Mutual Funds Q&A: We Answer Your Questions

by the Schwab Center for Financial Research
March 10, 2009

Each month, we receive thousands of questions from Schwab clients. Here, we tackle the top questions on mutual funds, with answers and guidance that we believe will address some of your most pressing concerns.

If you have a question that doesn't appear below, we have more Q&As on timely topics in the box at right. If you have a question that we haven't already addressed, you can submit it using the Editor Feedback form at right—we may include it when we add new questions and answers.

To talk to a Schwab investment professional about your particular circumstances, please call 800-435-4000.

On mutual funds

Why are interest rates on money market funds so low?
As far as foreign stocks are concerned, what would be a couple of the best funds to invest in?
Should dividends on funds be reinvested in the fund paying the dividend?
Could you explain exchange-traded funds (ETFs) and discuss their advantages and disadvantages?
Are mutual funds or ETFs more effective in providing safety for IRAs in a bear market?
Are ETFs, because of their higher liquidity, better suited for turbulent markets than mutual funds?
Do you think it's better to buy individual bonds or bond funds?
What bond funds do you recommend?
What bond funds would be good to invest in during a recession?
What is the safest bond fund to invest in that pays at least 5% interest?

Why are interest rates on money market funds so low?
The interest rates money market funds pay are driven by the interest rates on the short-term securities they invest in—often Treasury bills. And right now, those rates are at record lows.

Here's why. In light of the financial turmoil, the Federal Reserve has been lowering its fed funds rate to encourage borrowing and to help stabilize the markets. At the same time, investors have desperately sought the protection of Treasuries over even slightly riskier investments, pushing down rates.

In December, 2008, the Treasury actually sold new four-month bills with negative yields—in other words, instead of getting a return on their investment, investors were paying for the chance to put their money in the safety of Treasuries.

What's more, for the past several years, many money market funds sought to increase returns by investing in nongovernment securities with slightly higher risk and, consequently, higher interest rates. During the credit crunch, the bottom fell out of many of these securities. As a result, we believe many money market funds are shedding investments perceived as riskier and reinvesting in Treasuries.

It all adds up to record-low interest rates on money market funds.. For that to change, interest rates overall must rise, or the perception of risk in anything other than Treasuries must decline.

For our current views on the Fed, Treasury and economy, read the Liz Ann Sonders and David Kastner "Schwab Market Perspective," which we update every two weeks.

As far as foreign stocks are concerned, what would be a couple of the best funds to invest in?
Whether you're looking for an international mutual fund or any other kind, check out our Mutual Fund OneSource Select List (see the Related Resources box at right). Schwab's experts have applied rigorous criteria to create this quarterly list of pre-screened, no-load, no-transaction-fee funds.

Should dividends on funds be reinvested in the fund paying the dividend?
We think so, especially if you hold the fund in a tax-advantaged account like an IRA or 401(k). Reinvesting dividends (which you can set to happen automatically) can be a great way to build wealth via the power of compounding.

That said, in these situations it may not be the best choice:

If you plan to withdraw cash from the account that holds the fund—including required minimum distributions (RMDs) from retirement accounts—you may be better served taking fund dividends in cash to offset the need to sell shares.
If you hold the fund in a taxable account, consider the need to rebalance your portfolio. In a rising market, rebalancing from cash is more tax-efficient than selling investments with reinvested distributions.

For more about rebalancing, see "Why You Should Rebalance Your Portfolio."

Could you explain exchange-traded funds (ETFs) and discuss their advantages and disadvantages?
To learn more about ETFs, read our related articles:

Are mutual funds or ETFs more effective in providing safety for IRAs in a bear market?
ETFs are designed to track indexes and, as such, are generally not designed to perform better, or worse, in bear markets. Mutual funds designed to track an index (aka index funds) are basically in the same boat. But with actively managed mutual funds, the fund managers have more flexibility to try and provide some downside protection relative to broad market indexes like the S&P 500. But performing relatively better in a down market doesn't mean that you won't lose money.

Lastly, if you're looking for funds that tend to do relatively better than their peers in bear markets, you may want to consider funds that generate income and focus more on capital preservation. You can find funds like this on our Income Mutual Fund Select List (see the Related Resources box at right). Keep in mind, though, that in rising markets, these funds may struggle against their more aggressive peers.

Are ETFs, because of their higher liquidity, better suited for turbulent markets than mutual funds?
In a turbulent market, ETFs do offer some potential benefits for investors that mutual funds may lack. However, they also present some potential pitfalls that mutual funds don't.

