401(k) of the Internal Revenue Code (26 U.S.C. § 401(k)) in the United States, and some other countries.

A 401(k) plan allows a worker to save for retirement while deferring income taxes on the saved money and earnings until withdrawal. The employee elects to have a portion of his or her wage paid directly, or "deferred," into his or her 401(k) account. In participant-directed plans (the most common option), the employee can select from a number of investment options, usually an assortment of mutual funds that emphasize stocks, bonds, money market investments, or some mix of the above. Many companies' 401(k) plans also offer the option to purchase the company's stock. The employee can generally re-allocate money among these investment choices at any time. In the less common trustee-directed 401(k) plans, the employer appoints trustees who decide how the plan's assets will be invested.

Some assets in 401(k) plans are tax deferred. Before the January 1, 2006 effective date of the designated Roth account provisions, all 401(k) contributions were on a pre-tax basis (i.e., no income tax is withheld on the income in the year it is contributed), and the contributions and growth on them are not taxed until the money is withdrawn. With the enactment of the Roth provisions, participants in 401(k) plans that have the proper amendments can allocate some or all of their contributions to a separate designated Roth account, commonly known as a Roth 401(k). Qualified distributions from a designated Roth account are tax free, while contributions to them are on an after-tax basis (i.e., income tax is paid or withheld on the income in the year contributed). In addition to Roth and pre-tax contributions, some participants may have after-tax contributions in their 401(k) accounts. The after-tax contributions are treated as after-tax basis and may be withdrawn without tax. The growth on after-tax amounts not in a designated Roth account are taxed as ordinary income.

What makes 401(k) different?

Four things differentiate a 401(k) plan from other retirement plans.

1. When you participate in a 401(k) plan, you tell your employer how much money you want to go into the account. You can usually put up to 15 percent of your salary into the account each month, but the employer has the right to limit that amount. It might be worth your while to rally for a higher limit if it isn't as high as you would like it to be. The IRS limits your total annual contribution to $15,000 (for 2006).

2. The money you contribute comes out of your check before taxes are calculated, and more importantly, before you ever have a chance to get your hands on it. That makes the 401(k) one of the most painless ways to save for retirement.

3.If you're lucky, your employer will match a portion of your contribution. Your employer wants you to participate in the plan because of compliance issues we'll talk about later. The matched amount they offer (the free money part) is your incentive to participate.

4.The money is given to a third party administrator who invests it in mutual funds, bonds, money market accounts, etc. They don't determine the mix of investments -- you do that. They usually have a list of investment vehicles you can choose from as well as some guidelines for the level of risk you are willing to take. We'll also talk about that later.

401 k

When people talk about 401(k) plans, you often hear about advantages like:
    - Free money from your employer
    - Lower taxable income
    - Savings and earnings that accumulate without you having to remember to make deposits
    - The opportunity to retire and not have to worry about money anymore

Does this sound too good to be true? It isn't. It's what you can gain from investing in your company's 401(k) plan. The 401(k) is one of the most popular retirement plans around.

Although retirement plans may be the farthest thing from your mind, think about how much of a difference 10 years can make in the investing world. You'll learn about that difference in this article. If your employer offers a 401(k) plan, it makes a lot of sense to participate in it as soon as possible. If you start early, maybe when you're 25 or so, you can very likely have a million or two (or more) in your account by the time you retire.

401(k) plans are part of a family of retirement plans known as defined contribution plans. Other defined contribution plans include profit sharing plans, IRAs and Simple IRAs, SEPs, and money purchase plans. They are called "defined contribution plans" because the amount that is contributed is defined either by the employee (a.k.a. the participant) or the employer.

Glossary of Key Mutual Fund Terms

12b-1 Fees : fees paid by the mutual fund out of fund assets to cover the costs of marketing and selling mutual fund shares and sometimes to cover the costs of providing shareholder services. "Distribution fees" include fees to compensate brokers and others who sell mutual fund shares and to pay for advertising, the printing and mailing of prospectuses to new investors, and the printing and mailing of sales literature. "Shareholder Service Fees" are fees paid to persons to respond to investor inquiries and provide investors with information about their investments.

Account Fee : a fee that some funds separately impose on investors for the maintenance of their accounts. For example, accounts below a specified dollar amount may have to pay an account fee.

Back-end Load : a sales charge (also known as a "deferred sales charge") investors pay when they redeem (or sell) mutual fund shares, generally used by the fund to compensate brokers.

