7936 / What are mutual funds?

Mutual funds are managed, in the sense that the underlying portfolio is changing as assets are bought and sold. Funds are generally designed to accomplish some primary investment objective, such as growth, income, capital appreciation, tax-exempt interest, international investing, etc., and therefore emphasize investments they consider appropriate to this purpose. Many funds (e.g., asset allocation funds, balanced funds, equity-income funds, hybrid funds) combine two or more investment objectives in an effort to maintain a more diversified portfolio. “Tax-managed” funds (i.e., tax-sensitive, tax-efficient funds) employ investment strategies designed to minimize current income taxes by keeping taxable gains and income as low as possible and emphasizing long-term growth. Although the specific methods vary from one fund to another, they generally include: (1) keeping turnover low; (2) offsetting capital gains with capital losses; and (3) keeping dividends and interest at a minimum. “Life cycle” funds (or “target date” funds) invest in stocks, bonds, and cash in a ratio considered appropriate for investors with a particular age and risk tolerance.¹

The Securities and Exchange Commission (SEC) requires mutual fund companies to disclose standardized after-tax returns for one-, five-, and 10-year periods to help investors understand the magnitude of tax costs and compare the impact of taxes on the performance of different funds. After-tax returns must accompany before-tax returns in a fund’s prospectus and must be presented in two ways: (1) returns after taxes on fund distributions only; and (2) returns after taxes on fund distributions and redemption of fund shares. The SEC also requires that funds include standardized after-tax returns in certain advertisements and other sales material.