Mutual Funds: The Basic Ingredients
Mutual funds are popular investment vehicles which allow investors to buy shares in a collection of securities, such as stocks and bonds. Portfolio managers oversee buying and selling securities that are held by the fund. By purchasing shares of the fund itself, you are able to own a proportional interest in all of the securities that the fund holds. This can quickly and efficiently aid in your quest for diversification. There is a wide variety of mutual funds available, which we will explore in Chapter 22. Let’s first look at the basic concepts involved in mutual funds, in general.
The Structure of Mutual Funds
An entity organized as either a corporation or a trust both creates and oversees a mutual fund. There is a governing body elected by the shareholders of the fund or the board itself in the form of a Board of Directors or Board of Trustees, which is charged with ensuring that the mutual fund is operating properly according to its organizational requirements. The selection of securities in the fund is overseen by a portfolio manager(s), who relies on a team of analysts and investment advisors to provide pertinent information. This aids him or her in selecting securities for the fund. The fund will also have a broker to facilitate the buying and selling of securities for the fund at the direction of the portfolio manager. There are often multiple mutual funds set up by an entity; these groups of funds are sometimes referred to as fund families. Each individual fund will have a specific objective laid out for it in terms of the securities it is permitted to have in its portfolio and the goals the fund is seeking to achieve.
When corporations issue shares of stock on the market they specify the number that they are issuing, which then remains fixed unless the corporation decides to issue additional ones. Shares of mutual funds, on the other hand, typically have no fixed number of shares that are issued or any limitation on how many can be issued. Therefore, shares are always available to be bought from the fund and can always be sold back to the fund. For this reason, the funds are sometimes referred to as open-end funds. If a board feels that too much money is coming into a fund for it to be effectively managed, they can decide to close the fund to new investors. This is one s cenario that would prevent additional shares from being issued.
All of the details of a fund, including its objective, its portfolio manager and other items we will be discussing in this chapter can be found in a document called the fund’s prospectus. The prospectus can be located online at the fund’s website or you can have the fund mail it to you. Ordinarily, you will be asked to confirm that you have seen and reviewed the fund’s prospectus before you will be allowed to invest in the fund.
How Can You Profit from Them?
You can profit from mutual funds in several ways, including any increase in the price of the fund shares themselves. When shares of a company trade on the open market, their price fluctuates throughout the day. Mutual fund shares, conversely, are valued at the end of each day after the markets have closed. The value of all of the securities in the fund’s portfolio as of the close of business are calculated and then divided by the number of fund shares outstanding. This provides the Net Asset Value (NAV) of the shares and determines the price at which they are bought or sold on that day. Therefore, while individual stock shares could be bought or sold at various prices throughout the trading day, shares of mutual funds that are bought or sold will all have the same price for any given day. If you sell your fund shares for a higher price than you bought them, you realize a profit in the form of a capital gain, just as you would with shares of stock.
In addition, stock dividends and bond interest earned by the securities within a fund are typically passed directly to the fund owners. You can choose to have these reinvested in additional shares of the fund or paid directly to you. Typically, even if a fund is closed to new investors, dividends can be reinvested in new shares by current fund holders. This reinvestment of dividends or interest is a way to take advantage of the compounding principal.
When the portfolio manager sells securities within the fund for a profit, those capital gains are also passed on to the fund owners. This is a third way that you can earn money from a mutual fund. As with dividends or interest, you can either choose to have these gains reinvested in additional shares of the fund, or have them paid directly to you. Again, by reinvesting the distributed capital gains, you would benefit from compounding.
Advantages of Mutual Funds
There are advantages to buying shares in mutual funds over purchasing individual stocks or bonds when building your portfolio. Let’s examine some of the benefits you could realize from investing in mutual funds.