Classes : different types of shares issued by a single fund, often referred to as Class A shares, Class B shares, and so on. Each class invests in the same "pool" (or investment portfolio) of securities and has the same investment objectives and policies. But each class has different shareholder services and/or distribution arrangements with different fees and expenses and therefore different performance results.

Closed-End Fund : a type of investment company that does not continuously offer its shares for sale but instead sells a fixed number of shares at one time (in the initial public offering) which then typically trade on a secondary market, such as the New York Stock Exchange or the Nasdaq Stock Market. Legally known as a "closed-end company."

Contingent Deferred Sales Load : a type of back-end load, the amount of which depends on the length of time the investor held his or her shares. For example, a contingent deferred sales load might be (X)% if an investor holds his or her shares for one year, (X-1)% after two years, and so on until the load reaches zero and goes away completely.

Conversion : a feature some funds offer that allows investors to automatically change from one class to another (typically with lower annual expenses) after a set period of time. The fund's prospectus or profile will state whether a class ever converts to another class.

Deferred Sales Charge : see "back-end load" (above).

Distribution Fees : fees paid out of fund assets to cover expenses for marketing and selling mutual fund shares, including advertising costs, compensation for brokers and others who sell mutual fund shares, and payments for printing and mailing prospectuses to new investors and sales literature prospective investors. Sometimes referred to as "12b-1 fees."

Exchange Fee : a fee that some funds impose on shareholders if they exchange (transfer) to another fund within the same fund group.

Exchange-Traded Funds : a type of an investment company (either an open-end company or UIT) whose objective is to achieve the same return as a particular market index. ETFs differ from traditional open-end companies and UITs, because, pursuant to SEC exemptive orders, shares issued by ETFs trade on a secondary market and are only redeemable from the fund itself in very large blocks (blocks of 50,000 shares for example).

Expense Ratio : the fund's total annual operating expenses (including management fees, distribution (12b-1) fees, and other expenses) expressed as a percentage of average net assets.

Front-end Load : an upfront sales charge investors pay when they purchase mutual fund shares, generally used by the fund to compensate brokers. A front-end load reduces the amount available to purchase mutual fund shares.

Index Fund : describes a type of mutual fund or Unit Investment Trust (UIT) whose investment objective typically is to achieve the same return as a particular market index, such as the S&P 500 Composite Stock Price Index, the Russell 2000 Index, or the Wilshire 5000 Total Market Index.

Investment Adviser : generally, a person or entity who receives compensation for giving individually tailored advice to a specific person on investing in stocks, bonds, or mutual funds. Some investment advisers also manage portfolios of securities, including mutual funds.

Investment Company : a company (corporation, business trust, partnership, or limited liability company) that issues securities and is primarily engaged in the business of investing in securities. The three basic types of investment companies are mutual funds, closed-end funds, and unit investment trusts.

Load : see "Sales Charge."

Management Fee : fee paid out of fund assets to the fund's investment adviser or its affiliates for managing the fund's portfolio, any other management fee payable to the fund's investment adviser or its affiliates, and any administrative fee payable to the investment adviser that are not included in the "Other Expenses" category. a mutual fund's management fee appears as a category under "Annual Fund Operating Expenses" in the Fee Table.

Market Index : a measurement of the performance of a specific "basket" of stocks considered to represent a particular market or sector of the U.S. stock market or the economy. For example, the Dow Jones Industrial Average (DJIA) is an index of 30 "blue chip" U.S. stocks of industrial companies (excluding transportation and utility companies).

Mutual Fund : the common name for an open-end investment company. Like other types of investment companies, mutual funds pool money from many investors and invest the money in stocks, bonds, short-term money-market instruments, or other securities. Mutual funds issue redeemable shares that investors purchase directly from the fund (or through a broker for the fund) instead of purchasing from investors on a secondary market.

NAV (Net Asset Value) : the value of the fund's assets minus its liabilities. SEC rules require funds to calculate the NAV at least once daily. To calculate the NAV per share, simply subtract the fund's liabilities from its assets and then divide the result by the number of shares outstanding.

No-load Fund : a mutual fund that does not charge any type of sales load. But not every type of shareholder fee is a "sales load," and a no-load fund may charge fees that are not sales loads. No-load funds also charge operating expenses.

Open-End Company : the legal name for a mutual fund. An open-end company is a type of investment company

Operating Expenses : the costs a mutual fund incurs in connection with running the fund, including management fees, distribution (12b-1) fees, and other expenses.

