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Factors to ConsiderBefore Investing in Mutual Funds or ETFs: Determine your financial goals and risk tolerance. Whenit comes to investing in mutual funds and ETFs, investorshave thousands of choices. Before you invest in any mutualfund or ETF, you must decide whether the investment strategy and risks are a good fit for you. You should also consider more generally whether the unique style of investing ofthe mutual fund’s or ETF’s sponsor is a good fit for you. Thefirst step to successful investing is to figure out your currentfinancial goals and risk tolerance—either on your own orwith the help of an investment professional. Beware of risk. All investments carry some level of risk.An investor can lose some or all of the money he or sheinvests—the principal—because securities held by a fund goup and down in value. Dividend payments may also fluctuate as market conditions change. Mutual funds and ETFshave different risks and rewards. Generally, the higher thepotential return, the higher the risk of loss. Consider the sponsor’s investing style. Before you invest,you may want to research the sponsor of the mutual fundor ETF you are considering. The sponsor’s website is oftena good place to begin, and it is helpful to spend some timebrowsing through the website to get a better understandingof the sponsor’s underlying philosophy on investing. EachU.S. SECURITIES AND EXCHANGE COMMISSION 11

sponsor has its own style of investing that will affect how itmanages its mutual funds and ETFs. It is helpful to understand each sponsor’s style of investing, so you can betterchoose the right investment for you. Ask and check. Before you engage an investment professional or purchase shares of a mutual fund or ETF, makesure you research and verify relevant information to determine which option is best suited for you. Investment professionals: The SEC’s Investor.govwebsite has a free and simple search tool that allowsyou to find out if your investment professional islicensed and registered, and if he or she has a disciplinary history or customer complaints. If you haveany questions about checking the background of aninvestment professional, you can call the SEC’s toll-freeinvestor assistance line at (800) 732-0330 for help. Mutual funds and ETFs: You can research a mutual fundor ETF by reading its prospectus (discussed on pages37–39) carefully to learn about its investment strategyand the potential risks. You can find the prospectus onthe mutual fund’s or ETF’s website or on the SEC’s EDGARdatabase (www.sec.gov/edgar) and download the documents for free.12 MUTUAL FUNDS AND ETFS

A Word about DerivativesDerivatives are financial instruments whose performance is derived, at least in part, from the performance of an underlying asset, security, or index. Evensmall market movements can dramatically affect theirvalue, sometimes in unpredictable ways.There are many types of derivatives with manydifferent uses. A mutual fund’s or ETF’s prospectus willdisclose whether and how it may use derivatives. Aninvestor may also want to call a fund and ask how ituses these instruments.Different Types of Mutual Funds and ETFsMutual funds and ETFs fall into several main categories. Someare bond funds (also called fixed income funds), and some arestock funds (also called equity funds). There are also funds thatinvest in a combination of these categories, such as balancedfunds and target date funds, and newer types of funds suchas alternative funds, smart-beta funds and esoteric ETFs. Inaddition, there are money market funds, which are a specifictype of mutual fund. Bond FundsBond funds invest primarily in bonds or other types of debtsecurities. They generally have higher risks than moneymarket funds (discussed on pages 18–19), largely becauseU.S. SECURITIES AND EXCHANGE COMMISSION 13

they typically pursue strategies aimed at producing higheryields. Unlike money market funds, the SEC’s rules do notrestrict bond funds to high-quality or short-term investments.Because there are many different types of bonds, bond fundscan vary dramatically in their risks and rewards.Some of the risks associated with bond funds include: Credit Risk—the possibility that companies or otherissuers whose bonds are owned by the fund may fail topay their debts (including the debt owed to holders oftheir bonds). Credit risk is less of a factor for bond fundsthat invest in insured bonds or U.S. Treasury Bonds. Bycontrast, those that invest in the bonds of companieswith poor credit ratings generally will be subject tohigher risk; Interest Rate Risk—the risk that the market value of thebonds will go down when interest rates go up. Becauseof this, an investor can lose money in any bond fund,including those that invest only in insured bonds or U.S.Treasury Bonds. Funds that invest in longer-term bondstend to have higher interest rate risk; and, Prepayment Risk—the chance that a bond will be paidoff early. For example, if interest rates fall, a bond issuermay decide to pay off (or retire) its debt and issue newbonds that pay a lower rate. When this happens, thefund may not be able to reinvest the proceeds in aninvestment with as high a return or yield.14 MUTUAL FUNDS AND ETFS