Liquidity alone (the ability to trade at any time) doesn't necessarily give ETFs an advantage over mutual funds in a volatile market. If anything, the ability to trade ETFs in the middle of the day (rather than having to wait for the market close to trade a mutual fund) may increase the impact of turbulence by allowing investors to jump in and out of the market in short-term moves.

If an investor is truly trying to time the market midday, then yes, an ETF allows that possibility, but we generally recommend that investors avoid this kind of ultra-short-term market timing. It's extremely difficult to pull off, and frequent trading of ETFs can become costly because each trade requires a commission.

However, one potential advantage of ETFs in a volatile market is that, unlike with a mutual fund, an investor can set a sell-stop order on an ETF, which can trigger automatically if the fund loses a certain amount of value.

For instance, an investor could buy shares of an ETF at $20 per share and set a stop order to sell the ETF if the shares go below, say, $18 (a 10% loss in addition to any loss according to where the order is actually filled). Of course, the investor would miss out on any subsequent rebound in the market, but some investors prefer to put a floor under their losses.

Do you think it's better to buy individual bonds or bond funds?
There's no one correct answer—what's best for you depends on your needs. See "Bonds or Bond Funds?" for a detailed discussion.

What bond funds would you recommend?
For a list of our favorite bond funds, see our Mutual Fund OneSource Select List® and our Income Mutual Fund Select List (see the Related Resources box at right).

What bond funds would be good to invest in during a recession?
In recessionary times, intermediate to longer-term government bond funds will typically perform better—and this is what investors have experienced in the current recession.

You should be aware, though, that as a recession unfolds and investors flock to the relative safety of Treasuries, Treasury yields generally fall. For that reason, funds that focus on corporate bonds (including high-yield bonds) and mortgage-backed bonds have generally done better as the economy stabilizes and starts to improve.

You can search for funds in the categories mentioned above using the fund screener on Schwab.com or see our top choices by using the Mutual Fund OneSource Select List (see the Related Resources box at right).

What is the safest bond fund to invest in that pays at least 5% interest?
With Treasury securities at such low yields and given the risk-averse market, investors looking for a defensive fund with an attractive yield have their work cut out for them.

That said, there are a few defensively positioned funds out currently offering attractive yields by investing predominantly in U.S. mortgage-backed securities, which receive the implicit backing of the U.S. Treasury, as well as a modest allocation to high-grade corporate bonds (rated AAA and AA).

Note that if the credit markets thaw, funds that invest along these lines may lag the broader bond market. In addition, corporate bonds may get more volatile if the economy deteriorates further.

Schwab's Income Mutual Fund Select List (see the Related Resources box at right) lists a variety of bond funds. Click on View The Funds > Fixed Income Funds to compare a variety of taxable and tax-free bond funds. To compare yields, click Dividends & Distributions.

Important Disclosures

Investors should consider carefully information contained in the prospectus, including investment objectives, risks, charges and expenses. You can request a prospectus by calling Schwab at 800-435-4000. Please read the prospectus carefully before investing.

The current and future portfolio holdings contained in a mutual fund is subject to risk you should be aware of prior to making an investment decision. Past performance is no guarantee of future results, and your investment value and return will fluctuate such that shares, when redeemed, may be worth more or less than original cost.

An investment in a money market fund is neither insured nor guaranteed by the FDIC or any other government agency. Although the fund seeks to preserve the value of your investment at $1 per share, it is possible to lose money by investing in the fund. Please note that bank deposits are FDIC insured up to $250,000 while nonbank independent products have no such guarantees.

Exchange-traded funds (ETFs) are subject to risks similar to those of stocks. Investment returns will fluctuate and are subject to market volatility, so that an investor's shares, when redeemed or sold, may be worth more or less than their original cost.

Approximately 2,100 funds participate in the Mutual Fund OneSource service. Only these funds, including Schwab Affiliate Funds, are eligible for the Mutual Fund OneSource Select List. Schwab receives remuneration from fund companies, and/or their affiliates, in the Mutual Fund OneSource service for recordkeeping, shareholder services and other administrative services.

A bond fund's Net Asset Value (NAV) will fluctuate with the price of the underlying bonds and portfolio turnover activity. Return of principal is not guaranteed. Bond fund shares are subject to increased loss of principal during periods of increasing interest rates.

International investments are subject to additional risks such as currency fluctuation, political instability and the potential for illiquid markets. Investing in emerging markets may accentuate these risks.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor, CPA, financial planner or investment manager.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

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Related Resources

Mutual Fund OneSource Select List®
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