Portfolio : an individual's or entity's combined holdings of stocks, bonds, or other securities and assets.

Profile : summarizes key information about a mutual fund's costs, investment objectives, risks, and performance. Although every mutual fund has a prospectus, not every mutual fund has a profile.

Prospectus : describes the mutual fund to prospective investors. Every mutual fund has a prospectus. The prospectus contains information about the mutual fund's costs, investment objectives, risks, and performance. You can get a prospectus from the mutual fund company (through its website or by phone or mail). Your financial professional or broker can also provide you with a copy.

Purchase Fee : a shareholder fee that some funds charge when investors purchase mutual fund shares. Not the same as (and may be in addition to) a front-end load.

Redemption Fee : a shareholder fee that some funds charge when investors redeem (or sell) mutual fund shares. Redemption fees (which must be paid to the fund) are not the same as (and may be in addition to) a back-end load (which is typically paid to a broker). The SEC generally limits redemption fees to 2%.

Sales Charge (or "Load") : the amount that investors pay when they purchase (front-end load) or redeem (back-end load) shares in a mutual fund, similar to a commission. The SEC's rules do not limit the size of sales load a mutual fund may charge, but NASD rules state that mutual fund sales loads cannot exceed 8.5% and must be even lower depending on other fees and charges assessed.

Shareholder Service Fees : fees paid to persons to respond to investor inquiries and provide investors with information about their investments. See also "12b-1 fees."

Statement of Additional Information (SAI) : conveys information about an open- or closed-end fund that is not necessarily needed by investors to make an informed investment decision, but that some investors find useful. Although funds are not required to provide investors with the SAI, they must give investors the SAI upon request and without charge. Also known as "Part B" of the fund's registration statement.

Total Annual Fund Operating Expense : the total of a mutual fund's annual fund operating expenses, expressed as a percentage of the fund's average net assets. You'll find the total in the fund's fee table in the prospectus.

Unit Investment Trust (UIT) : a type of investment company that typically makes a one-time "public offering" of only a specific, fixed number of units. A UIT will terminate and dissolve on a date established when the UIT is created (although some may terminate more than fifty years after they are created). UITs do not actively trade their investment portfolios.

Classes of Funds

Many mutual funds offer more than one class of shares. For example, you may have seen a mutual fund that offers "Class A" and "Class B" shares. Each class will invest in the same "pool" (or investment portfolio) of securities and will have the same investment objectives and policies. But each class will have different shareholder services and/or distribution arrangements with different fees and expenses. As a result, each class will likely have different performance results.

A multi-class structure offers investors the ability to select a fee and expense structure that is most appropriate for their investment goals (including the time that they expect to remain invested in the fund). Here are some key characteristics of the most common mutual fund share classes offered to individual investors:

Class A Shares : Class A shares typically impose a front-end sales load. They also tend to have a lower 12b-1 fee and lower annual expenses than other mutual fund share classes. Be aware that some mutual funds reduce the front-end load as the size of your investment increases. If you're considering Class A shares, be sure to inquire about breakpoints.
Class B Shares : Class B shares typically do not have a front-end sales load. Instead, they may impose a contingent deferred sales load and a 12b-1 fee (along with other annual expenses). Class B shares also might convert automatically to a class with a lower 12b-1 fee if the investor holds the shares long enough.
Class C Shares : Class C shares might have a 12b-1 fee, other annual expenses, and either a front- or back-end sales load. But the front- or back-end load for Class C shares tends to be lower than for Class A or Class B shares, respectively. Unlike Class B shares, Class C shares generally do not convert to another class. Class C shares tend to have higher annual expenses than either Class A or Class B shares.

Annual Fund Operating Expenses

Management Fees : fees that are paid out of fund assets to the fund's investment adviser for investment portfolio management, any other management fees payable to the fund's investment adviser or its affiliates, and administrative fees payable to the investment adviser that are not included in the "Other Expenses" category (discussed below).

Distribution [and/or Service] Fees ("12b-1" Fees) : fees paid by the fund out of fund assets to cover the costs of marketing and selling mutual fund shares and sometimes to cover the costs of providing shareholder services. "Distribution fees" include fees to compensate brokers and others who sell mutual fund shares and to pay for advertising, the printing and mailing of prospectuses to new investors, and the printing and mailing of sales literature. "Shareholder Service Fees" are fees paid to persons to respond to investor inquiries and provide investors with information about their investments.

