Introduction
As you probably know, mutual funds have become extremely popular over the
last 20 years. What was once just another obscure financial instrument is now a
part of our daily lives. More than 80 million people, or one half of the households
in America, invest in mutual funds. That means that, in the United States alone,
trillions of dollars are invested in mutual funds.
In fact, to many people, investing means buying mutual funds. After all, it's
common knowledge that investing in mutual funds is (or at least should be) better
than simply letting your cash waste away in a savings account, but, for most
people, that's where the understanding of funds ends. It doesn't help that mutual
fund salespeople speak a strange language that is interspersed with jargon that
many investors don't understand.
Originally, mutual funds were heralded as a way for the little guy to get a piece of
the market. Instead of spending all your free time buried in the financial pages of
the Wall Street Journal, all you had to do was buy a mutual fund and you'd be set
on your way to financial freedom. As you might have guessed, it's not that easy.
As you probably know, mutual funds have become extremely popular over the
last 20 years. What was once just another obscure financial instrument is now a
part of our daily lives. More than 80 million people, or one half of the households
in America, invest in mutual funds. That means that, in the United States alone,
trillions of dollars are invested in mutual funds.
In fact, to many people, investing means buying mutual funds. After all, it's
common knowledge that investing in mutual funds is (or at least should be) better
than simply letting your cash waste away in a savings account, but, for most
people, that's where the understanding of funds ends. It doesn't help that mutual
fund salespeople speak a strange language that is interspersed with jargon that
many investors don't understand.
Originally, mutual funds were heralded as a way for the little guy to get a piece of
the market. Instead of spending all your free time buried in the financial pages of
the Wall Street Journal, all you had to do was buy a mutual fund and you'd be set
on your way to financial freedom. As you might have guessed, it's not that easy.
Mutual funds are an excellent idea in theory, but, in reality, they haven't always
delivered. Not all mutual funds are created equal, and investing in mutuals isn't
as easy as throwing your money at the first salesperson who solicits your
business.
In this tutorial, we'll explain the basics of mutual funds and hopefully clear up
some of the myths around them. You can then decide whether or not they are
right for you.
What Are They?
The Definition
A mutual fund is nothing more than a collection of stocks and/or bonds. You can
think of a mutual fund as a company that brings together a group of people and
invests their money in stocks, bonds, and other securities. Each investor owns
shares, which represent a portion of the holdings of the fund.
You can make money from a mutual fund in three ways:
1) Income is earned from dividends on stocks and interest on bonds. A fund pays
out nearly all of the income it receives over the year to fund owners in the form of
a distribution.
2) If the fund sells securities that have increased in price, the fund has a capital
gain. Most funds also pass on these gains to investors in a distribution.
delivered. Not all mutual funds are created equal, and investing in mutuals isn't
as easy as throwing your money at the first salesperson who solicits your
business.
In this tutorial, we'll explain the basics of mutual funds and hopefully clear up
some of the myths around them. You can then decide whether or not they are
right for you.
What Are They?
The Definition
A mutual fund is nothing more than a collection of stocks and/or bonds. You can
think of a mutual fund as a company that brings together a group of people and
invests their money in stocks, bonds, and other securities. Each investor owns
shares, which represent a portion of the holdings of the fund.
You can make money from a mutual fund in three ways:
1) Income is earned from dividends on stocks and interest on bonds. A fund pays
out nearly all of the income it receives over the year to fund owners in the form of
a distribution.
2) If the fund sells securities that have increased in price, the fund has a capital
gain. Most funds also pass on these gains to investors in a distribution.
3) If fund holdings increase in price but are not sold by the fund manager, the
fund's shares increase in price. You can then sell your mutual fund shares for a
profit.
Funds will also usually give you a choice either to receive a check for
distributions or to reinvest the earnings and get more shares.
Advantages of Mutual Funds:
fund's shares increase in price. You can then sell your mutual fund shares for a
profit.
Funds will also usually give you a choice either to receive a check for
distributions or to reinvest the earnings and get more shares.
Advantages of Mutual Funds:
• Professional Management - The primary advantage of funds (at least
theoretically) is the professional management of your money. Investors purchase
funds because they do not have the time or the expertise to manage their own
portfolios. A mutual fund is a relatively inexpensive way for a small investor to get
a full-time manager to make and monitor investments.
