Introduction Advantages Disadvantages Classification
Fees Selecting Funds
funds have been around for a long time, dating back to the early 19th
century. The first modern American mutual fund opened in 1924, yet it
was only in the 1990s that mutual funds became mainstream investments,
as the number of households owning them nearly tripled during that decade.
With recent surveys showing that over 88% of all investors participate
in mutual funds, you're probably already familiar with these investments,
or perhaps even own some. In any case, it's important that you know exactly
how these investments work and how you can use them to your advantage.
to Mutual Funds
A mutual fund is a
special type of company that pools together money from many investors
and invests it on behalf of the group, in accordance with a stated set
of objectives. Mutual funds raise the money by selling shares of the fund
to the public, much like any other company can sell stock in itself to
the public. Funds then take the money they receive from the sale of their
shares (along with any money made from previous investments) and use it
to purchase various investment vehicles, such as stocks, bonds and money
market instruments. In return for the money they give to the fund when
purchasing shares, shareholders receive an equity position in the fund
and, in effect, in each of its underlying securities. For most mutual
funds, shareholders are free to sell their shares at any time, although
the price of a share in a mutual fund will fluctuate daily, depending
upon the performance of the securities held by the fund.
of Mutual Funds
Buying a mutual fund provides instant holdings of several different
Mutual funds come in a wide variety of types. Some mutual funds invest
exclusively in a particular sector (e.g. energy funds), while others
might target growth opportunities in general. There are thousands of
funds, and each has its own objectives and focus. The key is for you
to find the mutual funds that most closely match your own particular
is the ease with which you can convert your assets--with relatively
low depreciation in value--into cash. In the case of mutual funds, its
as easy to sell a share of a mutual fund as it is to sell a share of
stock (although some funds charge a fee for redemptions and others you
can only redeem at the end of the trading day, after the current value
of the fund's holdings has been calculated).
- Low Investment
Minimums. Most mutual funds will allow you to buy into the fund
with as little $1,000 or $2,000, and some funds even allow a "no
minimum" initial investment, if you agree to make regular monthly
contributions of $50 or $100. Whatever the case may be, you do not need
to be exceptionally wealthy in order to invest in a mutual fund.
When you own a mutual fund, you don't need to worry about tracking the
dozens of different securities in which the fund invests; rather, all
you need to do is to keep track of the fund's performance. It's also
quite easy to make monthly contributions to mutual funds and to buy
and sell shares in them.
- Low Transaction
Costs. Mutual funds are able to keep transaction costs -- that is,
the costs associated with buying and selling securities -- at a minimum
because they benefit from reduced brokerage commissions for buying and
selling large quantities of investments at a single time. Of course,
this benefit is reduced somewhat by the fact that they are buying and
selling a large number of different stocks. Annual fees of 1.0% to 1.5%
of the investment amount are typical.
Mutual funds are regulated by the government under the Investment Company
Act of 1940. This act requires that mutual funds register their securities
with the Securities and Exchange Commission. The act also regulates
the way that mutual funds approach new investors and the way that they
conduct their internal operations. This provides some level of safety
to you, although you should be aware that the investments are not guaranteed
by anyone and that they can (and often do) decline in value.
- Additional Services.
Some mutual funds offer additional services to their shareholders, such
as tax reports, reinvestment programs, and automatic withdrawal and
Management. Mutual funds are managed by a team of professionals,
which usually includes one mutual fund manager and several analysts.
Presumably, professionals have more experience, knowledge, and information
than the average investor when it comes to deciding which securities
to buy and sell. They also have the ability to focus on just a single
area of expertise. (However, it should be noted that this apparent benefit
has not always translated into superior performance, and in fact the
majority of all mutual funds don't manage to keep up with the overall
performance of the market.)
of Mutual Funds
- No Insurance.
Mutual funds, although regulated by the government, are not insured
against losses. The Federal Deposit Insurance Corporation (FDIC) only
insures against certain losses at banks, credit unions, and savings
and loans, not mutual funds. That means that despite the risk-reducing
diversification benefits provided by mutual funds, losses can occur,
and it is possible (although extremely unlikely) that you could even
lose your entire investment.
Although diversification reduces the amount of risk involved in investing
in mutual funds, it can also be a disadvantage due to dilution. For
example, if a single security held by a mutual fund doubles in value,
the mutual fund itself would not double in value because that security
is only one small part of the fund's holdings. By holding a large number
of different investments, mutual funds tend to do neither exceptionally
well nor exceptionally poorly.
- Fees and Expenses.
Most mutual funds charge management and operating fees that pay for
the fund's management expenses (usually around 1.0% to 1.5% per year).
In addition, some mutual funds charge high sales commissions, 12b-1
fees, and redemption fees. And some funds buy and trade shares so often
that the transaction costs add up significantly. Some of these expenses
are charged on an ongoing basis, unlike stock investments, for which
a commission is paid only when you buy and sell.
- Poor Performance.
Returns on a mutual fund are by no means guaranteed. In fact, on average,
around 75% of all mutual funds fail to beat the major market indexes,
like the S&P 500, and a growing number of critics now question whether
or not professional money managers have better stock-picking capabilities
than the average investor.
- Loss of Control.
The managers of mutual funds make all of the decisions about which securities
to buy and sell and when to do so. This can make it difficult for you
when trying to manage your portfolio. For example, the tax consequences
of a decision by the manager to buy or sell an asset at a certain time
might not be optimal for you. You also should remember that you are
trusting someone else with your money when you invest in a mutual fund.
- Trading Limitations.
