What is a Mutual Fund ?
A mutual fund investor must decide between passive or active management, stick to a plan, understand fees, and choose where to buy funds. Would you like to mimic the market or try to beat it? This is not a difficult decision to make. One approach is more expensive than the other and does not necessarily offer better results. Actively managed funds are those that are managed by professional managers.
These managers research and buy with a goal of beating the market. There are fund managers that have done this successfully over the short term. However, it is not easy to outperform the market regularly over the long term. Because of the involved human touch, these funds cost more. Passive investing is simpler and often delivers better results. Many people opt for passive investing because there are fewer fees involved and it is cheaper. The index fund is the most common passive investment. Patience pays; have this in mind when considering your budget. To be on the safe side, make sure that you can leave the amount you have decided untouched for five years or more.
These questions should help you as you come up with a budget: How much do you need to begin? Mutual fund providers always have a minimum amount set. It is the least amount you can open an account with and start investing. Other brokers have not set a minimum amount while for others it could be anywhere from $500 to $3000. How should you invest the money? What should you settle on as your initial mix of funds? Older investors should not ride out risky bets because they are closer to retirement age. Stocks require that you have a brokerage account, but mutual funds give several options.
If you contribute to a 401(k) or any other employer-sponsored retirement account, you are probably already investing in mutual funds. Another alternative is to purchase the fund directly from the company that created it such as BlackRock Funds or Vanguard. A wise idea would be to look for an online brokerage and buy from them. Many of them offer a wide selection of mutual funds.
If you opt for a broker, consider the following: Fund choices, Affordability, Educational and research tools, and Ease of use. Active vs Passive: actively managed accounts offer great services, but the cost is also high. Regardless, companies charge you an annual fund management fee, among other costs related to running the fund. This fee is usually a percentage of your invested cash and is called the expense ratio. It is difficult to determine these fees upfront, but you should at least try to understand them because they can greatly reduce your returns over time. Mutual funds do not usually have commissions, but transaction fees may be involved.
There is also a sales load. After determining your preferred mutual funds, start thinking about managing your investment. It would be wise to rebalance your portfolio yearly so that you can keep it in line with your plan of diversification. Another thing is, try to stick to a plan and do not chase performance. Always remember that, “past performance is no guarantee of future performance.” When it comes to choosing mutual funds for your investment portfolio, you have so many options and this can be overwhelming.
Every investor’s situation is different, but it is always a wise decision to go with funds whose investment strategy you understand and those that are compatible with your portfolio. Another good idea is to be up to par on the fees you must pay and the overall quality of the fund. Before you start buying shares, consider your reasons for investing. Do you have financial goals? Are you looking for a current income or long-term capital gains? When you have clear goals, it becomes easier to choose the right fund to help you achieve that goal.
For instance, money market funds are the best for short-term goals. Bond funds are great for goals to be achieved in a few years. If your goals are long-term, stock funds may suit you just fine. Another thing to consider is risk tolerance. Will you be okay, will dramatic swings or are you looking for a conservative investment? For the former, stock funds may be a better choice for you while for the latter, you may want to investigate bond funds. You should also ask yourself this question, “do you care more about outperforming the benchmark index of your fund or does your investments’ cost matter more?”
Index funds are the way to go if you answered, “cost”. Finally, consider the amount you have available for investing, how you should invest it and taxes. The internet makes it so easy to find funds. Most mutual fund companies now have websites and you can always Google search a specific fund family or fund. If you still have not decided on a fund company, search for specific terms based on your preferences. There are many online services that will help you identify different possibilities. Kiplinger and Morningstar, LipperLeaders, MAXFunds , and FundReveal. Brokerages are also great sources of information and they offer guides. You can buy mutual funds through financial planners, banks, a broker, or insurance agents. You will be required to pay a load (commission fee). Some companies allow you to buy their mutual funds directly from them—most no-load funds are bought directly.
You can buy no-load funds from brokers as well. Mutual funds can be bought through no- or low- transaction free programs. These programs (sometimes called fund supermarkets) usually provide multiple funds from various companies. They offer consolidated record keeping which includes all the sales they have made. Fidelity’s FundNetwork, Vanguard’s FundAccess, and Schwab’s OneSource are good examples of these programs. Once you know the fund you want to purchase, look at the price. Many shares are priced using their Net Asset Value (NAV); that is, the assets of a fund minus its liabilities. The value of a single share in the fund is the NAV per share.
