The Risks of mutual funds
The major risk of investing in a mutual fund is the risk of loss of principal
owing to a decline in NAV. Many types of risk exist: interestrate
risk, market risk, and quality of the securities, to name a few.
Rising market interest rates tend to depress both the stock and the
bond markets, resulting in a decline in the NAVs of stock and bond
funds. Adecline in market rates of interest results in an appreciation
of stock and bond prices (and the NAVs of stock and bond funds).
The quality of securities determines the volatility of the fund’s
price swings. Stock funds that invest in small-company stocks and
emerging growth stocks see greater upward swings in price during
bull markets and greater downward swings during bear markets
than conservative income equity funds, which invest in the stocks
of larger, more established companies. Some small-cap funds have
invested in small-cap stocks of dubious value, which has caused
some losses to their funds.
With bank failures in the past and the shaky financial status of
some savings and loan associations in the United States, investors
are naturally concerned about the risk of insolvency of mutual funds.
A mutual fund can always “go under,” but the chance of it happening
is small. The key distinction between banks and mutual
funds is the way in which mutual funds are set up, which reduces
the risk of failure and loss owing to fraud.
Mutual funds typically are corporations owned by shareholders.
Aseparate management company is contracted by shareholders
to run the fund’s daily operations. Although a management company
oversees the fund’s investments, the company does not have
possession of the assets (investments). A custodian, such as a bank,
holds the investments. Therefore, if a management company gets
into financial trouble, it does not have access to the fund’s investments.
Yet, even with these checks and balances, the possibility of
fraud always exists. The SEC cleared two mutual funds whose
prices were quoted in the financial newspapers along with all the
other mutual funds, but they turned out to be bogus funds.
A transfer agent maintains shareholders’ accounts and keeps
track of shareholders’ purchases and redemptions. In addition,
management companies carry fidelity bonds, a form of insurance
to protect the investments of the fund against malfeasance or fraud
perpetrated by its employees.
Along with these safeguards, two other factors differentiate
mutual funds from corporations such as banks and savings and
* Mutual funds must be able to redeem shares on demand,
which means that a portion of its investment assets must
* Mutual funds must be able to price their investments at the
end of each day, which is known as marking to market. This
adjustment of market values of investments at the end of
the trading day reflects gains and losses.
For these reasons, mutual funds cannot hide their financial difficulties
as easily as banks and savings and loans can.
The SEC regulates mutual funds, but as noted earlier in this
chapter, fraudulent operators can always find a way into any
industry. Although the risk of fraud is always present, it is no
greater in the mutual fund industry than in any other industry.
Above all, you should be aware that you can lose money
through purchasing a fund whose investments perform poorly on
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