Other Expenses : expenses not included under "Management Fees" or "Distribution or Service (12b-1) Fees," such as any shareholder service expenses that are not already included in the 12b-1 fees, custodial expenses, legal and accounting expenses, transfer agent expenses, and other administrative expenses.

Total Annual Fund Operating Expenses ("Expense Ratio") : the line of the fee table that represents the total of all of a mutual fund's annual fund operating expenses, expressed as a percentage of the fund's average net assets. Looking at the expense ratio can help you make comparisons among funds.

Shareholder Fees

Sales Charge (Load) on Purchases : the amount you pay when you buy shares in a mutual fund. Also known as a "front-end load," this fee typically goes to the brokers that sell the fund's shares. Front-end loads reduce the amount of your investment. For example, let's say you have $1,000 and want to invest it in a mutual fund with a 5% front-end load. The $50 sales load you must pay comes off the top, and the remaining $950 will be invested in the fund. According to NASD rules, a front-end load cannot be higher than 8.5% of your investment.

Purchase Fee : another type of fee that some funds charge their shareholders when they buy shares. Unlike a front-end sales load, a purchase fee is paid to the fund (not to a broker) and is typically imposed to defray some of the fund's costs associated with the purchase.

Deferred Sales Charge (Load) : a fee you pay when you sell your shares. Also known as a "back-end load," this fee typically goes to the brokers that sell the fund's shares. The most common type of back-end sales load is the "contingent deferred sales load" (also known as a "CDSC" or "CDSL"). The amount of this type of load will depend on how long the investor holds his or her shares and typically decreases to zero if the investor holds his or her shares long enough.

Redemption Fee : another type of fee that some funds charge their shareholders when they sell or redeem shares. Unlike a deferred sales load, a redemption fee is paid to the fund (not to a broker) and is typically used to defray fund costs associated with a shareholder's redemption.

Exchange Fee : a fee that some funds impose on shareholders if they exchange (transfer) to another fund within the same fund group or "family of funds."

Account fee : a fee that some funds separately impose on investors in connection with the maintenance of their accounts. For example, some funds impose an account maintenance fee on accounts whose value is less than a certain dollar amount.

Fees and Expenses

As with any business, running a mutual fund involves costs - including shareholder transaction costs, investment advisory fees, and marketing and distribution expenses. Funds pass along these costs to investors by imposing fees and expenses. It is important that you understand these charges because they lower your returns.

Some funds impose "shareholder fees" directly on investors whenever they buy or sell shares. In addition, every fund has regular, recurring, fund-wide "operating expenses." Funds typically pay their operating expenses out of fund assets - which means that investors indirectly pay these costs.

SEC rules require funds to disclose both shareholder fees and operating expenses in a "fee table" near the front of a mutual fund's prospectus. The lists below will help you decode the fee table and understand the various fees a mutual fund may impose:

How Funds Can Earn Money for You

You can earn money from your investment in three ways:

1.Dividend Payments : A mutual fund may earn income in the form of dividends and interest on the securities in its portfolio. The fund then pays its shareholders nearly all of the income (minus disclosed expenses) it has earned in the form of dividends.
2.Capital Gains Distributions : The price of the securities a mutual fund owns may increase. When a mutual fund sells a security that has increased in price, the fund has a capital gain. At the end of the year, most funds distribute these capital gains (minus any capital losses) to investors.
3.Increased NAV : If the market value of a mutual fund's portfolio increases after deduction of expenses and liabilities, then the value (NAV) of the fund and its shares increases. The higher NAV reflects the higher value of your investment.

With respect to dividend payments and capital gains distributions, funds usually will give you a choice: the fund can send you a check or other form of payment, or you can have your dividends or distributions reinvested in the fund to buy more shares (often without paying an additional sales load).

Different Types of Funds

When it comes to investing in mutual funds, investors have literally thousands of choices. Before you invest in any given fund, decide whether the investment strategy and risks of the fund are a good fit for you. The first step to successful investing is figuring out your financial goals and risk tolerance - either on your own or with the help of a financial professional. Once you know what you're saving for, when you'll need the money, and how much risk you can tolerate, you can more easily narrow your choices.

Most mutual funds fall into one of three main categories - money market funds, bond funds (also called "fixed income" funds), and stock funds (also called "equity" funds). Each type has different features and different risks and rewards. Generally, the higher the potential return, the higher the risk of loss.

