Now, What’s a Mutual Fund Again? Answers to Some Basic Questions

In recent weeks in this column, we’ve talked about technology-sector funds, small-cap growth stock funds and so-called new-economy funds. We’ve also addressed somewhat obscure statistical measures such as a fund’s Sharpe ratio, R-squared and beta.

Great. Now, what’s a mutual fund again? How is the share price figured? How do you measure your return?

Last weekend, more than 1,000 people paid good money to find answers to basic questions such as these. In fact, the “Mutual Fund Basics” panel at The Times’ annual Investment Strategies Conference drew about one-sixth of the total conference attendance. Which says something.

Mutual funds have been around for more than 75 years. Yet even though nearly half of all households own at least one fund, many still don’t understand how funds work exactly.

For those who have always wondered about the basics, or who could use a refresher course, here are answers to some key questions:

* What is a mutual fund? A mutual fund is an “investment company” that pools people’s money and invests it in a diversified basket of securities, such as stocks, bonds, money market instruments and other assets. Mutual funds are professionally managed, offer instant diversification and allow you to buy in or sell out whenever you choose.

Funds typically require relatively small minimum investments, often $2,500 or less.

* Is there a difference between an equity fund and a mutual fund? This question was raised by some readers after The Times redesigned its mutual fund listings earlier this year and listed some funds under the header “Equity Funds.”

A mutual fund that primarily invests in stocks is called an “equity fund” or a “stock fund.” Though all equity funds are mutual funds, not all mutual funds are equity funds. Bond funds, for example, invest primarily in bonds, which are fixed-income securities issued by companies or government entities. Funds that invest in a mix of stocks and bonds are often called “balanced funds.”

Because a fund is a basket of securities, it’s important to know what kinds of securities a fund holds before investing in it.

* What is a fund family? Fidelity Investments, Vanguard Group and Janus are examples of fund families. A fund family doesn’t own its funds--technically, you, as a fund shareholder, own your fund. The “family” firms manage and administer the various portfolios on shareholders’ behalf for a management fee that is deducted directly from the funds’ assets.

* When you invest in a fund, what are you investing in? Each share--or fraction of a share--of a fund you buy gets you a tiny cross-section of everything the fund owns.

For instance, if you buy shares of the Vanguard Index 500 fund, an equity fund that tracks the Standard & Poor’s 500 index of blue-chip stocks, you’re technically getting a tiny bit of all 500 stocks in the portfolio. Similarly, if you’re investing in a bond fund, you’re getting a tiny sliver of all the bonds held in that fund.

* What’s NAV? NAV stands for “net asset value.” It’s not to be confused with a fund’s “total net assets.”

Total net assets refer to the value of all securities in a fund. For instance, if a fund owns $1 million of Microsoft stock, $2 million of Cisco Systems and $3 million of Intel, its total net assets would be $6 million.

NAV, on the other hand, refers to the per-share value of those total net assets.

* Does NAV matter? One reader e-mailed me last week wondering: “Should I be concerned about a fund’s NAV? My current fund has a NAV of around $15, but [some] funds range around $40, $50 and even $60 for a NAV” share value. The answer is yes and no.

Obviously, the NAV of your specific fund should matter to you over time, because the NAV multiplied by the number of shares you own is the value of your investment at any moment.

But it makes no difference that one fund has a high NAV and another a low one. Fidelity Magellan, for instance, has a NAV of about $130 a share, whereas Alliance Growth & Income’s NAV is closer to $3. Both are four-star Morningstar-rated funds that invest in large blue-chip stocks.

True, you can buy more shares of Alliance Growth & Income for fewer dollars. But whether you own one share of Alliance Growth & Income or 0.0231 share of Magellan, your investment is still $3. What matters is how that dollar value grows over time.

Bear in mind that unlike individual stocks, mutual fund shares can be bought and sold in fractions.

* How do you use NAV to calculate fund performance? A year ago, a reader e-mailed me wondering why the Dow Jones industrial average was doing so well while his fund was doing so lousy. He was looking at a day when the Dow jumped about 100 points while his fund’s NAV rose 50 cents a share.

But that 50-cent gain was based on a NAV of around $30. In percentage terms, the daily increase was about 1.7%. Meanwhile, the Dow’s 100-point gain that day was from a base of around 9,000. So the Dow’s percentage increase was about 1.1%--significantly less than what this reader’s fund gained.

When measuring your fund’s performance, it’s important to remember to compare apples to apples--that is, the percentage change, not the NAV change. The Times’ new daily fund tables, Monday through Saturday, show funds’ NAV each day. The tables also show the daily percentage change and year-to-date percentage change in each fund.

When comparing funds’ performance over the long term, NAV becomes virtually worthless as a measure. Why? Because funds are required to pay out their realized capital gains each year to shareholders. If you compare your fund’s NAV over time on your annual statements, you might see it increase only slowly, if at all. But your true return is probably much higher, once you count the capital gains you’ve been paid each year, usually in more fund shares.

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Do you have ideas for mutual fund and 401(k) topics for this column? Times staff writer Paul J. Lim can be reached at paul.lim@latimes.com.