All About Mutual Funds: 5,500 Words Should About Do It
Table of Contents
A Mutual Fund is, in essence, a pool of money from several investors that is managed by a professional money manager or “Fund Manager” for a fee. Granted, that’s a simplistic description for a complex type of security but from an investor’s perspective, it’s a pretty accurate definition.
They’re a relatively new creation. While King William I created the idea of a pooled investment fund in 1822 for his rich buddies, there really was nothing that closely resembled our modern day mutual funds until after the 1940 Investment Company Act. This Act popularized funds because it required a lot more disclosure and helped to minimize conflicts of interest that were common prior to the 1929 market crash. Investors were finally able to tell what a fund was trying to do and how they were doing it.
By the 1980s, fund managers were emerging from obscurity into the financial spotlight and becoming household names as investors poured billions into the largest and most popular funds. One name you might recognize is Peter Lynch who took over the $18 million dollar Magellan Fund in 1977 that grew to more than $14 billion in assets by the time he retired only thirteen years later in 1990. Peter advises beginners to “invest in what you know”, and his message still resonates with working people who don’t have the time to learn complicated technical stock measures or read financial reports as thick as a phone book.
Today, there are over 10,000 funds to choose from and they cover every industry and investing strategy imaginable. They are extremely popular in 401k and IRA retirement plans because of the many options they offer to investors. They are also becoming the investment of choice for many online investors since they offer advantages such as allowing you to trade without paying any transaction fees at all. On the flip side, there are risks that relate specifically to mutual funds and we will discuss those in detail, but don’t worry, funds have proven to be significantly less risky than stocks.
Mutual Fund Checklist
The rest of the guide won’t make much sense unless you have some basic knowledge to work with so let’s talk in a little more detail about what makes a mutual fund tick. You already know that a professional fund manager and his team of analysts are responsible for choosing investments for a pool of investor money. Before 1940, you basically put your money in the mutual fund vacuum and hoped for the best. Luckily, the Investment Company Act set out a lot of rules to level the playing field for investors. Whenever you want to research a mutual fund you can request or download a Prospectus. In a prospectus, funds are required to disclose their strategy, everything they buy and sell, their expenses, their assets, and the risks associated with the types of investments in their fund.
All of these disclosure rules have made it a wonderful opportunity for investors that take the time to understand a prospectus and use quality investing tools to identify top performing mutual funds. We’ll talk more about identifying top performers in our Introduction to Investing Strategies Guide.
However, since a prospectus can be an intimidating document, an easier option for beginners is to go to a reputable investment site and pull up a mutual fund summary. Each site presents their own unique variety of information but all of them will contain most of the essential info you need to decide whether or not the fund is one you want to buy.
A lot of what we’re going to explain will make more sense if you have an example in front of you so let’s learn how to pull up a mutual fund. Remember the word “ticker” from the stock basics guide, the group of letters that follow a company or mutual fund name in any investment article and looks like gibberish? Well, every mutual fund has one as well and it acts as an ID tag so that everyone knows which mutual fund you’re referring to regardless of which variation of the name you use. One of the easiest ways to look up a mutual fund ticker is to go to Morningstar.com and then type in a ticker in the top left-hand box that says “Quotes”. For this example, type in JSVAX, the ticker for Janus Contrarian. You should see a summary for Janus Contrarian that doesn’t make a lot of sense to you at the moment but don’t worry, it will shortly. Now you know how to look up a mutual fund! Leave the window open so you have an example to flip to as we walk through the information below.
Let’s jump to a fun subject, the actual buying and selling of mutual funds. There are several questions you’ll want to answer every time you buy a mutual fund, and some of these terms might be foreign to you so we’ll cover them in detail to make sure you understand each.
Choose a fund strategy
There are a myriad of strategies, but we wanted to at least touch on the major ones in this introduction; Growth Investing, Value Investing, Income Investing, International Investing, Hedge Fund Investing, or a combination. In addition to these strategies you will often see something in the title of a mutual fund that further defines the area they invest in such as “Small Cap Growth”. However, we’ll focus on the broader strategies in this section. Remember that most successful fund investors use a combination of fund types rather than just one because, like we remind you in every guide, diversity is your friend.