Money Market Funds

Money market funds have relatively low risks, compared to other mutual funds (and most other investments). By law, they can invest in only certain high-quality, short-term investments issued by the U.S. government, U.S. corporations, and state and local governments. Money market funds try to keep their net asset value (NAV) - which represents the value of one share in a mutual fund - at a stable $1.00 per share. But the NAV may fall below $1.00 if the fund's investments perform poorly. Investor losses have been rare, but they are possible.

Money market funds pay dividends that generally reflect short-term interest rates, and historically the returns for money market funds have been lower than for either bond or stock funds. That's why "inflation risk" - the risk that inflation will outpace and erode investment returns over time - can be a potential concern for investors in money market funds.

Bond Funds

Bond funds generally have higher risks than money market funds, largely because they typically pursue strategies aimed at producing higher yields. Unlike money market funds, the SEC's rules do not restrict bond funds 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. Some of the risks associated with bond funds include:

Credit Risk : the possibility that companies or other issuers whose bonds are owned by the fund may fail to pay their debts (including the debt owed to holders of their bonds). Credit risk is less of a factor for bond funds that invest in insured bonds or U.S. Treasury bonds. By contrast, those that invest in the bonds of companies with poor credit ratings generally will be subject to higher risk.

Interest Rate Risk : the risk that the market value of the 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. Funds that invest in longer-term bonds tend to have higher interest rate risk.

Prepayment Risk : the chance that a bond will be paid off early. For example, if interest rates fall, a bond issuer may decide to pay off (or "retire") its debt and issue new bonds that pay a lower rate. When this happens, the fund may not be able to reinvest the proceeds in an investment with as high a return or yield.

Stock Funds

Although a stock fund's value can rise and fall quickly (and dramatically) over the short term, historically stocks have performed better over the long term than other types of investments - including corporate bonds, government bonds, and treasury securities.

Overall "market risk" poses the greatest potential danger for investors in stocks funds. Stock prices can fluctuate for a broad range of reasons - such as the overall strength of the economy or demand for particular products or services.

Not all stock funds are the same. For example:

-Growth funds focus on stocks that may not pay a regular dividend but have the potential for large capital gains.
-Income funds invest in stocks that pay regular dividends.
-Index funds aim to achieve the same return as a particular market index, such as the S&P 500 -Composite Stock Price Index, by investing in all - or perhaps a representative sample - of the companies included in an index.
-Sector funds may specialize in a particular industry segment, such as technology or consumer products stocks.

Advantages and Disadvantages of Mutual Funds

Every investment has advantages and disadvantages. But it's important to remember that features that matter to one investor may not be important to you. Whether any particular feature is an advantage for you will depend on your unique circumstances. For some investors, mutual funds provide an attractive investment choice because they generally offer the following features:
Professional Management : Professional money managers research, select, and monitor the performance of the securities the fund purchases.
Diversification : Diversification is an investing strategy that can be neatly summed up as "Don't put all your eggs in one basket." Spreading your investments across a wide range of companies and industry sectors can help lower your risk if a company or sector fails. Some investors find it easier to achieve diversification through ownership of mutual funds rather than through ownership of individual stocks or bonds.
Affordability : Some mutual funds accommodate investors who don't have a lot of money to invest by setting relatively low dollar amounts for initial purchases, subsequent monthly purchases, or both.
Liquidity : Mutual fund investors can readily redeem their shares at the current NAV - plus any fees and charges assessed on redemption - at any time.

But mutual funds also have features that some investors might view as disadvantages, such as:

Costs Despite Negative Returns : Investors must pay sales charges, annual fees, and other expenses (which we'll discuss below) regardless of how the fund performs. And, depending on the timing of their investment, investors may also have to pay taxes on any capital gains distribution they receive - even if the fund went on to perform poorly after they bought shares.
Lack of Control : Investors typically cannot ascertain the exact make-up of a mutual fund's portfolio at any given time, nor can they directly influence which securities the fund manager buys and sells or the timing of those trades.
Price Uncertainty : With an individual stock, you can obtain real-time (or close to real-time) pricing information with relative ease by checking financial websites or by calling your broker. You can also monitor how a stock's price changes from hour to hour - or even second to second. By contrast, with a mutual fund, the price at which you purchase or redeem shares will typically depend on the fund's NAV, which the fund might not calculate until many hours after you've placed your order. In general, mutual funds must calculate their NAV at least once every business day, typically after the major U.S. exchanges close.

