Whenever novice investors ask whether mutual funds are safe, it reminds me of the 1976 movie "Marathon Man."
In that film, a Nazi dentist in hiding, portrayed by Laurence Olivier, tortures Dustin Hoffman's character because he suspects somebody is on his trail and that Hoffman knows who. But Hoffman does not know, and he feels the sharp tip of the dental drill when he can't answer the war criminal's nebulous query, "Is it safe?"
Similarly, when new investors ask whether mutual funds are safe, it is often unclear what they're really referring to. Questions about mutual fund safety can be answered in several ways, depending on the type of perceived danger.
Here are the most common categories.
* Risk of foul play. Mutual funds are highly immune to this type of danger. Several legally required checks and balances minimize the possibility that shareholders will lose money from fraud on the part of the management company or other parties.
Among other things, fund operations are supervised by an independent board, the management company is prohibited from making related-party transactions, and fund operations must be audited.
Perhaps most significant, actual fund assets--stocks, bonds and cash--are permanently kept with an independent custodian, typically a bank.
* Bankruptcy risk. Perhaps you worry that the management company might fail, taking the fund with it. If so, relax. Because of the safeguards described above, fund assets are insulated from the management company's other operations.
By contrast, consider the fixed-rate investment products offered by insurance companies. Because the rates paid by these investments are guaranteed by the insurer and included as part of its "general account," the company's solvency is important.
This explains why insurers--but not mutual fund management companies--are rated for credit-worthiness.
It's worth noting that the legal, marketing and other work needed just to get a mutual fund off the ground typically runs several hundred thousand dollars or more--in addition to the $100,000 in seed money that must stay invested for at least five years.
This helps explain why unsavory or undercapitalized operators are not likely to start up a fund.
* Liquidity risk. This essentially is the danger of not being able to gain access to your money quickly and at low cost. In general, mutual funds are highly liquid investments from which shareholders can make redemptions on any business day, often with a simple phone call.
Typically, you can expect to receive your cash within two weeks of making a redemption request, including mail time, or sooner if you have signed up for a wire-transfer connection with your bank.
You can also gain access to cash quickly by switching assets from a stock or bond fund into a money market portfolio with check-writing privileges and then writing a check against the account.
Some funds impose various types of back-end loads or redemption fees, which might range from 1% to 6% of an account balance and typically are phased out over time. These charges serve to penalize investors who get out in a hurry, but they don't impede a person's basic access to his or her cash.
* Risk of market losses. Prices for stock and bond funds can be expected to rise and fall, reflecting fluctuations in the securities held by each portfolio.
The level of volatility depends on a fund's investment orientation, of course. An aggressive growth product that uses leverage to purchase small stocks can be expected to fluctuate much more than a portfolio full of short-term government bonds.
Market risk can be gauged in various ways, from sophisticated measures such as standard deviation, to the simple practice of checking to see what a fund's worst year was over the last decade.
However it is measured, market risk is the one key danger from which shareholders in stock and bond funds are not insulated.
One of the best features about mutual funds is the relative ease with which they can be monitored--a factor that should help allay fears for first-time investors. Not only are fund prices listed daily in the newspaper, but shareholders can consult a variety of public sources for additional information.
* Newspapers and financial magazines. Many list daily prices or periodic performance data, along with articles about mutual funds. Various investment newsletters provide higher-priced coverage.
* Brokers, financial planners, insurance agents and bank representatives. All can provide marketing or research material on funds they sell.
* Rating services. Morningstar Inc. of Chicago and CDA/Wiesenberger of Rockville, Md., are among the companies that evaluate mutual funds. Their guides can be found in many libraries.
* Education groups. The Investment Company Institute in Washington, D.C., and the Mutual Fund Education Alliance in Kansas City, Mo., both publish low-cost fund directories.
* Mutual fund companies. Upon request, they will supply the prospectus or legal disclosure document required of all funds. Fund companies also offer various marketing brochures, pamphlets on specialized subjects, like college or retirement planning, and more.