Financial Literacy Month: What is a Mutual Fund?

MintLife is continuing their contribution to Financial Literacy Month by tacking another personal finance topic: mutual funds. You can catch up on this ongoing series, by reading the first installment, “What are Equities?”

What is a Mutual Fund?

Investing can be pretty scary stuff. Financial fraud, volatile markets, crooked brokers, macroeconomic headwinds – we are constantly bombarded with news of investors losing their shirts after dipping their toes in the nebulous investment universe. But investing doesn’t have to be such a daunting task. There are a number of ways the average investor can distribute risk across their portfolio so that they can sleep easy at night. One of the most popular ways to do that is to invest in a mutual fund.

The mutual fund is the quintessential collective investing scheme. It is basically a variety of securities (stocks, bonds, etc), which are owned collectively by a large number of investors. The securities make up a single fund and shares are sold to investors based on their collective value. It is managed by a group of financial professionals who make all the investment decisions on the fund’s behalf. If the securities in the fund increase in value, then the value of your shares also rise, equating to a positive return on your initial investment.

The aim of a mutual fund is to yield a greater return for their investors than they would have normally received by investing their money alongside an index of some sort, known as a benchmark. For example, if a mutual fund is invested primarily in equities, which are stocks (see last week’s piece), then the fund managers will try to beat the performance of the Standard and Poor’s 500 index, which is a stock index that tracks the rise and fall of 500 stocks that trade in the US.

Which Mutual Funds Should I Invest In?

There are over 10,000 mutual funds available in the US for you to invest in. There are massive, multi-billion dollar funds and there are small boutique funds. There are funds that invest in higher-risk securities and some that invest in securities that have a very low risk profile. But for the most part, mutual funds tend to be divided into three main types: equity funds, fixed income funds and money market funds. Equity funds invest in stocks; fixed income funds invest in debt, like bonds; and money market funds invest in super safe short-term debt securities, like bonds issued by the US government.

Money market funds yield the lowest return for investors out of the three because it is very low risk. The equity and fixed income funds have varying levels of risk and returns based on what they are holding. When you go to invest in a fund, you will be able to see the risk level of the portfolio and can invest accordingly. Funds that are labeled as “growth” funds tend to be riskier than those that are “value” funds. Your risk tolerance is based on your comfort level and on how close you are to retirement.

Why Invest in a Mutual Fund?

Mutual funds are a solid option for people who don’t want to get their hands dirty investing, but who also aren’t keen on seeing their cash locked away in some low to no yield checking or savings accounts, either. There was a time that you could park your cash in a bank savings account or a bank certificate of deposit and receive a relatively decent return on your money. But with the Federal Reserve keeping interest rates so low due to the sluggish economy, chances are you would be better off just stuffing your cash under your mattress than locking it away in a bank.

By pooling your money with others in a mutual fund, you not only get to spread out the risk, but you also are able to take a lot of the guesswork out of investing. You don’t have to spend hours researching a particular stock or a bond – that work has been done for you (hopefully) by the fund managers. And you don’t have to pay the high brokerage fees to buy and sell a security – the fund manager can do that at a much cheaper rate. All you have to do is hand over your cash and go on your daily business. You’ll receive a statement in the mail every few months or every year updating you on how the fund has performed.

The Disadvantages of Investing in a Mutual Fund

But while there are many advantages in investing in a mutual fund, there are also several disadvantages as well. The one that always miffs investors is the fees. Generally, investors have to pay a fee to buy and/or sell their shares in the mutual fund. This fee is known as a “load” and it covers the sales and marketing expenses to the broker who sold you the fund.

When you are invested in a fund you need to pay a few other fees to maintain it. First, there is the management fee, which covers the salaries and personal expenses of the managers running the fund. This fee is usually worth 1% to 2% of the assets you have invested in your portfolio. The fee is paid daily, but is calculated on an annual basis. Some funds also have a marketing fee, known as a 12b-1 fee, which can cost investors around 0.5% to 1% annually. These two fees make up the firm’s management expense ratio. The lower the fees as a percentage of its assets, the more efficient the fund is at managing your money. Separate from those fees is another fee to cover all the trading expenses associated with the portfolio. This fee fluctuates based on the strategy of the fund. For example, if the fund buys and sells securities often, the fee will be higher than if the fund tends to buy and sit on securities for a while.

Beyond fees there is performance. Mutual fund managers aim to beat an index, not make you money. This means that if the S&P 500 index was down 20% last year, a mutual fund manager would be considered successful if the fund was only down 19%. An absolute return, which is making your money grow regardless of how the broader market performs, is not in a mutual fund manager’s mandate. Sure, the fund manager would like to make you money if they can, but they feel like they have done you a service, and earned their fee, if they were able to mitigate your losses compared to that of the broader market.

There have been many studies conducted over the years that try to track the long-term performance of mutual funds. The results mostly show that, net of fees, the mutual fund industry as a whole has not returned a lot of money to investors. Some blame the high fees, while others say that fund managers aren’t doing a good job. But it is sort of unfair to lump the entire industry together. There are, after all, thousands of funds invested in vastly different securities.

The Bottom Line

The key is to put your money in funds where you think have the best chance of growing over a set time. While you can invest and forget for a while with a mutual fund, you still need to rebalance your portfolio – at least yearly. So if there is a recession, in say, Asia, forecasted for the coming year, you might want to pull your money out of the mutual fund that owns a lot of  Asian stocks and put it in one that invests in something else safe, like US debt. So while mutual funds are a great alternative for people who don’t want to follow the day-to-day drama of the market, it still doesn’t mean you can check out completely.

Cyrus Sanati is a frelance financial journalist whose work has appeared in dozens of leading publications, including The New York Times, BreakingViews.com, and WSJ.com. Follow Cyrus on Twitter @csanati