A Word About Hedge Funds and "Funds of Hedge Funds"

"Hedge fund" is a general, non-legal term used to describe private, unregistered investment pools that traditionally have been limited to sophisticated, wealthy investors. Hedge funds are not mutual funds and, as such, are not subject to the numerous regulations that apply to mutual funds for the protection of investors - including regulations requiring a certain degree of liquidity, regulations requiring that mutual fund shares be redeemable at any time, regulations protecting against conflicts of interest, regulations to assure fairness in the pricing of mutual fund shares, disclosure regulations, regulations limiting the use of leverage, and more.

"Funds of hedge funds," a relatively new type of investment product, are investment companies that invest in hedge funds. Some, but not all, register with the SEC and file semi-annual reports. They often have lower minimum investment thresholds than traditional, unregistered hedge funds and can sell their shares to a larger number of investors. Like hedge funds, funds of hedge funds are not mutual funds. Unlike open-end mutual funds, funds of hedge funds offer very limited rights of redemption. And, unlike ETFs, their shares are not typically listed on an exchange.

You'll find more information about hedge funds on our website. To learn more about funds of hedge funds, please read NASD's Investor Alert entitled Funds of Hedge Funds: Higher Costs and Risks for Higher Potential Returns.

How Mutual Funds Work

What They Are

A mutual fund is a company that pools money from many investors and invests the money in stocks, bonds, short-term money-market instruments, other securities or assets, or some combination of these investments. The combined holdings the mutual fund owns are known as its portfolio. Each share represents an investor's proportionate ownership of the fund's holdings and the income those holdings generate.

Some of the traditional, distinguishing characteristics of mutual funds include the following:
-Investors purchase mutual fund shares from the fund itself (or through a broker for the fund) instead of from other investors on a secondary market, such as the New York Stock Exchange or Nasdaq Stock Market.
-The price that investors pay for mutual fund shares is the fund's per share net asset value (NAV) plus any shareholder fees that the fund imposes at the time of purchase (such as sales loads).
-Mutual fund shares are "redeemable," meaning investors can sell their shares back to the fund (or to a broker acting for the fund).
-Mutual funds generally create and sell new shares to accommodate new investors. In other words, they sell their shares on a continuous basis, although some funds stop selling when, for example, they become too large.
-The investment portfolios of mutual funds typically are managed by separate entities known as "investment advisers" that are registered with the SEC.

What types of fees are involved in mutual fund investing?

Many mutual funds are sold with a sales charge, known as a load, which can be payable either at the time of purchase or when shares are sold. This sales charge is in part used to compensate financial advisers for their work. Other funds have no up-front or back-end fee, but have ongoing expenses. All mutual funds charge annual expenses, which are paid by shareholders on a percentage of assets basis. For those investors who hold funds over the long-term, annual expenses may have a greater effect on the cost of investing in the fund than sales charges.
Frequently, mutual fund companies offer multiple share classes, each with a different fee structure, in order to provide shareholders with more flexibility. Your financial adviser can help you choose the type of fee structure most consistent with your individual needs.

How can investing in mutual funds help me reach my college savings and retirement goals?

Most tax-advantaged college and retirement savings vehicles, for example Individual Retirement Accounts (IRAs), 401(k) retirement plans and 529 college savings plans, can be invested in mutual funds.
When you choose to make a mutual fund investment as part of a tax-advantage retirement or college savings plan, taxes are not payable until the funds are actually withdrawn, allowing you to increase the value of your investment through the power of tax-deferred compounding.

How will I know what type of mutual fund is right for me?

Investment decisions are highly personal, and are based on many factors that include your individual financial goals, your time horizon, your tolerance for risk and your financial circumstances. It’s a good idea to sit down with your financial advisor and talk about some of these issues.

Financial Goals: It is particularly important to give your financial advisor an accurate picture of what you would like to achieve financially, and what types of issues are important to you. Do you need to generate income in the present, or are you concerned with growing your assets to fund your retirement? Do you have a child’s college education to prepare for? Would you like to purchase a second home? These are all important issues to be considered. Generally, the longer your investment horizon, or the time until you will need to realize income from your portfolio, the larger your allocation can be to growth-oriented stock investments. If you need your money in the near future, you will want to make a larger allocation to less volatile securities like bonds. If you need liquidity in the nearest term, you will want to consider money market instruments.

