Mutual funds are professionally managed pools of money sold to individuals in the form of shares. Your individual investment is added to the investments of many others, creating a sum large enough to build a diversified portfolio of holdings that reflect the objective set forth in the prospectus of the particular fund. Interestingly, there are more mutual funds traded than there are individual stocks. The question is: How do we pick a fund and what makes for a good fund; there are several items to look at when making that decision.
Begin by reviewing the Fund Families available to you. You should have one with reasonable operating expenses and a large selection of individual funds which are considered good performers. Your investment needs are likely to change over the years and mutual funds offer no cost transfers to other family funds. Do remember possible income tax impact when swapping around for free.
Cost
Cost is one of the biggest concerns and mysteries when it comes to mutual funds. First, there are traditional mutual load funds and traditional no load funds. The difference is if you pay a sales fee or not. There are also exchange-traded funds (ETFs) which are sometimes referred to as “closed-end funds”. The ETFs are covered in the stock chapter.
Our discussion in this section pertains to the traditional open-end mutual funds in which we are examining funds that accept money to buy new or additional products on an ongoing basis. All open-end funds have operational and managerial costs because they are actively managed. In addition, there are internal trading expenses and various fees which are subtracted from the invested funds. Those expenses affect the performance of your investment. Obviously, the fund with the lower expenses is likely to out perform a similar fund with higher costs.
When purchasing a fund through an adviser you are likely buying a “loaded” fund. Note that when you buy a particular fund, you are, in effect, also buying that Fund Family and all of the privileges that are available within that Family. Investors are allowed as we said, to switch to and from that family’s funds at almost any time within the fund family at no additional cost. However, it is important to remember that tax consequences should always be taken into consideration when making any swaps of funds if your investment is outside of a retirement account.
You should select a fund family that will accommodate your changing needs well into the future. This takes careful consideration because ideally, you will own those funds for many years to come. No load funds usually have lower expenses, but don’t just assume they do; check and remember that an advisor can be of great help and significant value to you. Index funds are popular and may be a valuable investment tool. They should be a low cost investment tool, but may not be the best choice for you. See the Asset Allocation topic for a more extensive review.
Mutual Fund Allocation:
Your success as an investor requires employing a proper asset allocation. A mutual fund is a very good instrument for allocation in a smaller account. Asset allocation has several components. First it must be truly diversified, which means that your fund doesn’t own one kind of stock, (large cap growth) or two funds that still own only one type. Diversification only works if you are diversified all of the time. Mutual fund investing is the best starting tool for a small account as it can be a single vehicle providing a diversified portfolio of stocks and/or bonds.
Every mutual fund has an overall objective. It may be a Growth and Income fund, an Income and Growth fund, a balanced fund, a Growth fund, a Value fund, or a Bond fund. These can be bought according to whether the companies in the fund are of small, middle, and large size. A fund that owns all sizes is often referred to as an “all caps” fund.
In addition, there are funds that are very specific, such as sector funds. They own a selection of company stocks limited to one industry group. They either give you an allocation within an industry or they could be restricted to specific geographical areas. The key is to build an allocation that fits your portfolio by making sure you have an appropriate exposure in each of the categories you wish to own. Mutual funds are great tools to incorporate a stock portfolio of a high-risk asset class such as small and micro companies or foreign investments. There is risk in picking individual small company stocks or foreign stocks because of the limited research opportunities. Here you may be hoping the one you choose will become a ‘super company’ without being able to do all of the necessary homework, thus you are playing very long odds.
Selecting a Fund
Human nature tells us to select a fund with a high current return, but is that present return sustainable? What are the managers doing to generate the return? What is the track record of the fund compared to similar funds and does that record belong to the current manager(s)?
Another important criterion is the risk versus return factor. A perfect investment is one with the highest level of return combined with the lowest risk (volatility). Every fund, whether conservative or aggressive has a risk to return ratio that should not be ignored. How much price fluctuation do you experience relative to your return? See the Stock and Allocations sections.
There are several tools available to help in determining the return of a fund. The beginning piece is the Net Asset Value (NAV). The NAV is calculated daily when the basket of company stocks and bonds are closed for trading for the day. The value of the pool is then divided by the number of shares outstanding. As that NAV increases or decreases, the investor gains or loses based on the net value of the fund. An additional and very valuable piece to the equation is the yield of the fund. The yield measures the income generated from the dividends or interest from the portfolio. The appreciation of NAV plus the income yield gives you the true measure of the fund and is identified as the Total Return.
Mutual Funds are required to report Capital Gains/Losses, and dividends and interest at least once a year. These are normally calculated and paid in November or December. It is important to remember that if you buy a fund shortly before the ex-date, you will receive a dividend payout which was actually earned earlier and is already built into the price you paid for the shares. This means that you bought the payout and now have the opportunity to pay tax on gains you just bought, if this is occurring in a taxable account. As an alternative, it would be good to buy your favorite just after the record date. The gains due to you may be a check made out to you or, more commonly, you are presented with additional shares purchased by the payout. Regardless of the kind of shares you own, there are no fees with this transaction. You will see the change in the number of shares you own on the first statement sent after the declared dividend is paid.
