When Are Mutual Funds Right for Your Client?

Advising people about how to most effectively invest theirhard-earned money is an important responsibility. Mutual funds can be a great addition to your client's portfolio, but with so many different investment options, it may be difficult to assess which products and strategies are best for any one individual. In some cases, mutual funds may not be the right fit, so it is important to know when other options may be more suitable.

By discussing your client's investment goals and gaining a clear understanding of what she wants to achieve, you can determine if mutualfunds are right for her. Make sure to cover the following topics in detail when discussing mutual funds with your client to ensure you recommend products that meet her needs.

Risk Tolerance

The first step in determining the suitability of any investment product is to assess your client's risk tolerance. This is the ability and desire your client has to take on risk in return for the possibility of higher returns. Though mutual funds are often considered one of the safer investments on the market, certain types of mutual funds are not suitable for those whose main goal is to avoid losses at all costs.

Aggressive stock funds, for example, are not suitable for clients with very low risk tolerances. Similarly, some high-yield bond funds may also be too risky if they invest in low-rated or junk bonds to generate higher returns.

Investment Goals

Your client's specific investment goals are of one of the most important considerations when assessing the suitability of mutual funds. Depending on what she wants to achieve through her investment, some mutual funds are more appropriate than others.

For an investor whose main goal is to preserve capital, meaning she is willing to accept lower gains in return for the security of knowing her initial investment is safe, high-risk funds are not a good fit. This type of investor has a very low risk tolerance and should avoid most stock funds and many more aggressive bond funds. Instead, look to bond funds that invest in only highly rated government or corporate bonds or money market funds.

If your investor's chief aim is to generate big returns, she is likely willing to take on more risk. In this case, high-yield stock and bond funds can be excellent choices. Though the potential for loss is greater, these funds have professional managers who are more likely than the average retail investor to generate substantial profits by buying and selling cutting-edge stocks and risky debt securities. Investors looking to aggressively grow their wealth are not well suited to money market funds and other highly stable products because the rate of return is often not much greater than inflation.

Desired Income

Mutual funds generate two kinds of income: capital gains and dividends. Though any net profits generated by a fund must be passed on to shareholders at least once a year, the frequency with which different funds make distributions varies widely.

If your client is looking to grow her wealth over the long-term and is not concerned with generating immediate income, funds that focus on growth stocks and use a buy-and-hold strategy are best because they generally incur lower expenses and have a lower tax impact than other types of funds.

If instead she wants to use her investment to create regular income, dividend-bearing funds are an excellent choice. These funds invest in a variety of dividend-bearing stocks and interest-bearing bonds and pay dividends at least annually but often quarterly or semi-annually. Though stock-heavy funds are riskier, these types of balanced funds come in a range of stock-to-bond ratios, so finding a fund that meets your client's specific risk tolerance is easy.

Tax Strategy

When assessing the suitability of mutual funds for your client, it is important to discuss her tax needs. Depending on her current financial situation, income from mutual funds can have a serious impact on her annual tax liability. The more income she earns in a given year, the higher her ordinary income and capital gains tax brackets. Finding a mutual fund with tax implications your client is comfortable with is key.

If your client wants to minimize her tax liability as much as possible, dividend-bearing funds are a poor choice. Though funds that employ a long-term investment strategy may pay qualified dividends, which are taxed at the lower capital gains rate, any dividend payments increase your client's taxable income for the year. The best choice is to direct her to funds that focus more on long-term capital gains and avoid dividend stocks or interest-bearing corporate bonds. Funds that invest in tax-free government or municipal bonds generate interest that is not subject to federal income tax, so these may be a good choice. However, not all tax-free bonds are completely tax-free, so make sure to verify whether those earnings are subject to state or local taxes.

Many funds offer products managed with the specific goal of tax-efficiency. These funds employ a buy-and-hold strategy and eschew dividend- or interest-paying securities. They come in a variety of forms, so consider your client's risk tolerance and investment goals when recommending a tax-efficient fund.