Although mutual funds are highly liquid in general, most mutual funds
(called open-ended funds) cannot be bought or sold in the middle of
the trading day. You can only buy and sell them at the end of the day,
after they've calculated the current value of their holdings.
- Size. Some
mutual funds are too big to find enough good investments. This is especially
true of funds that focus on small companies, given that there are strict
rules about how much of a single company a fund may own. If a mutual
fund has $5 billion to invest and is only able to invest an average
of $50 million in each, then it needs to find at least 100 such companies
to invest in; as a result, the fund might be forced to lower its standards
when selecting companies to invest in.
of Cash Reserves. Mutual funds usually maintain large cash reserves
as protection against a large number of simultaneous withdrawals. Although
this provides investors with liquidity, it means that some of the fund's
money is invested in cash instead of assets, which tends to lower the
investors potential return.
- Different Types.
The advantages and disadvantages listed above apply to mutual funds
in general. However, there are over 10,000 mutual funds in operation,
and these funds vary greatly according to investment objective, size,
strategy, and style. Mutual funds are available for virtually every
investment strategy (e.g. value, growth), every sector (e.g. biotech,
Internet), and every country or region of the world. So even the process
of selecting a fund can be tedious.
Mutual funds now come
in every possible size, shape, and color, and if you're in your company's
401(k) or 403(b) plan, you've probably noticed that already. Here are
some of the general categories of mutual funds.
Bond mutual funds are pooled amounts of money invested in bonds.
A purchaser of a bond is lending money to the issuer, and will usually
collect some regular interest payments until the money is returned. Usually
the amount of interest paid (the coupon) is fixed at a setage of the amount
invested, thus, bonds are called "fixed-income" investments.
Balanced funds mix some stocks and some bonds. A typical balanced fund
might contain about 50-65% stocks and hold the rest of shareholder's money
in bonds. It is important to know the distribution of stocks to bonds
in a specific balanced fund to understand the risks and rewards inherent
in that fund.
(Stock) Funds: Styles and Sizes
Stock or equity mutual funds are pooled amounts of money that are invested
in stocks. Stocks represent part ownership, or
equity, in corporations, and the goal of stock ownership is to see the
value of the companies increase over time. Stocks are often categorized
by their market capitalization (or caps), and can be classified in three
basic sizes: small, medium, and large. Many mutual funds invest primarily
in companies of one of these sizes and are thus classified as large-cap,
mid-cap or small-cap funds.
International funds invest in companies located in other countries. Global
funds invest in both U.S. and international-based companies. In general,
international and global funds are more volatile than domestic funds.
Sector funds invest in one particular sector of the economy: technology;
financial, computers, the Internet. Sector funds can be extremely volatile,
since the broad market will find certain sectors very attractive and very
unattractive - often in rapid succession.
Stock index funds seek to match the returns of a specified stock benchmark
or index. An index fund simply seeks to match "the market" by
buying representative amounts of each stock in the index. Index funds
do not attempt to beat the equities market, they simply seek to come as
close as possible to equaling it.
A mutual fund's expense
ratio is the most important fee to understand.
The expense ratio is made up of the following:
- The investment
advisory fee or management fee is the money used to pay the
manager(s) of the mutual fund. On average, this fee is about 0.5% to
1.0% annually of the fund's assets.
costs are the costs of recordkeeping, mailings, maintaining a customer
service line, etc. They vary in size from fund to fund, between 0.2%
and 0.4% of fund assets.
- The 12b-1 distribution
fee ranges from 0.25% of a fund's assets all the way up to 1.0%
of the fund's assets. This fee is spent on marketing, advertising and
You don't really need
to concern yourself with how these components of the expense ratio are
divided. You just need to know the bottom line.
For actively managed funds, the average number is between 1% - 1.5%.
For index funds, the expense ratio is typically around 0.20% - 0.25%.
refers to the sales charge many funds use to compensate the broker for
his or her "services" in selling the fund to an investor, and
this is in addition to the annual expenses discussed above. "No-load"
funds simply are those funds that are sold directly to the investor, rather
than through a middleman.
- Front-End Load.
A front-end load (or sales load) is a fee that a broker charges
when you purchase shares in the fund. Front-end loads may be as low
as 1% of the amount you're investing, or as high as 8%.
- Deferred Load.
Deferred load or contingent deferred sale load (CDSL) funds (sometimes
called back-end loads), often labeled "B" class shares,
defer the sales fee until you leave the fund.
- Level Loads.
Level load funds, or "C" shares, charge small front loads,
and level loads every year thereafter.
Turnover Rate and
Taxes. A fund's turnover rate basically represents the percentage
of a fund's holdings that it changes every year. A managed mutual fund
has an average turnover rate of approximately 85%, meaning that funds
are selling most of their holdings every year. Because buying and selling
stocks costs money through commissions and spreads, a high turnover indicates
higher costs (and lower shareholder returns) for the fund. Also, funds
that have large turnover ratios will end up distributing yearly capital
gains to their shareholders. Shareholders will have to pay taxes on these
gains. Keep an eye on the turnover rate of any fund you own, and look
to own funds with low (preferably no higher than 25%) turnover rates.
(Index fund turnover is around 5% or lower.)
Before buying a fund,
please make sure that you understand all the costs and fees associated
with buying, and with owning, that fund.
Review the Prospectus
A mutual fund prospectus will provide most, if not all of the information
that you need to determine, "What's up with this fund?"
- Fees can
be found in the Fees Table.
and Policies tell you more or less how the fund plans to invest your
- Risk tells
you the risk involved in owning the fund.