It’s time to talk about products for investing! Are you ready?
This week’s blog will cover the basics of mutual funds and a blog later this month will cover exchange-traded funds, along with pros and cons of each.
What experience do you have with investing?
If you have a retirement plan at work, you probably own a mutual fund. That was my first experience with them. Companies often offer retirement plans as part of an employee benefits package along with life and health insurance, vacations, etc. When I first entered the workforce and enrolled in my company’s retirement plan, there weren’t many investment choices, and they all were mutual funds. That made my selection relatively easy, especially after I went through a risk tolerance assessment. (See my blog, The Key to Investing – Know Yourself.) How did you make your choice(s)?
There are hundreds of mutual funds so understanding what they are and how to assess them will give you a head start.
What are mutual funds? As the name suggests it is mutual—an investment jointly made by many people. Simplistically, you and hundreds of other people pool your money to invest in a specific mutual fund created by an investment company. The investment company hires managers and supporting staff that select securities to be included in the fund. An investment company, the creator of the fund, typically offers a wide variety of mutual funds, but some specialize in certain types of investments—stocks or bonds, for example. For example, PIMCO is best known for its bond mutual funds.
Let’s say you want to buy a mutual fund invested in large U.S. company stocks. You look for a mutual fund whose professional managers have a good track record (more about track records later), and you invest $1,000. Your ownership is represented in shares of the mutual fund; however, you do not have a say in what the managers of the fund buy. You know they will buy large companies that are domiciled in the U.S. because they are required to invest according to the purpose stated in the fund’s prospectus, which is filed with the U.S. Securities and Exchange Commission (SEC) when the fund is created.
Here is a picture of the process of mutual fund investment:
Process of Mutual Fund Investment
Source: Surbhi, S. (2018, December 13) Process of Mutual Fund Investment. Retrieved from https://keydifferences.com/difference-between-mutual-fund-and-etf.html
How do mutual fund managers select securities for their funds? There are two styles of management.
When the investment manager selects securities to go into the mutual fund (or ETF) deliberately through analysis, it is called active management. Staff members review companies being considered for investment—for example, all U.S. companies designated as large. Then the managers decide which companies they think will do the best, and they buy the stock of those companies. The process for bond selection is similar but uses different criteria than stock selection. If, in the constant monitoring of those companies and other potential candidates, they decide that changes are necessary, the mutual fund managers will make those changes without checking with shareholders/investors/owners, you and me. The managers of an actively managed mutual fund are important because they are responsible for the choices and therefore for performance. Monitor an actively managed fund for recent changes in managers.
A different management approach is called passive management because the managers do not choose which securities to include. They typically copy or mirror an index and include all or most of the companies in that index. For example, instead of reviewing and selecting U.S. large companies based on their expected performance, the manager of an S&P 500 Index Fund will select ALL the companies in the S&P 500 Index, which includes 500 large U.S. publicly traded companies. Fund managers do not analyze which stocks (or bonds) to include. The managers copy the holdings and their proportions in the index.
People are often confused when they buy an index mutual fund or ETF. They are not actually buying the index. They are buying a mutual fund or ETF that replicates or copies the index. That is important because the return of the mutual fund or ETF will typically be slightly lower than the stated return of the index. Why? Because the operating costs of the mutual fund or ETF must be subtracted before its return is computed.
Which Is Better, Active or Passive?
Which type of mutual fund and ETF is better—active or passive? Do you prefer the guarantee of average market performance or the chance of outperformance? Although an active manager is trying to outperform the market and may do so for a few years, in general, it is difficult to outperform over long periods of time. “Over the past 10 years, fewer than one in 10 actively managed blue-chip stock funds have outperformed comparable index funds and only about 20% [of] small-company stock funds have done so.”[i] Index funds have an operating cost advantage because it is not necessary to hire a large staff to select appropriate securities. You may decide you like one or the other or perhaps a combination of both active and passive management. There is no right or wrong answer. I like to use both.
Mutual Fund Expenses
All mutual funds incur expenses. The fund must pay the professional investment managers along with bookkeepers, marketing and sales professionals, and human resource personnel. The fund must also cover the cost of supplies, offices, and utilities, for example. There is a way to measure the expenses of a mutual fund in relationship to its assets—the market value of the securities in the fund. The relationship is expressed as a ratio: the total annual cost or expense as a percentage of total assets. This is called the Operating Expense Ratio (OER), and it is readily available. It is published. The lower the OER compared to similar options, the better. More of your money is going toward investments and less to expenses.
Mutual fund providers may put additional restrictions on certain funds or charge a fee in some cases. Common ones are:
- redemption fees or short-term trading fees: fees meant to discourage selling too quickly
- minimum hold time: a length of time a mutual fund may require you to hold the fund before you can sell
- front-end or back-end loads: a commission or sales charge assessed at initial purchase (front-end) or sale (back-end)
According to Morningstar, asset-weighted fund fees have dropped substantially, from an average of 0.87% to 0.45% over the past twenty years. That is a good thing for investors!
Tracking Mutual Funds
How can you get information about mutual funds and tell if the manager is doing a good job? Independent companies track mutual fund performance along with other important information about a fund: its purpose, its holdings, how long it has been in existence, biographies of the managers, etc. The best-known company that tracks mutual fund performance is Morningstar. You can compare information about mutual funds on Morningstar’s website, morningstar.com, with a subscription, but you can also find mutual fund information on other websites. BigCharts/MarketWatch and Yahoo Finance are two that are well known. You could also search one of the major broker-dealer websites and select the research function. Some brokerage companies publish a list of the best performing mutual funds on a regular basis.
Just remember to compare apples to apples. For example, compare expense, returns, etc. for a mutual fund that invests in U.S. large company stock to another that also invests in U.S. large company stock, not to one that invests in international stocks or even U.S. small company stocks. That is like comparing the price of a warm sweater to the price of a tank top and choosing one just because it costs less. The sweater is more appropriate in the winter and the tank top in the summer. They serve different purposes.
You can track the daily price of a mutual fund online by checking its per share market value, its net asset value (NAV). Both Yahoo Finance and BigCharts/MarketWatch allow you to set up a free account and enter your personal holdings or funds you want to track. Many cell phones also have an app that allows you to track stock, exchange-traded fund, and mutual fund prices.
The Financial Industry Regulatory Authority (FINRA) Fund Analyzer at finra.org is a free tool to help investors sort and compare mutual funds and ETFs and understand the impact of fees and potential discounts. It also does the math to show how fees and expenses impact the value of an investment over time. (Select “For Investors” and then “Tools and Calculators.”)
If you have questions about mutual funds or other investment and savings topics, please go to my website, bevbowers.com, and look for “Send Me Your Questions” and while you are there, check out my other blogs.
On to ETFs!
~Bev Bowers, CFP®