1. A Growth Fund is one that tries to pick stocks that grow more quickly than the general economy. This means that you could earn better than average returns but you must accept greater than average risk.
2. A Value Fund is one that tries to buy stocks of undervalued companies. When we say undervalued we mean that the fund managers believe that the stocks they’re purchasing are trading below the true value of the stock and that the demand in the market will eventually correct the price. Value investing is often considered the opposite of growth investing, and it has proven to be the less risky of the two strategies since you’re buying stock that is already relatively low.
3. An Income Fund is one that seeks a high level of current income rather than growth, and they are considered lower risk than growth and value funds. They produce income by investing in stocks that pay out generous dividends and bonds with generous coupon payments.
4. International Funds are pretty self explanatory, they invest at least 80% of their assets into international stocks and other foreign investments. Take the time to review the prospectus if you’re thinking about an international fund, you want to make sure that they are diversified because you wouldn’t want 100% of your investment in one country or only a few foreign stocks. These can be risky investments, they are more volatile on average than growth and value funds.
5. Hedge Funds focus primarily on different types of derivative trading (options) and we don’t recommend them for most investors, especially not beginners. They can be high return but they are also the highest risk of any type of fund and most require a very large minimum investment to participate. Hedge funds are the least practical choice for beginning investors but you’ll hear about them a lot in the news because when they win, they can win big due to the big gambles that they take. Notice we used the word gamble in the hedge fund description that should tell you all you need to know, you’re an aspiring “Investor”, not an aspiring gambler.
6. Our last on the list is a Money Market Fund and they don’t provide stellar returns but are very low risk because they invest in short term securities such as CDs and short-term Treasuries. They are often used as a place to hold money that needs to be available at all times such as an emergency fund.
Exchange Traded Fund or Traditional Fund and what’s the difference?
Next you will need to decide between a Traditional Fund or an Exchange Traded Fund or ETF. A traditional fund doesn’t allow investors to buy and sell quite the same way as you would buy a stock. All traditional mutual fund orders are processed at 4PM EST, you can’t trade these types of funds more than once during a single day. The other option is the Exchange Traded Fund (ETF) which trades exactly like a stock, you can buy and sell them whenever you want throughout the day. Choosing really depends on your personal preferences.
1. Traditional Funds offer a broader array of funds and strategies to choose from but typically cost more to manage than an ETF since many follow a strategy rather than just being pegged to an Index. This means they require active management rather than passive management. Many also require that you hold them for a certain length of time before selling or you will incur penalty charges or Redemption Fees. One advantage you’ll be excited to learn is that, unlike stocks and ETFs, most traditional funds have no transaction fees involved when you purchase them.
2. Most current ETFs simply track an Index, which means if you buy an S&P 500 ETF, it will always try to maintain the same stocks as are in the S&P 500. The advantage is that these types of funds are very low maintenance so management fees are small compared to traditional funds. Another perk is that there is no holding or Redemption Period, you can get in and out an ETF whenever you want. The disadvantages are that your maximum return is the return of the S&P 500 (or whatever index your ETF tracks), you will pay a transaction fee every time you buy and sell, and there are a limited number of strategies available to the ETF investor.
One last note on ETFs. If you read the news a lot, you will start hearing about the new breed of funds that many fund companies are developing. They are creating new ETFs that will offer investing strategies typically only available to traditional fund owners. While this is a great innovation, be warned that we believe expenses will inevitably increase to reflect the fact that a lot more work is required to manage a more sophisticated strategy. Since expenses will be comparable, the choice will still come down to a matter of personal preference, traditional funds are not going away.
3. Always check the expenses and fees before you buy!
The next subject is important, Mutual Fund Expenses and Fees. There are several types of fees that you need to be aware of and they are Loads, Redemption Fees, Transaction Fees, and 12b-1 Fees. Whoa, that seems like a lot to remember, right? Well here’s a simple fact that will help you remember which fees to pay and which to try to avoid. Every fee is optional! That’s right, the funds decide what fees they’re going to try to get away with charging, so can you guess which ones you should pay? None.