Stock FundsStock funds invest primarily in stocks, which are also known asequities. Although a stock fund’s value can rise and fall quickly(and dramatically) over the short term, historically, stockshave performed better over the long term than other types ofinvestments—including corporate bonds, government bonds,and treasury securities.Stock funds can be subject to various investment risks,including Market Risk, which poses the greatest potentialdanger for investors in stock funds. Stock prices can fluctuatefor a broad range of reasons—such as the overall strength ofthe economy or demand for particular products or services. Balanced FundsBalanced funds invest in stocks and bonds and sometimesmoney market instruments in an attempt to reduce risk butstill provide capital appreciation and income. They are alsoknown as asset allocation funds and typically hold a relativelyfixed allocation of the categories of portfolio instruments. Butthe allocation will differ from balanced fund to balanced fund.These funds are designed to reduce risk by diversifying amonginvestment categories, but they still share the same risks thatare associated with the underlying types of instruments. Target Date FundsAlso called target date retirement funds or lifecycle funds,these funds also invest in stocks, bonds, and other investments. Target date funds are designed to be long-term investments for individuals with particular retirement dates in mind.The name of the fund often refers to its target retirement dateU.S. SECURITIES AND EXCHANGE COMMISSION 15

or target date. For example, there are funds with names suchas “Portfolio 2050,” “Retirement Fund 2050,” or “Target 2050”that are designed for individuals who intend to retire in or nearthe year 2050. Most target date funds are designed so that theallocation of investments will automatically change over timein a way that is intended to become more conservative as thetarget date approaches. That means that funds typically shiftover time from a mix with a lot of stock investments in thebeginning to a mix weighted more toward bonds.Even if they share the same target date, target date fundsmay have very different investment strategies and risks andthe timing of their allocation changes may be different. Theyalso may have different investment results and may chargedifferent fees. Often a target date fund invests in other funds,and fees may be charged by both the target date fund and theother funds. In addition, target date funds do not guaranteethat an investor will have sufficient retirement income at thetarget date, and investors can lose money. Target date fundsare generally associated with the same risks as the underlyinginvestments. Alternative FundsAlternative funds are funds that invest in alternative investments such as non-traditional asset classes (e.g., globalreal estate or currencies) and illiquid assets (e.g., privatedebt) and/or employ non-traditional trading strategies (e.g.,selling short). They are sometimes called “hedge funds forthe masses” because they are a way to get hedge fund-likeexposure in a registered fund. These funds generally seekto produce positive returns that are not closely correlated totraditional investments or benchmarks. Many investors may16 MUTUAL FUNDS AND ETFS

see alternative funds as a way to diversify their portfolios whileretaining liquidity. The risks associated with these investmentsvary depending on the assets and trading strategies employed.These funds can employ complicated investment strategies,and their fees and expenses are commonly higher than traditionally managed funds. In addition, these types of fundsgenerally have limited performance histories, and it is unclearhow they will perform in periods of market stress. Smart-Beta FundsThese funds are index funds (discussed below) with a twist.They compose their index by ranking stock using preset factorsrelating to risk and return, such as growth or value, and notsimply by market capitalization as most traditional index fundsdo. They aim to achieve better returns than traditional indexfunds, but at a lower cost than active funds. These fundscan be more complicated and have higher expenses thantraditional index funds, and the factors are sometimes basedon hypothetical, backward-looking returns. In addition,these types of funds generally have limited performancehistories, and it is unclear how they will perform in periodsof market stress. Esoteric ETFsEsoteric or exotic funds are ETFs that focus on niche investments or narrowly focused strategies. They may be complicated investments and may have higher expenses. In addition,these ETFs are often thinly traded, which means they can beharder to sell and may have larger bid-ask spreads (discussedon page 28–29) than ETFs that aren’t as thinly traded.U.S. SECURITIES AND EXCHANGE COMMISSION 17

A Word about Hedge FundsHedge fund is a general, non-legal term used todescribe private, unregistered investment poolsthat traditionally have been limited to sophisticated,wealthy investors. Hedge funds are not mutual fundsand, as such, are not subject to the numerous regulations that apply to mutual funds for the protection ofinvestors—including regulations requiring that mutualfund shares be redeemable at any time, regulationsprotecting against conflicts of interest, regulations toassure fairness in the pricing of fund shares, disclosureregulations, regulations limiting the use of leverage,and more. Money Market FundsMoney market funds are a type of mutual fund that hasrelatively low risks compared to other mutual funds and ETFs(and most other investments). By law, they can invest in onlycertain high-quality, short-term investments issued by the U.S.Government, U.S. corporations, and state and local governments. Government and retail money market funds try to keeptheir NAV at a stable 1.00 per share, but the NAV may fallbelow 1.00 if the fund’s investments perform poorly. Investorlosses have been rare, but they are possible. A Government Money Market Fund is a money marketfund that invests 99.5% or more of its total assets incash, government securities and/or repurchase agreements that are collateralized solely by governmentsecurities or cash.18 MUTUAL FUNDS AND ETFS