• Diversification - By owning shares in a mutual fund instead of owning individual
stocks or bonds, your risk is spread out. The idea behind diversification is to
invest in a large number of assets so that a loss in any particular investment is
minimized by gains in others. In other words, the more stocks and bonds you
own, the less any one of them can hurt you (think about Enron). Large mutual
funds typically own hundreds of different stocks in many different industries. It
wouldn't be possible for an investor to build this kind of a portfolio with a small
amount of money.
• Economies of Scale - Because a mutual fund buys and sells large amounts of
securities at a time, its transaction costs are lower than what an individual would
pay for securities transactions.
• Liquidity - Just like an individual stock, a mutual fund allows you to request that
your shares be converted into cash at any time.
• Simplicity - Buying a mutual fund is easy! Pretty well any bank has its own line
of mutual funds, and the minimum investment is small. Most companies also
have automatic purchase plans whereby as little as $100 can be invested on a monthly basis.
Disadvantages of Mutual Funds:
• Professional Management - Did you notice how we qualified the advantage of
professional management with the word "theoretically"? Many investors debate
whether or not the so-called professionals are any better than you or I at picking
stocks. Management is by no means infallible, and, even if the fund loses money,
the manager still takes his/her cut. We'll talk about this in detail in a later section.
• Costs - Mutual funds don't exist solely to make your life easier - all funds are in
it for a profit. The mutual fund industry is masterful at burying costs under layers
of jargon. These costs are so complicated that in this tutorial we have devoted an
entire section to the subject.
• Dilution - It's possible to have too much diversification. Because funds have
small holdings in so many different companies, high returns from a few
investments often don't make much difference on the overall return.
Dilution is also the result of a successful fund getting too big. When money pours into funds that have had strong success, the manager often has trouble finding a good
investment for all the new money.
• Taxes - When making decisions about your money, fund managers don't
consider your personal tax situation. For example, when a fund manager sells a
security, a capital-gains tax is triggered, which affects how profitable the
individual is from the sale. It might have been more advantageous for the
individual to defer the capital gains liability.
Different Types Of Funds
No matter what type of investor you are, there is bound to be a mutual fund that
fits your style. According to the last count there are more than 10,000 mutual
funds in North America! That means there are more mutual funds than stocks.
consider your personal tax situation. For example, when a fund manager sells a
security, a capital-gains tax is triggered, which affects how profitable the
individual is from the sale. It might have been more advantageous for the
individual to defer the capital gains liability.
Different Types Of Funds
No matter what type of investor you are, there is bound to be a mutual fund that
fits your style. According to the last count there are more than 10,000 mutual
funds in North America! That means there are more mutual funds than stocks.
It's important to understand that each mutual fund has different risks and
rewards. In general, the higher the potential return, the higher the risk of loss.
Although some funds are less risky than others, all funds have some level of risk
- it's never possible to diversify away all risk. This is a fact for all investments.
Each fund has a predetermined investment objective that tailors the fund's
assets, regions of investments and investment strategies. At the fundamental
level, there are three varieties of mutual funds:
1) Equity funds (stocks)
2) Fixed-income funds (bonds)
3) Money market funds
All mutual funds are variations of these three asset classes. For example, while
equity funds that invest in fast-growing companies are known as growth funds,
equity funds that invest only in companies of the same sector or region are
known as specialty funds.
Let's go over the many different flavors of funds. We'll start with the safest and
then work through to the more risky.
Money Market Funds
The money market consists of short-term debt instruments, mostly Treasury bills.
This is a safe place to park your money. You won't get great returns, but you
won't have to worry about losing your
principal. A typical return is twice the
amount you would earn in a regular checking/savings account and a little less
than the average
certificate of deposit (CD).
Bond/Income Funds
Income funds are named appropriately: their purpose is to provide current
income on a steady basis. When referring to mutual funds, the terms "fixed-
income," "bond," and "income" are synonymous. These terms denote funds that
invest primarily in government and corporate debt. While fund holdings may
appreciate in value, the primary objective of these funds is to provide a steady
cashflow to investors. As such, the audience for these funds consists of
conservative investors and retirees.