Professional Management
The mutual fund companies employ investment professionals who oversee buying and selling the securities that are held within the fund. They also typically have analysts who closely follow the market and research securities that are in the fund or being considered for the fund, to provide statistical information to the portfolio managers. This means that you do not have to track any of that. Once you’ve found a mutual fund that you like and one whose objectives suit your purpose, you simply invest in it and let the professionals take care of buying and selling the securities held by the fund.
Diversification
When you buy shares in a fund, you immediately become a proportional owner of all of the securities held within the fund. This can provide you with immediate diversification in return for what could be a fairly modest investment. For example, if you bought $3,000 worth of shares in a mutual fund that in turn held the shares of 50 different companies, your stock ownership would then be diversified over 50 companies, albeit with a small proportional share of each. Conversely, if you chose instead to purchase shares of the 50 companies yourself through a broker, you would probably need much more than $3,000 to acquire even a single share in each company.
Mutual funds are extremely easy to buy and sell. Typically you can buy them online directly from the company offering them or even from your bank or broker. We will go into more detail on this in the “How Do You Buy Them” section later in the chapter. If you choose to invest in mutual funds, you would save the time spent researching individual securities by shifting that responsibility to the professionals overseeing the fund. Also, as discussed, it is easier to become quickly diversified by investing in mutual funds than when buying individual stocks or bonds.
Lower Relative Broker Commissions
Mutual funds tend to purchase and sell large quantities of securities at a time. They also must have a broker to facilitate buying and selling for them, and the broker will charge the fund a commission, as we’ve discussed. Keep in mind that the cost per share for the broker’s commission will be much less if the fund purchases a block of 100,000 shares as opposed to a block of 100 shares. Therefore, brokerage commissions will typically be a much lower cost percentage for the fund than they would be for your portfolio of individual stocks.
Liquidity
Shares of mutual funds are typically easy to buy and sell quickly. There are some funds that have a required holding period for new purchases, but that is always disclosed in the fund’s prospectus. As a rule, the fund will always buy back shares that you want to sell, unless they have disclosed limitations on selling your shares.
Disadvantages of Mutual Funds
There are, of course, also some disadvantages to owning mutual funds. Let’s look at some of those, as well, so that you can weigh them against the advantages.
Professional Management and Fund Restrictions
Having professionals overseeing the securities within a fund can also be a disadvantage. Even professionals will not be right all the time and you, as an investor, have virtually no say in the decisions that they make. On the extreme end of the spectrum, you can have a situation of fraud, as with the Bernie Madoff debacle. A more common issue that could arise is that the portfolio manager may be prohibited from purchasing certain securities because of the specifications of the fund itself. When funds are set up, they define what the objective of the fund is and the types of securities that it will be holding. The portfolio manager must abide by this when considering which securities to add to the holdings of the fund. By purchasing individual securities yourself, you are not subject to those restrictions.
Professional management also has a particular effect on bond funds. If you hold an individual bond until its maturity date, you will receive back the principal amount of the bond plus the final interest payment. Any changes to the value of the bond due to trading on the market prior to the maturity date would essentially not affect you. Since the portfolio manager makes decisions regarding when to buy and sell bonds within the mutual fund, they will be affected by their market value if they are sold prior to their maturity date.
Diversification
Diversification reduces risk, but it also lessens the impact of high returns. If you held stock in only one company and its share price rose dramatically, you would receive a high return if you sold it. If there are other shares in your portfolio that don’t rise as dramatically or even fall in value, the average return you earned would be reduced. Of course, this is the trade-off for reducing overall risk by being diversified. But in a mutual fund with a large number of assets, it becomes even more magnified than it would in your individual portfolio. In addition, if a fund becomes too large and has too much money to invest, it could begin having trouble finding suitable investments to purchase for the fund.
Costs
The mutual fund companies do not provide these simple investment vehicles for free. The financial professionals overseeing and working for the fund need to be paid, which comes from the fund assets. Other costs, such as for advertising, record keeping, customer service, and brokerage commissions are also paid by the fund. As an owner of shares in the fund, you are contributing to the payment of these costs.