How do you check these fees? Do you still have your Morningstar.com example pulled up for JSVAX? On the left-hand side of your screen there should be a list of viewing options. Select “Fees & Expenses” and you will see a list of every type of fee and expense and which ones your fund charges. If you’re not as tech savvy or prefer a little more reassurance, call your online broker help number (see our Online Investing Directory for the help numbers of all the major online brokerages).
“Gasp!” Yes, I recommend that you actually call a help number! Here’s why. Online brokerage help desks are not some automated service that will keep you on hold for fifteen minutes and finally pass you to an attendant who seems to have less knowledge about the product than you do. Online brokerages make a lot of money on every mutual fund transaction, even when the investor doesn’t pay a fee, so it’s good business for them to have knowledgeable and friendly people answering their phones.
Many beginners ask us, if I avoid funds with fees am I passing up the best mutual funds? Definitely not, the best mutual funds have learned that charging these fees hurts their business. The majority of funds, especially good ones that you’d actually want to own, have dropped most if not all of their fees. It doesn’t make sense to charge them when all of your competitors are offering no-fee and no-load funds.
Finally, every fund will also have Management and Administrative Expenses and this is basically the cost to manage the fund. While there’s no getting out of this one, a good rule of thumb is to try to buy funds that have management expenses of 1.5% or less as often as possible since these expenses come right out of your returns.
Fees and Expenses
1. The Management and Administrative Expenses are the salary and administrative expenses required to manage the fund. These are unavoidable and every fund has them but like we stated above, try to keep them as low as possible. The management expense is usually expressed as a percentage called an Expense Ratio and can be found on the mutual summary page of any major investing site. 1.5% or lower is a good target for a traditional fund and 0.35% or lower is a good target for an ETF since most only require passive management. This might change when new ETFs are created with traditional fund strategies, but at the moment, most ETFs are index based so all they have to do is rebalance the portfolio each day to match the index that they track.
2. Loads and No-Loads, what does it mean? The most important thing to remember is that Loads are a rip-off and that’s why they’re nearly extinct. Never pay a load, it’s just a sales commission. Only buy No-Load funds, there aren’t many top notch funds left that charge loads so there’s no reason to ever pay one. How do sellers try to justify a load? People that charge them will tell you that loads are the small price you pay for outstanding investment advice from a professional mutual fund manager or financial planner. Bah! With the vast array of no-load options available, beware the financial planner that tries to shove a loaded fund down your throat, they have their own interests in mind, not yours.
3. Redemption Fees are a mutual fund’s way of discouraging short-term trading. A common redemption period is 90 days and the penalty is usually 2%. For example, if you bought a fund that had a 90 day redemption and then sold it 60 days later, you would pay a 2% penalty for selling before the redemption period was over. The reason funds have redemption periods is that it can become very expensive for them when they have a lot of people buying and selling short term. Because many funds pick up the transaction fees at online brokerages, they pay up to $90 every time you trade. A redemption period can be anywhere from 30 days to 12 months or longer so make sure you check the length of the redemption period before you buy.
4. 12b-1 Fees are described as marketing fees but they are most often a commission paid to a telemarketer for selling a fund. These fees are currently under fire, most people question the ethical justification for using a 12b-1 since there is a lot of evidence that this does absolutely nothing to enhance a fund’s performance. The thought process when this fee was invented was that marketing a mutual fund more aggressively would dramatically increase its assets (more people buy = more cash in the fund = more assets). They argued that bigger funds don’t necessarily cost more to manage, so as long as the assets are increasing and the management fees stay flat, the fund will experience economies of scale. This certainly hasn’t proven true, when you spend more to market a fund the expenses will usually increase as fast if not faster than the assets so 12b-1 fees are complete rubbish in our opinion. Avoid 12b-1 fees and don’t buy from cold callers.
5. Transaction Fees are not fees charged by the mutual fund, they are actually fees charged by your online brokerage. Most mutual funds pay these fees for you or have negotiated the fee down with the brokerage house so you should never see them. We do exhaustive research on online brokerages and can tell you which ones tend to charge a lot more transaction fees. Be sure to check our Online Investing Directory or our Compare Major Online Brokerages Guide if you’re trying to decide who you should invest with or want to know who offers the most no-load, no-fee mutual funds.