Bond funds are likely to pay higher returns than certificates of deposit and money
market investments, but bond funds aren't without risk. Because there are many
different types of bonds, bond funds can vary dramatically depending on where
they invest. For example, a fund specializing in high-yield
junk bonds is much
more risky than a fund that invests in government securities. Furthermore, nearly
all bond funds are subject to interest rate risk, which means that if rates go up the
value of the fund goes down.
Balanced Funds
rewards. In general, the higher the potential return, the higher the risk of loss.
Although some funds are less risky than others, all funds have some level of risk
- it's never possible to diversify away all risk. This is a fact for all investments.
Each fund has a predetermined investment objective that tailors the fund's
assets, regions of investments and investment strategies. At the fundamental
level, there are three varieties of mutual funds:
1) Equity funds (stocks)
2) Fixed-income funds (bonds)
3) Money market funds
All mutual funds are variations of these three asset classes. For example, while
equity funds that invest in fast-growing companies are known as growth funds,
equity funds that invest only in companies of the same sector or region are
known as specialty funds.
Let's go over the many different flavors of funds. We'll start with the safest and
then work through to the more risky.
Money Market Funds
The money market consists of short-term debt instruments, mostly Treasury bills.
This is a safe place to park your money. You won't get great returns, but you
won't have to worry about losing your
principal. A typical return is twice the
amount you would earn in a regular checking/savings account and a little less
than the average
certificate of deposit (CD).
Bond/Income Funds
Income funds are named appropriately: their purpose is to provide current
income on a steady basis. When referring to mutual funds, the terms "fixed-
income," "bond," and "income" are synonymous. These terms denote funds that
invest primarily in government and corporate debt. While fund holdings may
appreciate in value, the primary objective of these funds is to provide a steady
cashflow to investors. As such, the audience for these funds consists of
conservative investors and retirees.
Bond funds are likely to pay higher returns than certificates of deposit and money
market investments, but bond funds aren't without risk. Because there are many
different types of bonds, bond funds can vary dramatically depending on where
they invest. For example, a fund specializing in high-yield
junk bonds is much
more risky than a fund that invests in government securities. Furthermore, nearly
all bond funds are subject to interest rate risk, which means that if rates go up the
value of the fund goes down.
Balanced Funds
The objective of these funds is to provide a balanced mixture of safety, income
and
capital appreciation. The strategy of balanced funds is to invest in a
combination of fixed income and equities. A typical balanced fund might have a
weighting of 60% equity and 40% fixed income. The weighting might also be
restricted to a specified maximum or minimum for each asset class.
A similar type of fund is known as an asset allocation fund. Objectives are similar
to those of a balanced fund, but these kinds of funds typically do not have to hold
a specified percentage of any asset class. The portfolio manager is therefore
given freedom to switch the ratio of asset classes as the economy moves
through the business cycle.
Equity Funds
Funds that invest in stocks represent the largest category of mutual funds.
Generally, the investment objective of this class of funds is long-term capital
growth with some income. There are, however, many different types of equity
funds because there are many different types of equities. A great way to
understand the universe of equity funds is to use a
style box, an example of which is below.
The idea is to classify funds based on both the size of the companies invested in
and the investment style of the manager. The term value refers to a style of
investing that looks for high quality companies that are out of favor with the
market. These companies are characterized by low P/E and price-to-book ratios and high dividend yields. The opposite of value is growth, which refers to
companies that have had (and are expected to continue to have) strong growth in
earnings, sales and cash flow. A compromise between value and growth is
blend, which simply refers to companies that are neither value nor growth stocks
and are classified as being somewhere in the middle.
For example, a mutual fund that invests in
large-cap companies that are in strong
financial shape but have recently seen their share prices fall would be placed in
the upper left quadrant of the style box (large and value). The opposite of this
would be a fund that invests in startup technology companies with excellent
growth prospects. Such a mutual fund would reside in the bottom right quadrant
(small and growth).
Global/International Funds
international fund (or foreign fund) invests only outside your home country.
An Global funds invest anywhere around the world, including your home country.
