Mutual funds are a cornerstone of retirement planning. Yet they’re widely misunderstood and investing ignorance can really cost you.

Do you know the difference between an expense ratio and a turnover ratio? What about an open-end fund versus a closed-end?

Try this quiz, and check out the answers at bottom:

1. What percentage of households own mutual funds?

(a) 10 percent; (b) 27 percent; (c) 43 percent

2. When was the key law governing mutual fund operations adopted?

(a) 1929; (b) 1933; (c) 1934; (d) 1940

3. How many mutual funds are there in the U.S.?

(a) Nearly 1,000; (b) Nearly 4,000; (c) Nearly 8,000

4. What is a mutual fund’s expense ratio?

(a) The sales fee paid when you invest in a fund, expressed as a percentage of how much you invest;

(b) The total fees charged to manage the fund and cover ongoing expenses, expressed as a percentage of the fund’s assets;

(c) The fee you pay to a broker who sells you the fund

5. What’s a fund’s turnover ratio?

(a) A measure of how often a fund’s manager is replaced; (b) How frequently the fund trades stocks or other investments in and out of its portfolio; (c) How often the fund gets new investors and loses existing clients

6. Traditional open-end mutual funds can issue as many or as few shares as investors demand, with potentially no limits on the number of investors in the fund, or the amount of money it can hold.

(a) True; (b) False

7. Common stock funds will always provide investors with higher returns than bond mutual funds.

(a) True; (b) False

8. Mutual funds are prohibited from using investing strategies that unregulated hedge funds can employ.

(a) True; (b) False

9. You can lose money in an absolute return mutual fund.

(a) True; (b) False

10. Fund managers’ interests should be aligned with their investors. But what percentage of managers don’t invest in their funds — in other words, how many don’t “eat their own cooking”?

(a) 10 percent; (b) 35 percent; (c) More than 50 percent

 

ANSWERS

1. (c) A survey by the Investment Co. Institute, a fund industry organization, found 43 percent of U.S. households owned mutual funds in 2009, down from 45 percent a year earlier. Those households represent some 90 million individual fund shareholders.

2. (d) The main law is the Investment Co. Act of 1940, although mutual funds also are subject to the Securities Act of 1933 and the Securities and Exchange Act of 1934.

3. (c) The Investment Co. Institute counted 7,677 funds in February, holding nearly $11 trillion. Two common types are stock funds, numbering about 4,900; and taxable bond funds, with more than 1,800.

4. (b) A fund’s expense ratio covers the fund company’s costs before distributing earnings to investors. This amount can have a much bigger impact than any upfront sales costs — also known as loads, or commissions — since expenses can eat into returns for years to come.

5. (b) The turnover ratio measures the percentage of a fund’s holdings that have been replaced over the past year. If the manager makes smart trades, a higher ratio can boost short-term returns. But a fund with high turnover increases fund trading costs, and can boost an investor’s tax bill.

6. (a) True. Traditional open-end mutual funds are structured so that they can add investors and assets. Far less common are closed-end funds, where a fund company decides up front how many fund shares will be issued, limiting the number of investors. Those initial investors can later trade shares to others.

7. (a) False. While it’s true that in the long run stocks generally outperform bonds, there are times where the opposite is true. As we’ve seen during the recession, the stock market can post dramatic losses while bond investors are generally protected. For example, over the last decade, the Standard & Poor’s 500 stock index lost an average 0.95 percent per year. Meanwhile, a broad taxable bond index, the Barclays Capital Aggregate, returned a positive 6.3 percent per year.

8. (b) False. Regulations limit how much mutual funds can borrow to invest in derivatives, such as futures and options. But, depending on the guidelines in its prospectus, a fund can adopt some of the same strategies that hedge funds use, including short-selling.

9. (b) True. These funds generally employ the same strategies as many hedge funds to smooth out returns in good times and bad. But you can still lose money, even if you’ll fare better than most investors in a downturn. The same goes for stable value funds.

10. (c) A Morningstar study found a majority of funds did not count managers among their shareholders. For example, 59 percent of foreign stock funds had no manager ownership in the fund. The figure was 65 percent for taxable-bond funds, 70 percent for balanced funds owning stocks and bonds, and 78 percent for municipal bond funds. The exception was U.S. stock funds, where just 46 percent of funds had no manager ownership.

 

SCORING SYSTEM

0-3: It’s time to take Mutual Funds 101.

4-5: You’re progressing, but how about picking up a few mutual fund books or checking out some Web sites?

6-7: Pretty good, but your knowledge gaps could put you at risk of getting into the wrong fund.

8-9: Very good, your fund acumen is admirable.

10: Perfect! You have a solid foundation to build on.