Check the minimum investment
With the exception of ETFs, most funds have a Minimum Investment required on your initial purchase. It’s usually between $250 and $5,000 but can be much higher so make sure you check before you buy. One of the easiest ways to find the minimum investment is to use the Morningstar.com method we explained above to pull up a fund summary, the minimum is always listed on the first page.
Only buy diversified funds
Always verify that you are buying a Diversified Fund because there’s little point in buying a fund otherwise. In order to qualify as a “diversified” fund as defined by the Investment Company Act, 75% of a fund’s total asset value is limited to positions of no more than 5% of any one company. For example, if a fund only owns a couple stocks, why wouldn’t you just go buy them so you don’t have to worry about holding periods, management fees and the like? Not to mention the fact that a non-diversified fund is going to be more risky since the assets are concentrated into a few investments.
Mutual Fund Historical Performance
Many professional investors will tell you that historical performance is not a good measure of future performance. For individual stocks, we agree that it should not be the primary factor in your decision and here’s why: Historical performance does not reflect the many obstacles a company must deal with which are not as significant to a mutual fund. Competition could arrive tomorrow with a product that makes theirs obsolete. Companies also face the daunting task of constantly outperforming the prior year or they disappoint analysts regardless of how strong their earnings and balance sheet. To make matters more complicated, good companies must learn to adapt quickly to a constantly changing management team, culture, regulatory environment, and strategy as they grow.
Finally, the most daunting task is maintaining momentum despite increasing size. It gets very hard for large companies to deliver the kinds of returns that smaller companies can. For example, a $200 million dollar profit might be a drop in the bucket for a multibillion dollar Large Cap but it could double the size of a Small Cap. It’s not hard to figure out which company investors are going to get more excited about in this scenario regardless of historical performance.
However, historical performance can tell you a lot about a mutual fund, especially when you’re talking about longer periods of time. Why the difference? Let’s go back to the related points for individual companies in the paragraph above. A fund is diversified and owns many stocks so if one company’s product becomes obsolete they just replace it with another company. A company must always raise the bar and meet or beat analyst expectations or their price will suffer (especially in the short term). A mutual fund, on the other hand, doesn’t have to worry about price spikes as a result of analyst expectations and predictions because analysts very rarely concern themselves with mutual funds. A fund can keep most of its investors happy as long as it continues to beat its peers and the index.
Another interesting difference is that funds are the opposite of companies in terms of size. For a fund, the bigger the better. The increase in size actually increases your returns because the management fees become a smaller percentage of total assets (economies of scale). Admittedly, it can be tough to manage the mega funds that get up into the billions but every fund manager has the option to close the fund to new investment if they feel that performance is deteriorating. We’ve probably more than made our case, but one last remark. A company that performs well for several years in a row will inevitably get to a point where it is nearly impossible to top last year’s performance. Conversely, the longer a fund manager runs a fund, the more savvy and experienced he becomes so in most cases performance constantly improves.
So now that you’re convinced historical performance is a good measure to add to your checklist, let’s explore the easiest way to find this information. Let’s go back to our Morningstar example, JSVAX. In the right hand toolbar, select the Total Returns view. This will pull up a chart that will show you how the fund performed versus a relevant Index (the S&P 500 in this case) and versus its peers (Large Cap Growth Funds). While the returns slightly underperformed during the Tech Crash 2000-2002, returns have been astonishing since Q4 2002. How can we tell? The total return, +/- Index, and +/- Category are all strongly positive and the average category rank is 3.33 since Q4 2002. Phenomenal!
Check Fund Manager Tenure
The last thing to check is Fund Manager Tenure, which is how long the fund manager has been managing the fund. For example, if you were about to buy a fund that performed spectacularly over the last 10 years but then found out they just replaced the fund manager 3 weeks ago, shouldn’t that change your mind? If, on the other hand, a fund manager has outperformed his competitors and the index over periods as long as 20, 15 or even 10 years, we’re impressed. That’s a very long window of time and we feel it proves the value of his expertise.