It's tough to classify these funds as either riskier or safer than domestic
investments. They do tend to be more volatile and have unique
country and/or political risks. But, on the flip side, they can, as part of a well-balanced portfolio, actually reduce risk by increasing diversification. Although the world's economies
are becoming more inter-related, it is likely that another economy somewhere is
outperforming the economy of your home country.
Specialty Funds
This classification of mutual funds is more of an all-encompassing category that
consists of funds that have proved to be popular but don't necessarily belong to
the categories we've described so far. This type of mutual fund forgoes broad
diversification to concentrate on a certain segment of the economy.
Sector funds are targeted at specific sectors of the economy such as financial,
technology, health, etc. Sector funds are extremely
volatile. There is a greater possibility of big gains, but you have to accept that your sector may tank.
Regional funds make it easier to focus on a specific area of the world. This may
mean focusing on a region (say Latin America) or an individual country (for
example, only Brazil). An advantage of these funds is that they make it easier to
buy stock in foreign countries, which is otherwise difficult and expensive.
Just like for sector funds, you have to accept the high risk of loss, which occurs if the
region goes into a bad
recession.
Socially-responsible funds (or ethical funds) invest only in companies that meet
the criteria of certain guidelines or beliefs. Most socially responsible funds don't
invest in industries such as tobacco, alcoholic beverages, weapons or nuclear
power. The idea is to get a competitive performance while still maintaining a
healthy conscience.
Index Funds
index funds. This type of mutual The last but certainly not the least important are
fund replicates the performance of a broad market index such as the
S&P 500 or Dow Jones Industrial Average (DJIA). An investor in an index fund figures that
most managers can't beat the market. An index fund merely replicates the market
return and benefits investors in the form of low fees.
Costs
Costs are the biggest problem with mutual funds. These costs eat into your
return, and they are the main reason why the majority of funds end up with sub-
par performance.
What's even more disturbing is the way the fund industry hides costs through a
layer of financial complexity and jargon. Some critics of the industry say that
mutual fund companies get away with the fees they charge only because the
average investor does not understand what he/she is paying for.
Fees can be broken down into two categories:
1. Ongoing yearly fees to keep you invested in the fund.
2. Transaction fees paid when you buy or sell shares in a fund (
loads).
The Expense Ratio
The ongoing expenses of a mutual fund is represented by the expense ratio. This
is sometimes also referred to as the management expense ratio (MER). The
expense ratio is composed of the following:
• The cost of hiring the fund manager(s) - Also known as the management fee,
this cost is between 0.5% and 1% of assets on average. While it sounds small,
this fee ensures that mutual fund managers remain in the country's top echelon
of earners. Think about it for a second: 1% of 250 million (a small mutual fund) is
$2.5 million - fund managers are definitely not going hungry! It's true that paying
managers is a necessary fee, but don't think that a high fee assures superior
performance.
• Administrative costs - These include necessities such as postage, record
keeping, customer service, cappuccino machines, etc. Some funds are excellent
at minimizing these costs while others (the ones with the cappuccino machines in
the office) are not.
• The last part of the ongoing fee (in the United States anyway) is known as the
12B-1 fee. This expense goes toward paying brokerage commissions and toward
advertising and promoting the fund. That's right, if you invest in a fund with a
12B-1 fee, you are paying for the fund to run commercials and sell itself!
On the whole, expense ratios range from as low as 0.2% (usually for index funds)
to as high as 2%. The average equity mutual fund charges around 1.3%-1.5%.
You'll generally pay more for specialty or international funds, which require more
expertise from managers.
Are high fees worth it? You get what you pay for, right?
Costs are the biggest problem with mutual funds. These costs eat into your
return, and they are the main reason why the majority of funds end up with sub-
par performance.
What's even more disturbing is the way the fund industry hides costs through a
layer of financial complexity and jargon. Some critics of the industry say that
mutual fund companies get away with the fees they charge only because the
average investor does not understand what he/she is paying for.
Fees can be broken down into two categories:
1. Ongoing yearly fees to keep you invested in the fund.
2. Transaction fees paid when you buy or sell shares in a fund (
loads).