Taxable Event Timing
When you own securities directly, you decide when to buy and sell them. This means that you have control over when you realize capital gains or losses for tax purposes. With a mutual fund, the managers make that decision, so you could receive capital gains from a fund whether you want them or not. Even if you have distributed capital gains that you receive from a mutual fund reinvested in additional shares of the fund, it will still be a taxable event.
There are numerous costs associated with mutual funds, which are passed along to investors in one way or another. The cost of actually buying the shares of the fund—similar to a sales tax or a commission—is referred to as its load. The load can be either a front-end load, a back-end load, or no-load. A fund with a front-end load means that you will pay a fee to buy the shares of the fund, while one with a back-end load means that you will be charged a fee to sell the shares of the fund. No-load funds do not charge a fee to either buy or sell their shares. There are a large number of no-load mutual funds available, so I would suggest trying to avoid load funds unless you find one with unusually high returns that offset its load charges. The money that you save by not paying a load can be put to work for you.
In addition to the potential loads, there are other expenses associated with running a mutual fund, as we’ve discussed. Management fees include the cost of hiring and employing the fund managers. There are also administrative fees, which cover the cost of record keeping, customer service, and other support functions for the fund. The broker that buys and sells the securities will also charge commissions to the fund, and the fund will have some advertising expenses. Costs such as these are reported as 12B-1 fees by the fund. All of these annual costs for the fund are represented in a helpful statistic called the fund’s expense ratio, which is the percentage of the fund’s assets that is being used to pay its operating costs. The lower the fund’s expense ratio, the more your money is working for you and the other fund owners, rather than being used to pay the fund’s costs. When you begin shopping for mutual funds, be sure to check the fund’s expense ratio and compare it to that of other similar funds.
Mutual fund performances are rated by several different agencies. One of the most commonly cited is the Morningstar rating, which awards stars in several categories of performance criteria. Funds are rated against similar types of funds, with the lowest rated receiving one star and the highest rated in the group receiving five stars. Many of the online financial sites will have mutual fund screeners, just as they do for individual stocks and bonds. The ratings can be a factor in any search that you do. In addition, the fund’s rating is usually reported on its website.
HOW DO YOU BUY THEM?
Mutual funds are easily purchased from the fund families that offer them. Once you’ve found a fund that you wish to buy, either visit the website for instructions on purchasing it or give them a call. Usually, you can link your bank account to the fund family for ease of transactions. This can be used to facilitate the flow of funds both to purchase shares and for the proceeds from shares that you sell. Once you own one mutual fund within a family, buying shares of other ones within the family is even easier, since your bank account is already linked to the fund family. You can also buy mutual funds through your broker if you wish to or through a financial planner or advise, discussed in Chapter 30. Bear in mind, however, that you will usually have to pay your broker or planner/advise a commission to do so.
TAX TALK
It is important to remember that any capital gains—either distributed through the fund or from selling the fund’s shares—will be taxable. Dividends and interest payments will also create a taxable event, except for those from a tax-exempt fund, most likely. Even if you reinvest taxable proceeds into additional shares of the fund, they are still subject to taxation. With tax-free mutual funds also keep in mind that any distributed capital gains in the fund may be subject to income tax.
WHERE WOULD THEY FIT IN YOUR PORTFOLIO?
Mutual funds can be an easy, low-cost way to gain diversified investments. They also reduce the amount of decision-making you will need to do because the fund manager will be deciding which securities to buy and sell for the fund. The diversification within the fund portfolio also helps to lower your overall risk. By reinvesting the dividends and distributed capital gains you can also take advantage of the compounding principal. Mutual funds can play an important role in both your regular investments as well as your retirement investments. The trade-off is that you are paying someone else to manage these asset elements for you. They can be especially useful for people who are not comfortable with choosing individual securities but want to have assets that allow them the possibility of greater returns than cash. When you have retirement assets through an employer, it is likely that they will include mutual funds, so being familiar with them is important.