Risk tolerance: Understanding your relationship to risk is an essential component in successful investing, and it is critical to understand how risk and return are related in order to develop appropriate expectations. If you are highly uncomfortable with sharp fluctuations in value, for example, an aggressive growth fund is likely not right for you. If you hope to achieve a return in excess of 10% and have a long time horizon, you should develop a willingness to assume more risk in your portfolio. Over the long term, security prices are typically determined by corporate earnings. However, in the short term emotion can influence the market. In a bull market investors tend to ignore risk, while in a bear market long term opportunities are often ignored.

Financial circumstances: Your personal situation, income, assets, tax status and family structure, as well as many other factors, all influence your investment choices. Be sure that you thoroughly discuss these circumstances with your financial advisor.

Kinds of Mutual funds

There are mutual funds to suit every investor’s needs, each with a predetermined investment objective that specifies what types of investments are made and what investment strategies are pursued. Funds vary widely in the risk to return ratio, and it is important to understand that risk and reward are directly related – the higher the potential return, the higher level of risk that is assumed.
Funds typically invest in stocks, bonds and short-term money market instruments, and may target certain geographic regions, company types (small cap or large cap, for example), industries or sectors of the economy. Funds may invest according to particular investments strategies, for example value or growth. They may be actively managed, meaning that the managers select securities on the basis of the value they are believed to add to the portfolio, or passively managed, meaning that the fund is created to replicate the performance of an index, for example, the S&P 500.

Can investing in mutual funds be risky?

Certainly any investment carries the risk that you may lose money, and mutual funds are subject to risk. Mutual funds, unlike bank savings accounts and certificates of deposit (CDs), are not insured by the federal government. Mutual fund prices fluctuate with changes in the financial markets, and may go up or down in value like any stock. It is important to look at mutual fund investments with a view toward the long term, as staying invested over longer periods can reduce the impact of short term fluctuations.

Mutual funds may also offer several advantages in terms of managing risk. As previously discussed, mutual funds are diversified among many securities to mitigate the risk associated with any single holding. They are also highly liquid, and investors can generally redeem shares at any time for the current market value. Significantly, the mutual fund business is one of the most highly regulated in the United States, and the SEC carries out regular audits of mutual fund companies. 

Independent directors oversee funds’ activities, while independent auditors scrutinize their financial statements and major financial institutions maintain custody of fund assets. Shareholder reports and other communications, as well as marketing materials, are reviewed by the National Association of Securities Dealers (NASD).

Investing in Mutual Funds

How does an investment in a mutual fund compare to investing in individual securities?

Professional Management: The biggest advantage gained from investing in a mutual fund is access to professional money managers. Few people have the time and expertise necessary to manage their own portfolios, and a mutual fund provides an inexpensive way to access sophisticated investment management.
Diversification: By virtue of their size, mutual funds are able to invest in a large number of securities. A diverse mix of securities can reduce overall portfolio volatility since the impact of one poorly performing stock can be offset by a better-performing security. The more stocks that are held, the less one security can impact the overall result. Large mutual funds typically own many stocks in diverse industries. An individual investor would not be able to create a similarly diversified portfolio with a small amount of money.
Liquidity: A shareholder in a mutual fund can sell shares at any time without worrying about the liquidity of any given stock held in that mutual fund. Since the shares of the fund are valued at the market’s close each day, the shareholder would receive the fund’s current market value at the closing price (NAV) regardless of what time the sell order was placed during that day.
Simplicity: Most mutual funds require only a small initial investment, and shares can be easily purchased in a variety of ways including online. Mutual fund companies offer many convenient services for shareholders, including online account access, automatic investment and withdrawal programs, and reinvestment of distributions.

