Ok, here we go. Just about everything you ever wanted to know about mutual funds…
What is a Mutual Fund?
Wikipedia says it is “a professionally managed type of collective investment scheme that pools money from many investors and invests it in stocks, bonds, short-term money market instruments, and/or other securities. The mutual fund will have a fund manager that trades the pooled money on a regular basis.”
My definition would be: A vehicle for purchasing securities in which diversity (and subsequent stability) are inherent by virtue of pooling the assets of multiple investors together. In mutual funds, a manager utilizes the ‘mutual’ funds to purchase a well-rounded and well-researched collection of stocks.
What are the advantages of Mutual Fund ownership?
- Diversity - (the mantra of the investment community) mutual funds provide this diversity by offering a wide variety of stable stocks to a single investor, through a single transaction.
- Stability – due to the inherent diversity, mutual funds offer a much more stable investing medium. If you owned stock in a single company, that company could go bust seemingly overnight – [cough, cough] Enron! By investing in multiple companies through a mutual fund, you spread your risk. It is highly unlikely that 50+ companies would go bust over night. Thus, your investment grows in a much more stable environment. That’s a good thing.
- Small Cost of Entry – With mutual funds, an investor can purchase a stock interest in 50+ companies with an initial investment as low as $250.
Where to you buy Mutual Funds?
Like all traded securities, you must by mutual funds through a broker, of which there are two types:
1. A Discount Broker
Examples: E-Trade, Scottrade
Pros: lots of fund choices, good internet access to funds, low transaction fees for ‘good’ funds
Cons: higher fees for ‘great’ funds, no advice from a real person.
2. A Brokerage House
Examples: Vanguard, Fidelity, T. Rowe Price
Pros: Brokerage Houses offer the ‘great’ quality funds, fees for ‘great’ funds within their family are low
Cons: more limited choices (ex. you chose vanguard. their fee structure will encourage you to buy vanguard mutual funds. They have excellent funds, so that is ok. But if you wanted a Fidelity fund, it would be difficult). Also, these brokers are set up to be more personal, rather than virtual. Thus, web access with be decent, but probably not a good as E*trade.
How do you distinguish one Fund from another?
When categorizing funds, there are two characteristics to look at ‘type’ and ‘style’. Each fund has a classification in each characteristic.
stock: large cap (fund is comprised of stocks in big companies)
mid cap (medium companies)
small cap (you guessed it – small companies)
foreign/international: foreign companies
specialty: funds trying to target particular segments of the economy
bond: don’t worry about these, they are for old people
growth: sub categories: very aggressive & aggressive
value: less agressive & more stable
equity: income – for retired people
Additionally, some funds are ‘loaded’ and the rest are ‘no-load’ funds. This has nothing to do with alcohol. This has to do with management fees attached to the funds. ‘Loaded’ funds charge a higher fee, but promise better performance. The fees for ‘No-Load’ funds are more modest. Personally, I steer towards the ‘no-load’ funds. The superior performance of ‘loaded’ funds is not a guaranteed thing, however the higher fee is guaranteed. I’m just sayin’…
More about fees below.
How much do Mutual Funds cost?
There are two fees associated with Mutual Funds. First, there are transaction fees. This is a flat rate fee associated with the purchase or sell of a fund. This fee is common with the discount brokerages. Generally brokerage houses do not charge this fee if you are purchasing funds from within their family. Second, there are management fees. This fee is a percent of the total money you have invested in the fund and varies from fund to fund. The management fee is taken out of your invested money on a regular basis. It covers the cost (+ some profit) of the fund manager supervising your money.
Additionally, some funds are ‘loaded’ and the rest are ‘no-load’ funds. This has nothing to do with alcohol. This has to do with fees attached to the funds. ‘Loaded’ funds charge a higher fee, but promise better performance. The fees for ‘No-Load’ funds are more modest. Personally, I steer towards the ‘no-load’ funds. The superior performance of ‘loaded’ funds is not a guaranteed thing, however the higher fee is guaranteed. I’m just sayin’…
What funds are good?
There is no magic here. I don’t spend a lot of time researching. I go buy a issue of Kiplinger or Money. Both offer an annual listing of their picks for best funds. They have full time people who reseach, follow, and predict. Their guess is much better than mine. Among their guesses, it is a crap shoot. Any fund from a list is as good as any other. Only time will tell.
What is a reasonable rate of return for a Mutual Fund?
A good fund should average 11%-12% over a 5+ year period. In any given year, the rate of return could be much better or much worse. But in a 5-10 year period, you should see double digit returns.