What you need to know about mutual funds

Discover 10 essential things you need to know about mutual funds. Types of funds and costs, benefits and risks, and how they differ from other products.

Jack Bogle is 89 years old. He is also one of the most important people in American finance. Yet, unlike other successful money managers like Warren Buffet, very few people would recognize him.

Jack founded Vanguard in 1975 and as of January 2018, the company had more than 20 million customers. At that time, its total assets under management were $5.1 trillion making it the second biggest money manager after Blackrock, which has more than $63 trillion.

The difference between Vanguard and other money managers is the approach to investing. The company specializes on mutual funds. Its core purpose is ‘to take a stand for all investors, to treat them fairly, and to give them the best chance for investment success.’ Unlike other managers, the company does not charge high administrative and incentive fees. As a result, the company has not produced billionaires. In fact, Jack Bogle is worth less than $100 million. This article will look at the mutual fund industry that Bogle pioneered and highlight its most important aspects.

What is a mutual fund?

As an investor, you can decide to go it alone and conduct your own in-depth research on securities that you might invest in. Alternatively, you can give your investment funds to a money manager who invests in securities they believe will do well. The challenge with this is that many managers tend to charge exorbitant fees. For example, hedge fund managers charge a 2% administrative fee and another 20% incentive fee. This means that if you have invested $2000 and the manager delivers a 10% return, the manager will pocket $80. Your profit, on the other hand, will be $120.

In a mutual fund, investors pool their money together and give it to a money manager. They direct the manager on the type of investments to make. For example, if it is a large cap bond fund, the manager will find opportunities in the large cap stocks. The profit of the mutual fund is then distributed to the fund holders. The manager receives a management fee.

What is an expense ratio?

The expense ratio of a mutual fund is very important. It is the cost mutual fund companies charge investors to manage the fund. It is calculated by dividing the operating expenses of the fund and the total dollar value of the fund. For example, if the fund has assets of $1 million and the expenses are $25,000, the expense ratio is 0.025. In most cases, the common expense ratio is usually between 0.5% and 1%. It rarely goes above 2.5%.

There are many factors that affect the expense ratio of a fund. For example, an international fund will have a higher ratio because of the extra costs associated with international travels. In addition, the total number of the people managing the fund determine the costs.

Other costs

Apart from the expense ratio, it is important for you to understand the other costs associated with mutual funds. The front load are the charges required when you invest in the fund. For example, if you want to invest $1,000 in a mutual fund that has a 5% front load, you will need to pay $50. The back load is charged when you sell the fund. It is also known as the deferred sales charge. There are other funds that have a ‘no load’ or ‘load waived’ policy.

Benefits of mutual funds

There are a number of benefits of investing in mutual funds:

  • Diversified account: A mutual fund allows your funds to be in a diversified portfolio. You can invest in hundreds of companies at a given time. You can also invest in a mixed fund that has both stocks and bonds.

  • Professional money manager: A fund is managed by a professional manager who is experienced in making investment decisions.

  • Low fees: The fees charged by a mutual fund is less than that charged by other investment professionals as explained above.

  • Minimum balance: To invest with some money managers, you need a large minimum balance. Many hedge funds require that you have a minimum balance of more than $1 million. This is unaffordable to many people. On the other hand, many mutual funds allow people to invest with as little as $100.

  • Track performance: Unlike hedge funds, with mutual funds, you can easily track the performance of your investment.

Risks of mutual funds

As with all investment products, mutual funds come with their risks:

  • Poor performance of portfolio: When stocks lose, the performance of the mutual fund will lose as well.

  • Default risk: A mutual fund that invests in corporate bonds can suffer when the underlying companies default on their obligations.

  • Currency risk: For mutual funds invested globally, the depreciation of the local currencies could affect the performance.

  • Interest rates risks: For bond mutual funds, an increase in interest rates could lead to losses. When rates rise, the performance of bonds declines as well.

  • The money manager: When the money manager leaves the firm, the performance of the fund could be affected.

Past performance is not an indication of future performance

When making a decision on the mutual fund to invest in, you will likely consider the past performance. However, it is important to note that the past performance of a fund does not always mean that future performance will be good. To decide on the fund you want to invest in, you should look at the company offering the fund, the money manager and how long they have been with the fund. You should also look at their track record and career background.

How mutual funds make money

Mutual funds make money in a number of ways. Funds that invest in stocks make money when the stock price moves up. For example, if a stock of a company moves from $10 to $13, the value of the fund invested rises by 30%. They also make money from the dividends that are paid by the companies. Those that invest in REITs make money from the stock price and the annual distribution. Those that invest in bonds make money from the yields generated from the bond.

Type of mutual funds

There are different types of Mutual funds that depend on the assets that the fund invests in. They can be divided into stock funds, bond funds, hybrid funds and money market funds.

  • Stock funds: These are funds that invest in company stocks. They can further be categorized according to the size of the fund, the industry and the geography. With size, the fund can be divided into small cap, penny stock fund, large cap fund, and mega cap fund. With industry, the fund can be divided into technology, finance, consumer cyclical, consumer discretionary, materials, industrials, healthcare, real estate, communication and utilities. With geography, they can be divided into global, emerging markets, domestic and frontier markets.

  • Bond funds: Funds that invest in bonds can be categorized into treasury funds, high yield funds, corporate funds and municipal funds. They can also be categorized according to where they invest including domestic, emerging markets, frontier markets and global funds.

  • Hybrid funds: These are funds that invest in both stocks and bonds.

  • Money market funds: These are funds that invest in short term debt securities like treasury bills and commercial paper.

According to structure

  • Open-end funds: These are funds that don’t have a fixed amount to invest. They keep on adding shares which means that they are bought and sold on demand. Most mutual funds are in this category.

  • Close-end funds: These are funds that have a set number of shares available. Like shares, they are traded in an exchange where their prices move up and down depending on supply and demand. They are often traded at a discount of the net asset value (NAV).

  • Load funds: As mentioned above, these funds require the investor to pay a sales commission in addition to the funds that they buy.

  • No-Load funds: These are funds that don’t charge investors a fee to invest.

Open for everyone

A common misconception about mutual funds is that they are not intended for young people. However, the earlier a person starts to invest in funds, the better it may perform for them. This is because, by the time they retire, their investment will be worth much more. Like with all investments, a good risk strategy for investing in mutual funds is to diversify your portfolio and returns with other securities such as stocks, bonds and even more high-risk/high-return vehicles like Forex.

Start investing in mutual funds today

In most mutual funds, you don’t need a lot of money to get started. It is possible to create a portfolio of different mutual funds with less than $5000. The key to success is to conduct your due diligence on the funds. Here, you should look at the historical performance of the fund, the manager of the fund and the constituents of the fund.

Source   Presented by OctaFXForex Columns
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