This is the number you will see quoted in newspapers or online. Mutual funds are the go-to investment option for many people starting the journey of investment or for those looking for more investment opportunities. A mutual fund exposes you to a wide variety of industries and you do not have to do the heavy lifting of picking out individual stocks. However, all mutual funds are not equal. If you pick out the wrong one, you may end up paying ridiculous fees or worse, investing in a sector that will eat up your returns. Here are the mistakes you should avoid when picking out a mutual fund.
The fund determines the amount of fees you will pay. Mutual funds that are actively managed or those that have their stocks picked by a fund manager obviously have higher fees than passive mutual funds, like an index mutual fund. There are more fee differences apart from this one. Some funds pay a commission to brokers when they sell the fund to an investor. This commission is referred to as a front-end load; it can be as high as 5% of your invested assets and you pay it upfront. Again, when you sell the fund you are charged a fee known as a back-end load.
The sooner you sell the fund, the higher the fee will be. If you want to pay as few fees as possible, invest in a no-load fund—it usually has no commission when you sell or buy the fund. If you do not thoroughly evaluate the fees associated with a fund, you risk diminishing your returns. Most people invest based on past performances, hoping that history will repeat itself. Past performance does not determine future performance. Just because a fund has been doing well over the past couple years is not an indication that it will always perform well.
Consider the time horizon, the exposure, and whether it matches your risk tolerance. Past performance should only help you narrow down your choices, but it should not be your main reason for choosing a fund. A good number of investors bought mutual funds using retirement accounts sponsored by their companies. Nonetheless, they will also choose to invest outside these retirement accounts. If these investors are not careful, a tax event may occur.
Any mutual fund that has a high turnover rate, for example, will attract more tax events. Far too many investors think that once you invest in a mutual fund, you have nothing else to do. They forget (or are unaware) that a fund has underlying investments. People with a single mutual fund may get away with this but if you have invested in different funds (for diversification purposes), you have some work to do. Obviously, all your mutual funds do not have the same investments.
The reason for investing in multiple funds is so that you can be diversified. Regardless of your style of investment, you can never fail to find a mutual fund that suits your needs. Each mutual fund is different from the other in terms of rewards and risks. Generally, mutual funds with a higher return potential also have higher loss potential. Funds may have different levels of risk, but the fact remains—you cannot completely diversify away risk with any fund. For every mutual fund, there is a predetermined objective for investment; it tailors the assets, investment strategies, and investment regions of the fund. Basically, mutual funds come in three flavors based on what they invest in: equity funds invest in stocks, fixed-income funds invest in bonds, balanced funds invest in both bonds and stocks, and money market funds go for the risk-free rate. All the other asset classes are a variation of these three. Here are the various flavors of funds.
The money market is made up of safe short-term instruments of debt, mainly government treasury bills. If you are looking for a safe investment, this is it. The returns are not substantial but at least you are sure you will not lose your principal. Income funds are meant to offer a steady stream of income. They primarily invest in high-quality corporate and government debt. They hold the bonds until they mature to get interest. The value of fund holdings can be appreciated but the main objective is to give investors a steady flow of cash. Bond Funds invest and trade in different bond types. Bonds are managed actively and aim at buying undervalued bonds then reselling them at a profit.
You are likely to get higher returns with these mutual funds than with money market investments and certificates of deposits. Bonds come in many types. The main goal of balanced funds is to offer a balanced mixture of capital appreciation, income, and safety. They invest in both equities and fixed income. There must be a set minimum or maximum for each class of asset. Equity funds invest mainly in stocks and they are probably the biggest mutual funds category. Their main investment objective is long-term growth of capital.
Equity funds come in many types because there are numerous kinds of equities. Global/International Funds, also known as a foreign fund, an international fund only focuses on assets that are outside your country. Global funds, on the other hand, invest anywhere all over the world, even in your home country. The risks of these funds are unique. Specialty funds are not diversified—they focus on a specific strategy or sector of the economy (health, technology, financial, etc.) Index Funds seek to simulate a broad market index’s performance. They are also managed passively. Investors of these funds get the benefits of low fees. Exchange Traded Funds (ETFs) are very popular. They are not mutual funds, but their strategies are like those of mutual funds.