Introduction to Mutual Funds
More than half of the households in America today invests in mutual funds. They have become such an important part of our lives that when many people way that they are “investing their money, ” they mean that they have purchased mutual funds. But, unfortunately, that is where many people’s understanding of mutual funds ends.
Mutual funds are simply a collection of stocks and bonds. Because the stock market is such a complex system, mutual funds were created as a way for the little guy to invest with the big dogs.
Each investor in the fund owns shares that are valued at the proportion to which they invested into the fund. For example, if a fund is valued at $10 million and there are 10 million shares, each share would be worth $1.
Since funds are made up of stock and bonds, investors can earn money from investing in the fund in one of two ways. Funds which own stocks that earn dividends pay out a dividend distribution to the fund owners. Or, Funds that realize a capital gain increase in value, making each share of the fund more valuable. These shares can then be sold off for as a capital gain for the shareholder.
There are many advantages to using a mutual fund including:
- Having a professional manager to choose the stocks and bonds within the fund.
- Larger funds own hundreds of different stocks, diversifying the portfolio lowering the impact of poorly performing stocks by averaging out their losses.
- By purchasing large amounts of securities at a single time, transaction costs are significantly lower per trade.
- Similar to stocks, mutual funds allow you to convert your shares to cash at any time.
- Buying mutual funds is as easy as calling your bank or setting up monthly purchase plans of as little at $50 per month.
But there are also some things to keep in mind when investing in mutual funds.
- Mutual fund managers are paid for the amount of money that they have under management, usually about 1% of the total value of the fund, not for the performance of their funds. So, if you invest in a $200 million fund and it doesn’t have any earnings, you lose 1% of your money and the fund manager who helped you lose money this year gets $2 million.
- If a fund does very well one year, people will tend to invest more heavily into it. When this happens, the fund manager may not be able to find good investments for the new money, lowering the performance in the following years.
- Anytime a fund manager sells a security within the fund, a capital-gains tax is triggered. When you are choosing an investment, investors either need to be prepared to deal with the extra paperwork at tax season, invest in funds tax-sensitive funds or holding mutual funds in a tax-deferred account such as a 401(k) or IRA.
It is important to realize that, like in our previous example, that there is always an element of risk involved in any mutual fund. This means that while you can realize large gains, you can also lose some (or all — although this virtually impossible) of the money that you initially invest. As a general rule of thumb, the higher the potential return, the higher he risk of loss.
There are more than 10,000 mutual funds in America, more than there are stocks in the stock market! Every fund is a blend of the 3 basic types of funds.
- Equity funds (stocks) — This is the largest class of mutual fund and can be further divided up by the Investment Strategy (value, blend, growth) and the size (small, mid, large) of the companies that the fund will invest into.
- Fixed-income funds (bonds) — These invest in government and corporate debt and try to provide a low-risk, steady income for investors
- Money market funds — short-term debt instruments, usually treasury bills. These ensure you never lose your investment, but offer the least opportunity for high growth.
From these basic types of funds, come a whole range of derivative funds.
- Balanced Funds mix the safety of income funds with the capital appreciation of equity funds into a single fund.
- Global Funds invest in companies from other countries anywhere in the world.
- Sector funds target specific sectors of the economy such as financial, technology, health, etc.
Regional funds focus on a specific geographic area of the world such as Brazil or Asia.
- Socially responsible funds (or ethical funds) only invest in companies that meet the criteria of certain and allow you to avoid investing in industries such as tobacco or focus on companies you believe should be supported.
- Index Funds replicate the performance of a market index such as the S&P 500 or Dow Jones Industrial Average (DJIA).
Mutual funds have been criticized for their high fees, and for good reason, a quote from the Securities and Exchange Commission’s website states that “Higher expense funds do not, on average, perform better than lower expense funds.”
The last type of fund, index funds, are becoming very popular with investors as they generally have lower management expense ratios (MER) reaching as low as 0.25%.
The last expense that you need to be very careful to watch is the “load” — otherwise known as “the commission for the salesperson.” Whether it is a front-end or a back-end load it will usually be about 5% of the value of the money you invest. There is no reason to pay this as there is “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.” Basically, if someone asks you to pay a load, walk away. You can get the exact same fund without paying any fees at all to a salesperson, who provides no real value to the investment.
Mutual funds can be a great tool to help you take advantage of the potential growth available through equity markets. By investing in a no-load, index fund with a low MER the average investor can realize higher long-term returns on their investments while keeping their risk down through a diversified investment strategy.
Featured image credit: FOTER