Now if you’ve completed the Fee and Expense Checklist, verified the fund is diversified, and see very strong historical performance with an experienced, successful manager, are you ready to buy? No, not just yet. Like we explained in Stock Investing Basics, these guidelines can help you narrow down a list of mutual funds that meet your criteria, but eventually you have to narrow that list down to just one fund.
Mutual Fund Pricing
A question that has probably already occurred to you is, if a fund is a pool of money, does the price of the fund increase when investors add or subtract money? This is a good question, and the answer is no. A fund’s price only changes when its investments perform well but the process is slightly more complicated than the supply and demand involved in stock prices. When you hear people talking about mutual funds you’ll likely hear them use the word “NAV” rather than price.
What does the term “NAV” mean? It stands for Net Asset Value. Mutual fund managers wanted to make sure that their price reflected the performance of their investments, not the flow of money from investors. The formula that they came up with is called the NAV and it is (total market valueâ€”daily expenses) / total shares outstanding. To make this formula work, mutual funds must issue and cancel shares every time an investor buys or sells. Relax, this process will never affect you and you’ll never have to calculate the NAV. We only include this info so that you’ll know that a stock price and a fund price are calculated differently and that people are talking about the price per share of a mutual fund when they refer to the NAV. However, we appreciate the fact that many people will want to understand the calculation so click here for a NAV example.
Now that you have a basic understanding of mutual funds, how to do a fee and management expense checkup, and how to rate performance, let’s talk about the advantages and disadvantages of investing in mutual funds.
Mutual Fund Disadvantages
Mutual Fund Distributions are one of the most confusing stumbling blocks for beginning investors. Funds are required to distribute at least 90% of their profits (Capital Gains and Dividends) each year. They pass this to investors and then drop the NAV (fund price) to reflect the distribution, so you don’t lose any money on the transaction but it can create additional tax liability. For example, let’s say you bought Janus Fund on December 6th and they had a distribution on the 7th. Ouch, they are going to pass you a capital gains and dividends distribution even though you’ve only owned the fund for a single day.
Most funds distribute in December, so the last couple of months of the year are when you need to be most wary. Avoid buying right before a distribution whenever possible. Note that the longer you’ve held a fund the less these distributions matter because you will have actually reaped the benefit of good returns, not just the tax liability.
Even though there are a lot of disclosure laws in place to protect you, you will still receive phone calls, emails, and other solicitations containing misleading mutual fund advertisement that can lead beginners astray. For example, if a mutual fund bought stock in a Lithuathian (yes, that is a country) company that makes those crazy fiber optic toys you can only buy at carnivals and circuses and felt this gave them the right to call themselves a Foreign High-Tech Fund we would feel very misled. Make sure you go through your mutual fund checklist every time and review the fund’s historical performance. If something seems too good to be true, it probably is.
We beat fees to death and we’re going to mention them again here for this very simple reason: Every penny you spend reduces your returns. Always avoid loads, 12b-1s, and redemption fees and avoid transaction fees whenever possible. Try to stay within a reasonable range on management expense ratios as well, 1.5% or less for traditional funds unless a fund has a long history of extraordinary performance and 0.35% or less on ETFs and Index funds since they only require passive management.
Minimum investments are more of an annoyance to beginning investors that don’t yet have a lot of capital. It’s very frustrating to do all your homework and decide that you definitely want to buy a fund only to find out that you don’t have the $5,000 minimum investment. Take heart, if you invest wisely your money will grow quickly and soon you won’t even bat an eye at minimum amounts.
Finally, if you are not comfortable learning how to use new websites, it will take you a while to get used to one as robust as Morningstar.com. However, for your own good, please take the time to learn to use at least one of the major investing sites. They save you an enormous amount of time, work and money. Information is everything in the investment world and if you’re not using these tools to make informed decisions you’re just throwing darts. Plus, not only is a prospectus a confusing document for beginners, it can’t tell you enough about performance even if you read it cover to cover. You can find the fee and expense information, but only the investing websites will allow you to quickly and easily compare a fund versus the market and versus its peers and this is a critical piece of your checklist.
