3 Ways to Earn Money Through Mutual Funds

Whether you buy an open- or closed-end fund, there are three ways you make money in mutual funds:

  1. Dividends and interest. Whenever an investment inside the mutual fund declares a dividend or pays interest, you receive a pro rata share of that dividend or interest.
  2. Capital gains distributions. You also receive your share of any net profits from the sale of investments. These profits are called distributions of capital gains; and
  3. Increased share value as the value (NAV) of the investments that are held by the fund increases or, in a closed-end fund, as the share price increases.

Dividends and distributions may be paid monthly, quarterly or annually. In the case of fixed-income mutual funds, distributions may be declared daily but only paid out monthly or quarterly.

You can choose to collect them as you go, or you can have them automatically reinvested to buy more shares. But as rabid long-term investors, we always recommend that you reinvest them. You won't miss them, and they will give your portfolio an added boost through the incredible power of compounding. The more money you put in, the more you will have when you are ready to take it out!

For tax purposes, you'll get a year-end statement from the fund showing what part of the money you've earned represents ordinary income and what part represents long-term capital gains. This distinction is important. With the advent of the long-needed tax changes in the Jobs & Growth Tax Relief Reconciliation Act of 2003, dividends and long-term capital gains are taxed at a maximum rate of 15%, while ordinary income can be taxed at up to 28% (depending on your tax bracket). In addition, you can offset your capital gains with any capital losses you have for the year (or that you carried from previous years).

Dolan Ah-ha!

Some fund companies have become so desperate for new business they have offered brokers an extra commission to push their funds on you, the investor. Even major fund families have been known to do this.
 

The amount of dividends, interest or capital gain distributions you get from a mutual fund depends on the kinds of investments the fund owns. Funds invested in high-rated corporate bonds may pay you dividends of 5%–10%, based on the income from the bonds. A fund investing in small growth companies may have little or no income from dividends. Your profit from this fund would be due to any appreciation in the stocks owned by the fund. Or a balanced fund made up of stocks and bonds may pay you a combination of dividends and appreciation. (Reminder: You can read our primer on the ins and outs of different types of funds at Dolans.com now — just click here.)

How to Choose the Right Mutual Fund for You

So let's get to the all-important question: With so many mutual funds available, how do you choose the right one for you?

We'd like to begin our answer to that question with some very interesting and helpful information from Charles Jaffe, author of the syndicated column "Your Funds," which appears in more than 50 newspapers nationwide.

Charles wrote a column for The Boston Globe that really caught our eye. It was titled, "Putting Your Funds to the Test." He stated at the beginning of the article that if you can't answer the six basic questions below, you should plow into a prospectus, head to your fund company's website or revisit your portfolio-building strategy for a refresher course. And we heartily agree.

Here are the six questions you should ask — whether you already own a fund or are thinking of purchasing one:

  1. What is the fund's investment strategy, market-capitalization or bond-duration profile? For example, if you are looking for income, it would make no sense to buy a small-cap fund, which would typically invest in riskier, growth stocks. Or if you want to cash in your fund next year, you probably don't want to buy a fund that holds mostly 30-year corporate bonds.
  2. Who is the manager, and what is the investment style? You want to know the manager's experience and track record. Often, mutual funds change their managers as often as you may change your clothes, and the track record they are ballyhooing doesn't even belong to the current manager. And style is important too — if you are a buy-and-hold investor, you won't want a fund with a high turnover ratio (that just means it buys and sells a lot).
  3. What is the fund's expense ratio? (We'll talk more in-depth about that in a few moments.)
  4. How is the fund rated by independent experts (like Morningstar, Lipper, or Value Line)? You can go to these web sites to find out: www.morningstar.com, www.lipperweb.com, and www.valueline.com.
  5. What is the fund's role in your portfolio? Is it part of your conservative or speculative strategies? What percentage of your portfolio will it represent?
  6. Does it match (or, if you've owned it for some time, still match) your investment objectives? Are you looking for income, growth, a combination of income and growth, international exposure, sector exposure, etc.?

Those six questions are a great starting point. Combine them with just a few more steps we're about to walk you through, and you'll have the tools you need to find the best funds for you.

 

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