Benefits of Mutual Funds- II

11.Periodic Withdrawals
If you want steady monthly income, many funds allow you to arrange for monthly fixed checks to be sent to you, first by distributing some or all of the income and then, if necessary, by dipping into your principal.
12.Dividend Options
You can receive all dividend payments in cash. Or you can have them reinvested in the fund free of charge, in which case the dividends are automatically compounded. This can make a significant contribution to your long-term investment results. With some funds you can elect to have your dividends from income paid in cash and your capital gains distributions reinvested.
13.Automatic Direct Deposit
You can usually arrange to have regular, third-party payments -- such as Social Security or pension checks -- deposited directly into your fund account. This puts your money to work immediately, without waiting to clear your checking account, and it saves you from worrying about checks being lost in the mail.
14.Recordkeeping Service
With your own portfolio of stocks and bonds, you would have to do your own recordkeeping of purchases, sales, dividends, interest, short-term and long-term gains and losses. Mutual funds provide confirmation of your transactions and necessary tax forms to help you keep track of your investments and tax reporting.
15.Safekeeping
When you own shares in a mutual fund, you own securities in many companies without having to worry about keeping stock certificates in safe deposit boxes or sending them by registered mail. You don't even have to worry about handling the mutual fund stock certificates; the fund maintains your account on its books and sends you periodic statements keeping track of all your transactions.
16.Retirement and College Plans
Mutual funds are well suited to Individual Retirement Accounts and most funds offer IRA-approved prototype and master plans for individual retirement accounts (IRAs) and Keogh, 403(b), SEP-IRA and 401(k) retirement plans. Funds also make it easy to invest -- for college, children or other long-term goals. Many offer special investment products or programs tailored specifically for investments for children and college.
17.Online Services
The internet provides a fast, convenient way for investors to access financial information. A host of services are available to the online investor including direct access to no-load companies.
18.Sweep Accounts
With many mutual funds, if you choose not to reinvest your stock or bond mutual funds dividends, you can arrange to have them swept into your money market fund automatically. You get all the advantages of both accounts with no extra effort.
19.Asset Management Accounts
These master accounts, available from many of the larger fund groups, enable you to manage all your financial service needs under a single umbrella from unlimited check writing and automatic bill paying to discount brokerage and credit card accounts.
20.Margin
Some mutual fund shares are marginable. You may buy them on margin or use them as collateral to borrow money from your bank or broker. Call your fund company for details.

Benefits of Mutual Funds- I

1. Professional Investment Management.
By pooling the money of thousands of investors, mutual funds provide full-time, high-level professional management that few individual investors can afford to obtain independently. Such management can be important to achieving results in today's complex markets.
2. Diversification.
Mutual funds invest in a broad range of securities. This limits investment risk by reducing the effect of a possible decline in the value of any one security. Mutual fund shareowners can benefit from diversification techniques usually available only to investors wealthy enough to buy significant positions in a wide variety of securities.
3. Low Cost.
If you tried to create your own diversified portfolio of 50 stocks, you'd need at least $100,000 and you'd pay thousands of dollars in commissions to assemble your portfolio. A mutual fund lets you participate in a diversified portfolio for as little as $1,000, and sometimes less.
4. Convenience and Flexibility.
You own just one security rather than many, yet enjoy the benefits of a diversified portfolio and a wide range of services. Fund managers decide what securities to trade, clip the bond coupons, collect the interest payments and see that your dividends on portfolio securities are received and your rights exercised. It's easy to purchase and redeem mutual fund shares, either directly online or with a phone call.
5. Quick, Personalized Service.
Most mutual funds now offer extensive websites with a host of shareholder services for immediate access to information about your fund account. Or a phone call puts you in touch with a trained investment specialist at a mutual fund company who can provide information you can use to make your own investment choices, assist you with buying and selling your mutual funds shares, and answer questions about your mutual fund account status.
6. Ease of Investing
You may open or add to your account and conduct transactions or business with the mutual fund by mail, telephone or bank wire. You can even arrange for automatic monthly investments by authorizing electronic fund transfers from your checking account in any amount and on a date you choose.
7. Total Liquidity, Easy Withdrawal
You can easily redeem your shares anytime you need cash by letter, telephone, bank wire or check, depending on the fund. Your proceeds are usually available within a day or two.
8. Life Cycle Planning
With no-load mutual funds, you can link your investment plans to future individual and family needs -- and make changes as your life cycles change. You can invest in growth funds for future college tuition needs, then move to income mutual funds for retirement, and adjust your investments as your needs change throughout your life. With no-load mutual funds, there are no commissions to pay when you change your investments.
9. Market Cycle Planning
For investors who understand how to actively manage their portfolio, mutual fund investments can be moved as market conditions change. You can place your funds in equities when the market is on the upswing and move into money market mutual funds on the downswing or take any number of steps to ensure that your investments are meeting your needs in changing market climates. A word of caution: since it is impossible to predict what the market will do at any point in time, staying on course with a long-term, diversified investment view is recommended for most investors.
10.Investor Information
Shareholders receive regular reports from the mutual funds, including details of transactions on a year-to-date basis. The current net asset value of your shares (the price at which you may purchase or redeem them) appears in the mutual fund price listings of daily newspapers. You can also obtain pricing and performance results for the all mutual funds at this site, or it can be obtained by phone from the mutual funds.