Mutual Fund Advantages
Even though this section will be short because we’ve already covered most of these concepts, the advantages of mutual funds are powerful and far outweigh the drawbacks. First, we’d like to reemphasize that we believe beginners should start with mutual funds. Even when you are experienced enough to expand into stocks, covered calls and other passive income investment vehicles, mutual funds should form the core of your portfolio.
What do I emphasize over and over again? Diversification. That is the greatest strength of mutual funds. Each fund represents an entire portfolio, not just one stock. We’ve all seen companies that filed bankruptcy, committed fraud, or announced a major blunder. They instantly become a pariah in the eyes of investors and the share price plummets. Because a fund owns an entire portfolio of stocks, you have some protection from this type of loss. In addition, a fund’s portfolio is managed by a professional fund manager whose career and income is directly tied to how well he chooses investments for you, the person paying his salary (no investors = no fund).
The amount of information that funds are required to disclose makes their strategy and performance almost transparent. We wish this were true for individual companies, but the recent 2007-2008 Subprime Mortgage Crisis proves this isn’t the case since financial institutions keep surprising the market with multibillion dollar loss announcements. It’s very difficult for a mutual fund to fool wary investors, problems are pretty obvious as long as you know what to look for. Make sure that you occasionally go through the mutual fund checklist for funds in your portfolio to verify that their expenses, strategy, and performance are still in line with your expectations and that the same manager is still running the fund.
There are many investment strategies to choose from and this can be frustrating for beginners. Mutual funds offer a quick and easy way to test drive different strategies. For example, let’s say you’re really interested in Small Cap companies because you believe the economy will support strong growth for small companies over the next several years. You’ll quickly find that there are many funds specializing in various categories of small-cap growth investing. In fact, it’s very likely that you will be able to find a fund using the exact niche strategy you’re interested in. One caveat there’s no point in test driving a fund that is obviously failing at implementing that strategy, be sure to put it through the same rigorous checklist as any other fund to ensure that it is well managed.
Even though mutual funds are managed by professional investors, don’t forget that only one out of four beats the average market return. Should this discourage you? Not in the least, it’s pretty easy to find great fund managers that consistently beat the market over long periods of time. The easiest and, in our opinion, the smartest way for beginners to choose stocks, funds, or any other investment vehicle is to buy some good and affordable investment advice from people with a lot of experience and a proven track record. Then use what you learn in our guides to validate their advice or narrow down their short list of recommendations to a single fund.
How affordable? To give you an idea, several of the top 10 performing Investing Newsletters in the world cost less than $200 per year. The quality of advice doesn’t correlate at all with price, you can spend very small sums of money and still receive the best investing advice available. Surprisingly, some of the worst performers that haven’t beaten the S&P 500 or even turned a profit cost thousands of dollars per year we haven’t bothered to investigate but this is probably because they spend a fortune trying to con people into buying their poor quality products.
Most investment advisory services that have been around for at least five years are tracked by an independent rating service called the Hulbert Financial Digest. Many of these advisory services have historical track records of beating their competitors and the S&P 500 for over 20 years. Do your homework before you pick one! And remember, you know how to evaluate a fund now so there’s no excuse for not validating a fund that has been recommended to you by your advisory service before you buy.
Another great strategy for beginning investors is Index Investing, especially if you don’t have a lot of time to manage your portfolio. Index Funds and ETFs have extremely low expenses, are tax efficient since stock turnover is low, and guarantee that you will at least get the market return. They don’t even require active management since they simply mirror whatever stocks are in the index you choose (such as the S&P 500).
In the first paragraph we promised that even beginners could learn how to check fund fundamentals and performance before purchasing. Now that you’ve completed this guide you know how to avoid unnecessary fees, minimize expenses, and compare a fund’s performance to its peer group and to a relevant index. This is only an introduction and you’ve already learned enough to do a thorough investigation when someone recommends a fund.
Now that you know some mutual fund basics, it’s time to dive into the next guide, Introduction to Investing Strategies.