Mutual funds are one of the most common investment vehicles available to investors. They are generally the investment vehicle offered in employer-sponsored retirement plans like the 401(k), and are often the investment vehicle of choice for many investors in their taxable brokerage and IRA accounts. They are so common that we might take them for granted, but what are mutual funds really?
A mutual fund is a professionally managed investment vehicle that pools investor’s money to invest based on the fund’s objective, hence the term mutual fund.
Contributing to a mutual fund means you have access to professional services without having to invest as much time or money as individual investors. Regulated by the Securities Exchange Commission (SEC), mutual funds offer investors the advantage of a diversified portfolio within a specific investment objective or style with professional management that is generally only available to the wealthy.
Mutual funds are a popular investing tool for those who invest on their own and for those investors who work with a financial professional. Financial professionals often have access to funds that might not be available to you as an individual and they have the knowledge and analytical tools to evaluate individual mutual funds and how they might fit together inside of an overall portfolio.
Whether you’re working alone or with an investor, there are many factors to consider when choosing a mutual fund. Here are a few:
- How the fund fits with your investing and financial planning goals
- The fund’s objective and asset class
- Fees, expenses, loads, etc.
- How the fund compares to others within its peer group of funds
All About the Basics
Understanding the different categories is one way to start making sense of mutual funds. Mutual fund data provider Morningstar groups mutual funds into categories generally based upon their investment style. As of 2014 they listed 114 mutual fund categories, and the list has likely grown a bit since then. (1)
The categories span stocks, bonds, money market and various alternative categories. Across stocks there are large cap, small cap and mid-cap, as well as domestic and international. Large, mid and small cap categories refer to the average market capitalization of the average sized holdings in the fund. Market cap refers to the stock’s price times the number of shares outstanding. Examples of large cap stocks include household names like Apple, Facebook and Microsoft.
Generally, small cap stocks are considered riskier than large caps though this will vary from stock to stock. Small caps are often companies in an earlier stage of development and often don’t have systems and infrastructures in place to the extent that a larger company might. Companies can start as small caps and may grow to become a large cap.
International stocks are generally non-U.S. companies and can either be in developed markets or emerging markets. Developed markets include countries like Germany, Canada, the United Kingdom and many others. Emerging markets include countries like China, Brazil, India and Russia, also known as BRIC.
Another common type is fixed-income funds, which generally invest in bonds. These funds might invest in corporate bonds, government bonds including Treasuries or municipal bonds which are generally free from federal taxes as far as the interest received. Bond funds can also invest in foreign bonds, both from developed and emerging market issuers.
Beyond this there are balanced funds that invest in a mix of stocks and bonds; target date funds that invest towards a retirement goal; alternative funds that invest in a fashion that isn’t highly corelated to either stocks or bonds and may try to mimic hedge funds; funds that invest in a specific market sector like technology or retail and a whole host of others.
Active versus Passive
As you consider which type of mutual fund to invest in, you’ll also want to consider the management approach. Mutual funds can be both actively or passively managed. Active management means that the manager(s) will proactively select the fund’s underlying holdings whether they be stocks, bonds or other types of investments based upon the fund’s stated objectives.
A passively managed fund is one that generally mimics the performance of a market index such as the S&P 500 stock index. There are a number of funds that track this and other indexes exactly. Index investing has become very popular in recent years, especially with the gains in the stock market since the market bottom in March of 2009.
One of the reasons that passive index funds are popular is that their expenses are generally lower than for actively managed funds within the same asset class. High expenses add up over time and can drastically reduce the amount an investor might otherwise have accumulated. In some cases, index funds have outperformed many of their actively managed peers.
On the other hand, an active manager with a solid investment process can add real value over time. As an investor, you need to understand who is managing the fund, their process and their track record over time compared to their peers.
Making Sense of Fees and Expenses
The returns earned by mutual fund investors are always net of any internal expenses. The fund’s expense ratio is a way to compare the expenses of one fund to those of another that you might be considering.
How important are expenses? The SEC did a study (2) and found:
- Over 20 years an initial investment of $100,000 would be reduced in value by an additional $10,000 based on annual expenses of 0.50% as compared to a portfolio with annual expenses of 0.25%.
- The same portfolio would be reduced in value by nearly $30,000 if the expenses were 1% as compared to a portfolio with annual expenses of 0.25%.
- The study assumed an annual return of 4%.
The thing to keep in mind with any fee is its expense ratio. You’ll want to be sure that the fees are worth the return on investment and in line with the going rate of peer funds.
Mutual fees can also include:
- A front-end sales charge or load that reduces the amount of your investment that actually goes to work for you. For example, if you invest $10,000 in a fund with a 5% front-end sales load only $9,500 of your money will actually be invested. This often occurs in broker-sold A shares.
- Some funds have a level sales load of 1% that is assessed as long as you own the fund. These are generally C shares and the 1% serves to increase the overall expenses of the fund.
- Some funds have 12b-1 fees that are a part of the expense ratio. This is a fee that compensates the broker or advisor and is usually around 0.25% of the fund’s value.
- Less common than in the past, some funds charge a surrender fee if you sell the fund before a pre-determined time. The amount of your proceeds from the sale would be reduced by the amount of the surrender charge.
Mutual funds can bring a lot of value to the table in a financial planning strategy, but you’ll want to take the time to do your research and decide if it’s the right approach for you. We all have goals for our financial future, and mutual funds are one of the many different options to help achieve those goals over the long term.