A good financial advisor will try to explain concepts in such a way that their clients can really grasp the knowledge. As obvious as that may sound, many people who work with financial advisors do not learn much about how to make financial decisions, they merely pay to have those decisions made for them. Mutual fund investing is one such financial concept that all investors should know about. If you haven’t already, you’ll likely encounter mutual funds at some point during your financial life, through either your individual savings, or a company retirement plan. According to the Investment Company Institute, which compiles statistics on various investment classes, currently over $9.5 trillion is invested through more than 10,000 mutual funds in the United States.* In fact, many retirement plans require their participants to use mutual funds rather than individual stocks to prevent them from taking on too much risk. Imagine if inexperienced investors decided to put the full balances of their 401(k) plans into the stock of a single company? What if the company became distressed or went bankrupt? They could say good-bye to their retirement nest eggs, possibly forever.
My own first taste of the stock market was with mutual funds, because I knew they were professionally managed and didn’t require very large initial investments. That turned out to be a great decision, as I still have my mutual fund investment and contribute to it monthly. So, what exactly do you need to know about mutual funds? We’ll start with the basics and then jump into a more detail.
What are Mutual Funds?
Mutual funds are pools of managed money. Their primary purpose is to provide easy access to diversified portfolios of securities. Upon buying shares in a fund, you are really buying smaller position in the underlying securities. Depending on what the fund’s style is, you might be purchasing stocks, bonds, treasury bills, or any other allowable securities. Some mutual funds may be smaller, with only a few million dollars under management, while others may have thousands of shareholders, and the total assets of the fund could be well into the billions. A small percentage of the fund’s’ assets, generally 1 to 2 percent, is deducted to pay management fees and other operational expenses.
When you buy shares in a fund, you are essentially hoping for the underlying investments to do well. This is in part determined by how good a selection job the fund manager is doing. Some managers obviously perform better than others, but jumping into a fund that is having a good year does not mean you’re bound to make money. In fact, while looking at trailing performance over 5- and 10-year periods tends to be a popular performance measure, it doesn’t create any real guarantee as to future results of a fund.
The more important question to ask, prier to selecting a particular mutual fund or portfolio manager, is how you view your own tolerance for risk. This is essentially your willingness to watch your portfolio move around, both up and down, without becoming anxious or being tempted to redeem your shares. For some investors, the stock market is just too volatile; they may prefer bond funds or even money market funds, which are more conservative in nature and generally produce stable streams of income.
After you decide on the proper mix of mutual funds, you can start digging into which specfic fund families you like best. This process is difficult for a lot of investors because they may find 10 or more fund families that offer a similar type of fund. Does it really make a difference which mutual fund family you choose? Obviously some will outperform others each year, but again, choosing among fund companies for performance is anything but an easy task.
What you can look for with a bit more accuracy is a certain fund culture or sense of style. Some companies tend to have more aggressive portfolio managers who take risks, while others stick to index investing. Understanding the basic investment policies of a fund family may help guide you in the right direction if you know what you’re looking for.
What Are Some Different Types of Funds?
Once you’ve investigated your personal risk tolerance and decided to purchase mutual funds, you’ll need to understand the financial jargon attached to them. It would be easier if funds had names like “fund for conservative men in their 30s” or “technology fund for greedy youngsters with money to burn,” but that’s not how it goes. Mutual funds have standard terminology. In a typical retirement plan, you’ll quite possibly see some of the following names:
• Large-Cap Growth Funds — These funds invest in companies which seek growth. A fairly standard characteristic of these types of companies is that they reinvest earnings in the business rather than paying them out to shareholders as cash. The technology sector is a good example of a place to find growth stocks. A common understanding of these funds is that they offer you a great opportunity for profits, but come with a large amount of risk. Large-Cap traditionally indicates that the underlying stocks have market values of $5 billion or more. Growth funds can also be Mid-Cap, Small-Cap, or even Micro-Cap. These are smaller companies that you may or may not be familiar with.
• Large-Cap Value Funds — Rather than seeking rapidly growing companies, Value managers seek out stocks which they believe should be trading at higher prices. This might include a company which makes a hefty profit but is in the midst of a lawsuit. Perhaps investors got tired of tracking progress on the lawsuit and the stock price didn’t resume a fair valuation after the suit was settled. Spotting these sorts of inefficiencies within stock prices is what could potentially make a good Value manager.
• Blend Funds — These funds invest in a mix of growth and value stocks. They typically use a comparative benchmark such as the S&P 500 or the Dow Jones Industrial Average as a way of tracking their success. If they are outperforming the benchmark by several percentage points each year, the manager is considered to be doing a good job. If they are falling short of it, the investor is losing out because they could have purchased a low-cost index fund instead which would have produced a higher return. Blend funds are good for those who want an opportunity for growth along with the reassurance that their funds aren’t being invested too aggressively.
• International Funds — Why stick purely to companies based here in the United States? There are plenty of companies making money oversees as well. Managers understand these opportunities and have designed funds which invest in stocks located outside the United States. There are plenty of variations on International funds such as “Emerging Markets,” which are generally considered riskier because they invest in economies which are considered young and emerging. Global Funds invest internationally as well but they may include US stocks within the fund. Naturally, hold on to your seat if you invest in risky International funds. While they may pay off, you’re playing with all sorts of risks including currency fluctuations and potentially unstable governments.
• Sector Funds — These are mutual funds which invest predominantly in a single area. Sector funds tend to be more volatile than a broad market fund because the stocks have a very narrow focus; however, the risk level depends entirely on the sector. Utilities might not be considered as scary as emerging technologies. Some investors jump into a sector fund when they believe that sector is about to perform extremely well. An example of this would be investing in oil between 2001 and 2006 when turmoil pervaded the Middle East. Other investors choose sector funds as a hedge against other mutual funds in the portfolio. Some familiar sector funds may include financial services, healthcare, utilities, gold, and individual countries.
Why Do Mutual Funds Sometimes Receive Negative Press?
What we haven’t talked about yet is why some people are so opposed to investing in mutual funds. We can consolidate the opinions of most of these people with two related factoids. The first is that mutual fund ownership tends to be expensive. The second is that mutual fund managers, on average, have not shown such outstanding returns to their investors. In fact, many have returned less to investors than investors would have gotten had they bought low-cost index funds instead.
How are these two related? Well, if you’re paying both mutual funds’ expenses and a commission to the broker, you’re probably looking for some sort of return. If your funds don’t perform well, and they also get reduced by various sales charges, fees, and expenses, you’re not going to be a happy camper. For this reason, many investors stick to low-cost index investments.
What Else Should I Know?
Now that you have knowledge about what mutual funds are, what you can expect from them, and how to decipher some financial terminology, which funds are right for you? As I mentioned earlier, your own tolerance for risk will likely be an important factor in choosing a fund.
Two other important factors are the purpose and time frame for your investment. For example, if you’re buying a fund today that you will contribute to every year until you retire, you may want to consider funds with at least a little exposure to stocks. The reason is that you can withstand a bit more volatility than somebody who needs the money in six months to buy a home. If you are trying to make a diversified portfolio of funds, speak to your advisor about finding a good fund mix that gives you adequate exposure to the market and isn’t overly expensive. Remember, those expenses reduce your investment returns and add up over the years.
As always, feel free to e-mail me with questions or comments.
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*Investment Company Institute, “Trends in Mutual Fund Investing,” August 31, 2006.