A Retail Money Market Fund is a money market fundthat has policies and procedures reasonably designedto limit all beneficial owners of the money marketfund to natural persons.Other money market funds, however, have a floating NAV likeother mutual funds that fluctuates along with changes in themarket-based value of their portfolio securities.All money market funds pay dividends that generallyreflect short-term interest rates, and historically the returnsfor money market funds have been lower than for either bondor stock funds. A risk commonly associated with money market funds is Inflation Risk, which is the risk that inflation willoutpace and erode investment returns over time.Different Types of Investment Strategies Index-based FundsIndex-based mutual funds and ETFs seek to track an underlying securities index and achieve returns that closely correspond to the returns of that index with low fees. They generallyinvest primarily in the component securities of the index andtypically have lower management fees than actively managedfunds. Some index funds may also use derivatives (such asoptions or futures) to help achieve their investment objective. Index-based funds with seemingly similar benchmarkscan actually be quite different and can deliver very differentreturns. For example, some index funds invest in all of thecompanies included in an index; other index funds invest in arepresentative sample of the companies included in an index.Because an index fund tracks the securities on a particularindex, it may have less flexibility than a non-index fund to reactto price declines in the securities contained in the index. AlsoU.S. SECURITIES AND EXCHANGE COMMISSION 19

because market indexes themselves have no expenses, even apassively managed index fund can underperform its index dueto fees and taxes. Actively Managed FundsThe adviser of an actively managed mutual fund or ETF maybuy or sell components in the portfolio on a daily basis withoutregard to conformity with an index, provided that the tradesare consistent with the overall investment objective of thefund. Unlike similar mutual funds, actively managed ETFs arerequired to publish their holdings daily. Because there is nounderlying index that can serve as a point of reference forinvestors and other market participants as to the ETF’s holdings, disclosing the specific fund holdings ensures that marketparticipants have sufficient information to engage in activity,called arbitrage, that works to keep the market price of ETFshares closely linked to the ETF’s underlying value. Leveraged, inverse and inverse leveraged ETFsLeveraged, inverse, and inverse leveraged ETFs seek to achievea daily return that is a multiple or inverse multiple of the dailyreturn of a securities index. These ETFs are a subset of indexbased ETFs because they track a securities index. They seekto achieve their stated objectives on a daily basis. Investorsshould be aware that the performance of these ETFs over aperiod longer than one day will probably differ significantlyfrom their stated daily performance objectives. These ETFsoften employ techniques such as engaging in short sales andusing swaps, futures contracts and other derivatives that canexpose the ETF, and by extension the ETF investors, to a hostof risks. As such, these are specialized products that typically arenot suitable for buy-and-hold investors.20 MUTUAL FUNDS AND ETFS

A Word on Active and Passive InvestingAn active investment strategy relies on the skill of aninvestment manager to construct and manage the portfolio of a fund in an effort to provide exposure to certaintypes of investments or outperform an investmentbenchmark or index. An actively managed fund hasthe potential to outperform the market, but its performance is dependent on the skill of the manager. Also,actively managed funds historically have had highermanagement fees, which can significantly lower investment returns. The shareholder is paying for more activemanagement of portfolio assets, which often leads tohigher turnover costs in the portfolio and potentiallynegative federal income tax consequences.Passive investing is an investment strategy that isdesigned to achieve approximately the same return asa particular market index, before fees. The strategy canbe implemented by replication—purchasing 100% ofthe securities in the same proportion as in the index orbenchmark—or by a representative sampling of stocksin the index. Passive investing also typically comes withlower management fees. As discussed above, passivelymanaged mutual funds are typically called index funds.Most ETFs are also passively managed, althoughthere are some actively managed ETFs on the market.Passively managed ETFs typically have lower costs forthe same reasons index mutual funds do. In addition,index-based ETFs’ costs and taxes can be even lowerthan index mutual funds’ because of the manner inwhich ETFs operate.U.S. SECURITIES AND EXCHANGE COMMISSION 21

How Mutual Funds and ETFs CanProvide Returns to InvestorsInvestors can make money from their investments inthree ways:1. Dividend Payments—Depending on the underlying securities, a mutual fund or ETF may earn income in the form ofdividends on the securities in its portfolio. The mutual fund orETF then pays its shareholders nearly all of the income (minusdisclosed expenses) it has earned.2. Capital Gains Distributions—The price of the securities amutual fund or ETF owns may increase. When a mutual fundor ETF sells a security that has increased in price, the mutualfund or ETF has a capital gain. At the end of the year, mostmutual funds and ETFs distribute these capital gains (minusany capital losses) to shareholders. ETFs seek to minimizethese capital gains by making in-kind exchanges to redeemingAuthorized Participants instead of selling portfolio securities.3. Increased NAV/Increased Market Price—If the marketvalue of a mutual fund’s portfolio increases, after deduction ofexpenses and liabilities, then the net asset value of the mutualfund and its shares increases. If the market value of an ETF’sportfolio increases, after deduction of expenses and liabilities,then the net asset value of the ETF increases, and the marketprice of its shares may also increase.With respect to dividend payments and capital gainsdistributions, mutual funds usually will give investors a choice:the mutual fund can send the investor a check or otherform of payment, or the investor can have the dividends or22

Mutual Funds and Exchange- Traded Funds (ETFs) American investors often turn to mutual funds and exchange-traded funds (ETFs) to save for retirement and other financial goals. Although mutual funds and ETFs have similarities, they . Toll-free: (800) 732-0330 Website: www.Investor.gov. 2 MUTUAL FUNDS AND ETFS Table of Contents