To return to home page, Click Here.

Chapter 16 – Investing in Mutual Funds

 

I.                   Mutual Funds – General Overview

 

A. Mutual funds have become very popular in the United States. 

 

Examples:

 

An estimated 93.3 million individuals own mutual funds in the USA.

 

The number of mutual funds has grown from 361 in 1970 to over 8,300 in 2001.

 

The combined value of assets held in mutual funds in 2001 was almost $7 trillion.

 

B. A mutual fund.  What is it?

 

A “mutual fund” is an investment that pools money to buy stocks, bonds, or other investments.

 

The mutual fund is managed by an “investment company” that buys and sells stocks, bonds, etc, and charges a fee for managing the fund.

 

A “family of funds” is run by the same investment company (such as Merrill Lynch).

 

C. Why so popular?

 

Mutual funds are popular for two reasons:  diversification and professional management.

 

Diversification:  While it may be difficult for an individual to adequately diversify his/her portfolio, this person can “instantly diversify” by buying into a mutual fund that holds a basket of stocks.

 

Professional Management:  Mutual funds are usually managed by investment experts.  However, interestingly, most mutual funds “under perform” (do worse than) the market index.  (This is a strong case in favor of the Efficient Market Hypothesis.)

 

II.                Types of Mutual Funds

 

There are three types of mutual funds that you will need to remember.  They are Closed End Funds, Exchange Traded Funds (or ETFs) and Open-Ended Mutual Funds.

 

  1. Closed End Fund

 

A mutual fund whose shares are issued only when the fund is organized.  These shares trade on an exchange, and, can be bought or sold throughout the trading day.  Closed end funds sometimes trade at a discount to their “net asset value” (very large disadvantage).

Closed End funds are the least popular type of mutual fund, and, have become even less popular in the last few years.

 

As a basic investor, do not invest in closed end funds.

 

  1. Exchange Traded Funds

 

Exchange traded funds are relatively new, and, increasingly popular.  An ETF invests in the stocks that are contained in a specific index, such as the S&P 500 (the ETF’s symbol is SPY) or the Nasdaq 100 (QQQQ), or the Dow Jones Industrial Average (the Dow “Diamond”).

 

The ETF can also be traded anytime during the trading day.  The number of shares is not limited.  ETF’s have “passive management” (management makes no buy/sell decisions.  Management merely buys the stock index.)

 

ETF’s are popular for many reasons: (1) very low management fees, (2) very broad diversification, (3) often beats actively managed mutual funds in net returns, and (4) easy to track returns.

 

  1. Open End Funds

 

These are the funds you think of when you think “mutual fund”.  For example, the Fidelity Magellan Fund, the American Funds’ “Investment Company of America.”

 

 

Open End Funds (like Closed end funds) are generally Actively Managed.  Open end funds can only be bought or sold at the end of the trading day.  There is no preset number of shares.  Open End funds’ shares are issued and redeemed by the investment company at the option of the shareholder.

 

“Net Asset Value” or “NAV” is the value of the fund’s net assets divided by the number of shares outstanding.

 

Typically, you can sell your shares at this price (minus any early withdrawal fees, usually on Class B shares –more later).  You can buy shares at the NAV if the fund is no-load (more later on load vs. no-load.)

 

III.             Expenses Associated with Mutual Fund Investing

 

Investment companies charge various fees to manage your money in a mutual fund.  These fees are usually based upon a percent of the amount invested.  The names and timing of these fees will vary.  And, so will the amounts of these fees.  So, know the “fee structure” before you invest.

 

 

  1. “Load Funds”

 

A “Load Fund” charges the commission upfront.  A “load fund” is a mutual fund in which investors pay a commission upon the purchase of shares.  This commission typically ranges between 3% and 6%. 

 

This “load” reduces the net amount of your original investment.  For example, if you invest $1,000 in a fund that has a 5% load, then you will buy only $950 of the mutual fund’s shares.  (your tax basis is still $10,000).

 

Load funds are typically bought through a stock broker, and, the “load” serves as the commission for the broker.

 

 

  1. “No Load Funds”

 

No-Load Funds do not charge an upfront commission.  You will buy these funds directly from the Investment Company.  However, recently, Charles Schwab, TD Ameritrade, and E*Trade have begun offering “no load funds” directly to consumers.

 

Of course, if you purchase “no load funds”, you are foregoing any professional advice from a broker.  Experienced investors are the most frequent purchasers of “no load funds.”

 

  1. Contingent Deferred Sales Loads

 

A contingent deferred sales load is charged when you sell your shares early.   Some types of funds charge a load when you sell before five years.  You pay this “load” when you sell, not when you buy.  If you hold the fund shares for more than five years, then, the fund is essentially a “no load fund”.

