Why Do Mutual Funds Always Drop in Value in Late December or Early January?

As a mutual fund investor, you're probably socking your hard-earned funds away in preparation for retirement or a big-ticket purchase. Most mutual fund investors are fairly conservative folks with relatively long investment time frames. Some put their money in baskets of funds that accrue interest and dividends for years on end. Although others are more active, very few mutual fund investors buy and sell their funds on a regular basis.

There are several distinct reasons to buy and hold mutual funds. First, many mutual funds carry transaction charges known as "load fees." These fees can amount to as much as 5 percent of the initial investment: A 5 percent load fee on a $10,000 mutual fund would equal $500. Unfortunately, these fees are built into the fund's purchase price and can't be negotiated.

Secondly, many mutual funds carry high management fees of 1.5 percent or more. Assessed on an annual basis, these fees are subtracted from the earnings of the funds that charge them. Known as "capital gains," these earnings can fluctuate wildly on a year-to-year basis.

During years in which the market goes up, the average fund's value may increase by 20 to 30 percent. In relation to such a healthy gain, a management fee of 1.5 percent might seem like a small price to pay. On the other hand, management fees can seriously cut into a fund holder's profits during "down" years. If a fund's value increases by just 2 percent during a given year, a management fee of 1.5 percent may wipe out much of the profit that its holders feel entitled to enjoy. However, these fees are easier to stomach over long periods of time. This is because most mutual funds tend to increase in value as time goes on. As a result, the impact of management fees becomes less noticeable for long-term investors.

Finally, most mutual fund issuers charge "cash-out" fees that are designed to keep fund holders from ditching their investments. As a result, relatively few mutual fund holders choose to sell their holdings on a whim.

Ironically, all three of these factors contribute to the periodic "consolidation" of many mutual funds. If you notice that your funds lose value at roughly the same time each year, you should check your fund's cash balance. Since few fund holders sell their funds during any given year, most funds increase in value until a fixed calendar date. At that time, they make "distributions" of capital gains and dividends. These distributions reduce the value of the issuing funds and accrue in the cash accounts of their holders.

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