A mutual fund is a type of investment product where the funds of many investors are pooled into an investment product. The fund then focuses on the use of those assets to invest in a group of assets to reach the fund's investment goals. There are many different types of mutual funds available. For some investors, this vast universe of available products may seem overwhelming.
- Before investing in any fund, you must first identify your goals for the investment.
- A prospective mutual fund investor must also consider personal risk tolerance.
- A potential investor must decide how long to hold the mutual fund.
- There are several major alternatives to investing in mutual funds, including exchange-traded funds (ETFs).
Identifying Goals and Risk Tolerance
Before investing in any fund, you must first identify your goals for the investment. Is your objective long-term capital gains, or is current income more important? Will the money be used to pay for college expenses, or to fund a retirement that's decades away? Identifying a goal is an essential step in whittling down the universe of nearly 7,285 mutual funds available to investors, as of Sept. 2023 figures.
You should also consider personal risk tolerance. Can you accept dramatic swings in portfolio value? Or, is a more conservative investment more suitable? Risk and return are directly proportional, so you must balance your desire for returns against your ability to tolerate risk.
Finally, the desired time horizon must be addressed. How long would you like to hold the investment? Do you anticipate any liquidity concerns in the near future? Mutual funds have sales charges, and that can take a big bite out of your return in the short run. To mitigate the impact of these charges, an investment horizon of at least five years is ideal.
Style and Fund Type
The primary goal for growth funds is capital appreciation. If you plan to invest to meet a long-term need and can handle a fair amount of risk and volatility, a long-term capital appreciation fund may be a good choice.
These funds typically hold a high percentage of their assets in common stocks and are, therefore, considered to be risky in nature. Given the higher level of risk, they offer the potential for greater returns over time. The time frame for holding this type of mutual fund should be five years or more.
Growth and capital appreciation funds generally do not pay any dividends. If you need current income from your portfolio, then an income fund may be a better choice. These funds usually buy bonds and other debt instruments that pay interest regularly.
Government bonds and corporate debt are two of the more common holdings in an income fund. Bond funds often narrow their scope in terms of the category of bonds they hold. Funds may also differentiate themselves by time horizons, such as short, medium, or long-term.
If you are looking to invest outside of mutual funds, exchange-traded funds are a good alternative and are typically easier to buy and sell.
These funds often have significantly less volatility, depending on the type of bonds in the portfolio. Bond funds often have a low or negative correlation with the stock market. You can, therefore, use them to diversify the holdings in your stock portfolio.
However, bond funds carry risk despite their lower volatility. These include:
- Interest rate risk is the sensitivity of bond prices to changes in interest rates. When interest rates go up, bond prices go down.
- Credit risk is the possibility that an issuer could have its credit rating lowered. This risk adversely impacts the price of the bonds.
- Default risk is the possibility that the bond issuer defaults on its debt obligations.
- Prepayment risk is the risk of the bondholder paying off the bond principal early to take advantage of reissuing its debt at a lower interest rate. Investors are likely to be unable to reinvest and receive the same interest rate.
However, you may want to include bond funds for at least a portion of your portfolio for diversification purposes, even with these risks.
Of course, there are times when an investor has a long-term need but is unwilling or unable to assume the substantial risk. A balanced fund, which invests in both stocks and bonds, could be the best alternative in this case.
Fees and Loads
Mutual fund companies make money by charging fees to the investor. It is essential to understand the different types of charges associated with an investment before you make a purchase.
Some funds charge a sales fee known as a load. It will either be charged at the time of purchase or upon the sale of the investment. A front-end load fee is paid out of the initial investment when you buy shares in the fund, while a back-end load fee is charged when you sell your shares in the fund.
The back-end load typically applies if the shares are sold before a set time, usually five to 10 years from purchase. This charge is intended to deter investors from buying and selling too often. The fee is the highest for the first year you hold the shares, then dwindles the longer you keep them.
Class A shares typically have a front-end load, while Class C shares usually have a back-end load.
Both front-end and back-end loaded funds typically charge 3% to 6% of the total amount invested or distributed, but this figure can be as much as 8.5% by law. The purpose is to discourage turnover and cover administrative charges associated with the investment. Depending on the mutual fund, the fees may go to the broker who sells the mutual fund or to the fund itself, which may result in lower administration fees later on.
It's necessary to look at the management expense ratio, which can help clear up any confusion relating to sales charges.
No-load funds do not charge a load fee. However, the other charges in a no-load fund, such as the management expense ratio, may be very high.
Other funds charge 12b-1 fees, which are baked into the share price and are used by the fund for promotions, sales, and other activities related to the distribution of fund shares. These fees come off the reported share price at a predetermined point in time. As a result, investors may not be aware of the fee at all. The 12b-1 fees can be, by law, as much as 1% of your investment in the fund.
The expense ratio is simply the total percentage of fund assets that are being charged to cover fund expenses. The higher the ratio, the lower the investor's return will be at the end of the year.