 

  1. Management Fees (Other ways to get your money)

 

 

Marketing is everything.  And, mutual fund marketers know this too.  Thus, they have come up with different ways to charge fees that may look better to you (but, make no mistake, you’re still paying the fee at some point).  They have come up with the following:

 

There are two ongoing fees (charged annually against your account):

 

1. Management Fees – the fees charged for the professional management (pays the salaries of the investment professionals and support staff).  This fee is on an annual basis (it’s ongoing) and varies between funds from 0.25% to 2% of your investment (usually about 1%).

 

2. 12b-1 Fees – the fees charged for marketing the fund and for distributing literature (pays the salaries of the marketing people and for advertising).  Named for the provision of the SEC law that allowed this fee to be charged.  This fee varies between 0.5% and 2%. 

 

NOTE:  The Management Fee and the 12b-1 Fee (unlike the Loads which are one time fees) are annually recurring fees.

 

  1. New Ways to Market the Mutual Fund – Different Share “Classes”

 

Mutual Funds have come up with hybrids of the one-time fee and the annual fees (different combinations) to create a new way of marketing mutual funds.  The marketers have introduced different “classes” of funds (Class A, B, and C).  The difference in the classes:  when you pay, and how much you pay, in fees.

 

  1. Class A – the traditional upfront load.  You pay a “load” on the initial investment (and the management fee, and, a reduced 12b-1 fee).
  2. Class B – the traditional “contingent deferred” charge.  If you sell the shares before the time limit (usually 5 years), you pay a “load” as you sell.  You also pay the management fee, and, a reduced 12b-1 fee).
  3. Class C – a “no load” class for the mutual fund.  You do not pay a front “load” when buying the fund.  Nor do you pay any contingent fee regardless of when you sell.  But, you do pay the management fee, and, a HIGHER 12b-1 fee.

 

Which to choose?  It’s really tough to say.  But, be assured that the mutual fund companies have worked it out that you’re paying about the same if you hold the fund for the average length of time.

 

(Personally, my investments are long term, and I buy the Class B shares.  But your decision may be different).

 

IV.              Classifications of Mutual Funds (according to the types of their investments)

 

  1. Stock Funds

 

  1. Growth Funds – buys stocks in growth companies.  Ex. Google, Apple

 

  1. Income Funds – stresses more conservative, dividend paying stocks.

 

  1. Global Funds – invests throughout the world, including the USA.

 

  1. International Funds – invests in foreign stocks only (no investment in USA stocks).

 

  1. Index Funds – “buying the index”.  The mutual fund buys the contents of a stock index.  Much like an ETF.  Usually No Load with very small management and 12b-1 recurring fees.

 

  1. Large Cap Funds – generally over $5 billion in market cap.

 

  1. Mid Cap Funds – generally between $500 million and $5 billion in market cap.

 

  1. Small Cap Funds – generally up to $200 million or $500 million in market cap.

 

  1. Bond Funds

 

  1. High yield (junk bond ) Funds

 

  1. Municipal Bond Funds – remember dividends are federal tax free in your home state.

 

  1. Intermediate or Long Term Corporate Bond Funds

 

  1. Intermediate or Long Term U.S. Treasury Bond Funds

 

  1. Short term U.S. Treasury Bond Funds

 

  1. World Bond Funds

 

  1. Other types of Funds

 

  1. Asset Allocation Funds or Balanced Funds
  2. Money Market Funds (not insured by FDIC)

 

  1. General Definitions

 

  1. Family of Funds – a group of funds (of different types) offered by the same investment company.
  2. Automatic Reinvestment Plan – your dividends and capital gains from the fund are automatically used to purchase additional shares in the mutual fund.
  3. Dollar Cost Averaging – an investment technique where you put up the same amount of money each month (say $200) regardless of the price of the shares.
  4. Market Timer – someone who attempts to capitalize on changing market conditions by switching investments between funds.

 

V.                 How to Pick the Right Funds for You

 

  1. Your Goals

 

  1. Risk Tolerance
  2. Time Frame for the investment

 

  1. Tax situation

 

  1. Diversification

 

  1. Return and Risk Profile of the Fund

 

  1. Type of investments in the fund
  2. Historical return and risk of the fund (track record)
  3. You can get 1 year, 3 year, 5 year, 10 year performance in Prospectus or at Morningstar.com
  4. Morningstar Rating of the fund

 

VI.              Information on Mutual Funds  (objective information!)

 

  1. Morningstar.com

 

There is much information on this site (for free!).  Morningstar also markets a rating service for mutual funds – which you can usually get for free, also.  You must register at Morningstar.com , but, registration if free.  There are also some paid services.

 

  1. Mutual Fund Guides from Money Magazine, Kiplinger’s, Wall Street Journal, many other sources.