The Expense Ratio
The ongoing expenses of a mutual fund is represented by the expense ratio. This
is sometimes also referred to as the management expense ratio (MER). The
expense ratio is composed of the following:
• The cost of hiring the fund manager(s) - Also known as the management fee,
this cost is between 0.5% and 1% of assets on average. While it sounds small,
this fee ensures that mutual fund managers remain in the country's top echelon
of earners. Think about it for a second: 1% of 250 million (a small mutual fund) is
$2.5 million - fund managers are definitely not going hungry! It's true that paying
managers is a necessary fee, but don't think that a high fee assures superior
performance.
• Administrative costs - These include necessities such as postage, record
keeping, customer service, cappuccino machines, etc. Some funds are excellent
at minimizing these costs while others (the ones with the cappuccino machines in
the office) are not.
• The last part of the ongoing fee (in the United States anyway) is known as the
12B-1 fee. This expense goes toward paying brokerage commissions and toward
advertising and promoting the fund. That's right, if you invest in a fund with a
12B-1 fee, you are paying for the fund to run commercials and sell itself!
On the whole, expense ratios range from as low as 0.2% (usually for index funds)
to as high as 2%. The average equity mutual fund charges around 1.3%-1.5%.
You'll generally pay more for specialty or international funds, which require more
expertise from managers.
Are high fees worth it? You get what you pay for, right?
Wrong.
Just about every study ever done has shown no correlation between high
expense ratios and high returns. This is a fact. If you want more evidence,
consider this quote from the Securities and Exchange Commission's website:
"Higher expense funds do not, on average, perform better than lower expense
funds."
Loads, A.K.A. "Fee for Salesperson"
Loads are just fees that a fund uses to compensate brokers or other salespeople
for selling you the mutual fund. All you really need to know about loads is this:
don't buy funds with loads.
In case you are still curious, here is how certain loads work:
• Front-end loads - These are the most simple type of load: you pay the fee when
you purchase the fund. If you invest $1,000 in a mutual fund with a 5%
front-end
load, $50 will pay for the sales charge, and $950 will be invested in the fund.
• Back-end loads (also known as deferred sales charges) - These are a bit more
complicated. In such a fund you pay the a
back-end load if you sell a fund within
a certain time frame. A typical example is a 6% back-end load that decreases to
0% in the seventh year. The load is 6% if you sell in the first year, 5% in the
second year, etc. If you don't sell the mutual fund until the seventh year, you
don't have to pay the back-end load at all.
A no-load fund sells its shares without a commission or sales charge. Some in
the mutual fund industry will tell you that the load is the fee that pays for the
service of a broker choosing the correct fund for you. According to this argument,
your returns
will be higher because the professional advice put you into a better
fund. There is little to no evidence that shows a correlation between load funds
and superior performance. In fact, when you take the fees into account, the
average load fund performs worse than a no-load fund.
Picking A Mutual Fund
Buying and Selling
You can buy some mutual funds (no-load) by contacting the fund companies
directly. Other funds are sold through brokers, banks, financial planners, or
insurance agents. If you buy through a third party there is a good chance they'll
hit you with a sales charge (load).
fee programs that offer funds of many companies. Sometimes referred to as a
"fund supermarket," this service lets you consolidate your holdings and record
keeping, and it still allows you to buy funds without sales charges from many
different companies. Popular examples are Schwab's OneSource, Vanguard's
FundAccess, and Fidelity's FundsNetwork. Many large brokerages have similar
offerings.
Selling a fund is as easy as purchasing one. All mutual funds will redeem (buy
back) your shares on any business day. In the United States, companies must
send you the payment within seven days.
The Value of Your Fund
Net asset value (NAV), which is a fund's assets minus liabilities, is the value of a
mutual fund. NAV per share is the value of one share in the mutual fund, and it is
the number that is quoted in newspapers. You can basically just think of NAV per
share as the price of a mutual fund. It fluctuates everyday as fund holdings and
shares outstanding change.
When you buy shares, you pay the current NAV per share plus any sales front-
end load. When you sell your shares, the fund will pay you NAV less any back-
end load.
Finding Funds
The Mutual Fund Education Alliance™ is the not-for-profit trade association of
the no-load mutual fund industry. They have a tool for searching for no-load
funds at
http://www.mfea.com/FundSelector
Morningstar is an investment research firm that is particularly well known for its
fund information:
http://www.morningstar.com
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