Passive vs. Active Management
Determine if you want an actively or passively managed mutual fund. Actively managed funds have portfolio managers who make decisions regarding which securities and assets to include in the fund. Managers do a great deal of research on assets and consider sectors, company fundamentals, economic trends, and macroeconomic factors when making investment decisions.
Active funds seek to outperform a benchmark index, depending on the type of fund. Fees are often higher for active funds. Based on 2022 data, the average expense ratio for an actively managed equity fund is 0.66%.
Passively managed funds, often called index funds, seek to track and duplicate the performance of a benchmark index. The fees are generally lower than they are for actively managed funds, with average expense ratios of 0.05% in 2022. Passive funds do not trade their assets very often unless the composition of the benchmark index changes.
This low turnover results in lower costs for the fund. Passively managed funds may also have thousands of holdings, resulting in a very well-diversified fund. Since passively managed funds do not trade as much as active funds, they do not create as much taxable income. That can be a crucial consideration for non-tax-advantaged accounts.
There's an ongoing debate about whether actively managed funds are worth the higher fees they charge. In a 2023 Barron's report, analysts concluded that in 2022, a little more than half of U.S. large-cap equity fund managers performed below the S&P 500 index.
Of course, most index funds don't do better than the index, either. Their expenses, low as they are, typically keep an index fund's return slightly below the performance of the index itself. Nevertheless, the failure of actively managed funds to beat their indexes has made index funds immensely popular.
Evaluating Managers and Past Results
As with all investments, it's important to research a fund's past results. To that end, the following is a list of questions that prospective investors should ask themselves when reviewing a fund's track record:
- Did the fund manager deliver results that were consistent with general market returns?
- Was the fund more volatile than the major indexes?
- Was there an unusually high turnover that might impose costs and tax liabilities on investors?
The answers to these questions will give you insight into how the portfolio manager performs under certain conditions, and illustrate the fund's historical trend in terms of turnover and return.
Before buying into a fund, it makes sense to review the investment literature. The fund's prospectus should give you some idea of the prospects for the fund and its holdings in the years ahead. There should also be a discussion of the general industry and market trends that may affect the fund's performance.
Size of the Fund
Typically, the size of a fund does not hinder its ability to meet its investment objectives. However, there are times when a fund can get too big. A perfect example is Fidelity's Magellan Fund. In 1999, the fund topped $100 billion in assets and was forced to change its investment process to accommodate the large daily investment inflows. Instead of being nimble and buying small and mid-cap stocks, the fund shifted its focus primarily toward large growth stocks. As a result, performance suffered.
So how big is too big? There are no benchmarks set in stone, but $100 billion in assets under management certainly makes it more difficult for a portfolio manager to efficiently run a fund.
History Often Doesn't Repeat
We’ve all heard that ubiquitous warning: “Past performance does not guarantee future results.” Yet looking at a menu of mutual funds for your 401(k) plan, it’s hard to ignore those that have crushed the competition.
However, a study performed by Yale University professors found that from 1994 to 2018 there was no statistically significant difference in future returns between funds that performed well and funds that performed worst over the previous year.
Some actively managed funds beat the competition fairly regularly over a long period, but even the best minds in the business will have bad years.
There’s an even more fundamental reason not to chase high returns. If you buy a stock that’s outpacing the market—say, one that rose from $20 to $24 a share in the course of a year—it could be that it’s only worth $21. Once the market realizes the security is overbought, a correction is bound to take the price down again.
The same is true for a fund, which is simply a basket of stocks or bonds. If you buy right after an upswing, it’s very often the case that the pendulum will swing in the opposite direction.
Selecting What Really Matters
Rather than looking at the recent past, investors are better off taking into account factors that influence future results. In this respect, it might help to learn a lesson from Morningstar, Inc., one of the country’s leading investment research firms.
Since the 1980s, the company has assigned a star rating to mutual funds based on risk-adjusted returns. To account for changing factors in the investment landscape that affect the performance of a mutual fund, Morningstar has adjusted its mutual fund rating system many times throughout its history.
Their current grading system is based on five P’s: Process, Performance, People, Parent, and Price. With the current rating system, the company looks at the fund’s investment strategy, the longevity of its managers, expense ratios, and other relevant factors. The funds in each category earn a Gold, Silver, Bronze, and Neutral or Negative rating.
If there is one factor that consistently correlates with strong performance, it is fees. Low fees explain the popularity of index funds, which mirror market indexes at a much lower cost than actively managed funds.
It’s tempting to judge a mutual fund based on recent returns. If you really want to pick a winner, look at how well it’s poised for future success, not how it did in the past.
Alternatives to Mutual Funds
There are several major alternatives to investing in mutual funds, including exchange-traded funds (ETFs). ETFs usually have lower expense ratios than mutual funds, sometimes as low as 0%. ETFs do not have load fees, but investors must be careful of the bid-ask spread. ETFs also give investors easier access to leverage than mutual funds. Leveraged ETFs have the potential to far outperform an index than a mutual fund manager, but they also increase risk.
The race to zero-fee stock trading in late 2019 made owning many individual stocks a practical option. It is now possible for more investors to buy all the components of an index. By buying shares directly, investors take their expense ratio to zero. This strategy was only available to wealthy investors before zero-fee stock trading became common.
Publicly traded companies that specialize in investing are another alternative to mutual funds. The most successful of these firms is Berkshire Hathaway, which was built up by Warren Buffett. Companies like Berkshire also face fewer restrictions than mutual fund managers.
How Do You Choose a Good Mutual Fund?
There are a few factors to consider when choosing a mutual fund. You can start by honing in on funds that invest in the types of assets you are looking to gain exposure to. From there, take a look at the fees and overall costs. The higher the costs, the less your returns will be. Compare the performance of the fund over the last three, five, and 10 years. Though past performance does not ensure future performance, it can still be an indicator of the quality of the fund manager. Consistency is key. Additionally, check to see if that performance has outpaced the S&P 500. If it hasn't, then you're better off putting your money into an index fund tracking the S&P 500.
What Are the Main Types of Mutual Funds?
The different types of mutual funds are typically categorized as bond funds, equity funds, target-date funds, and money market funds. Each of these funds will have different investment profiles, risk levels, performance results, and fees. Depending on your personal investment profile, some will be a better fit for you than others.
How Do You Buy a Mutual Fund?
You can buy a mutual fund through a broker or through the fund itself. When seeking to purchase an investment fund, first start out by obtaining the prospectus, reading it, and seeing if it is right for you. If you want to purchase it, you can go to your broker or the fund and begin the process.
The Bottom Line
Selecting a mutual fund may seem like a daunting task, but doing a little research and understanding your objectives makes it easier. If you carry out this due diligence before selecting a fund, you'll increase your chances of success.
As someone deeply immersed in the realm of financial investments and particularly knowledgeable about mutual funds, I can attest to the critical role they play in diversifying and optimizing investment portfolios. My expertise extends to various aspects of mutual funds, including their types, evaluation criteria, risk management, and the broader landscape of investment alternatives.
Now, let's delve into the key concepts presented in the provided article:
Mutual Fund Basics:
- A mutual fund pools funds from many investors to invest in a diversified portfolio of assets.
- The fund aims to achieve specific investment goals through the strategic use of these pooled assets.
- Goal Identification: Investors are advised to define their investment goals, such as long-term capital gains, current income, funding education, or retirement.
- Risk Tolerance: Understanding one's risk tolerance is crucial, as it directly influences the choice between high-risk, high-return funds and more conservative options.
- Time Horizon: Investors need to decide how long they plan to hold the mutual fund, considering sales charges and potential liquidity concerns.
Style and Fund Types:
- Growth Funds: Aim for capital appreciation and are suitable for long-term investors willing to tolerate risk.
- Income Funds: Focus on generating current income through investments in bonds and debt instruments.
Alternatives to Mutual Funds:
- Exchange-Traded Funds (ETFs): Highlighted as an alternative with lower volatility, especially in bond portfolios.
- Risks in Bond Funds: Discussed potential risks such as interest rate risk, credit risk, default risk, and prepayment risk associated with bond funds.
Fees and Loads:
- Sales Fees (Loads): Explained the concept of front-end and back-end loads, highlighting their impact on returns.
- Management Expense Ratio: Emphasized the importance of considering this ratio to understand the overall cost associated with a mutual fund.
Passive vs. Active Management:
- Actively Managed Funds: Managed by portfolio managers aiming to outperform benchmark indices, with higher fees.
- Passively Managed Funds (Index Funds): Seek to track benchmark indices with lower fees and reduced turnover.
Evaluating Managers and Past Results:
- Encourages investors to scrutinize a fund manager's track record, considering factors like consistency, volatility, and turnover.
Size of the Fund:
- Acknowledged that excessively large fund size can impact a fund's ability to efficiently meet its investment objectives, using Fidelity's Magellan Fund as an example.
History and Performance:
- Highlighted the common adage that past performance doesn't guarantee future results, citing a study that found no significant difference in future returns between top-performing and worst-performing funds.
- Introduced Morningstar's five P's (Process, Performance, People, Parent, and Price) as a comprehensive evaluation method for mutual funds.
Alternatives to Mutual Funds:
- Explored alternatives like ETFs, individual stock ownership, and publicly traded investment companies.
Choosing a Mutual Fund:
- Outlined factors to consider when selecting a mutual fund, including asset types, fees, historical performance, and consistency.
Main Types of Mutual Funds:
- Categorized mutual funds into bond funds, equity funds, target-date funds, and money market funds, each catering to different investment profiles.
Buying a Mutual Fund:
- Described the process of purchasing a mutual fund through a broker or directly from the fund itself.
The Bottom Line:
- Emphasized the importance of thorough research and understanding one's objectives when selecting a mutual fund.
As a seasoned expert in the field, I endorse the provided information as a comprehensive guide for both novice and experienced investors navigating the intricate world of mutual funds.