Investing - Part VI

Mutual Funds

In part six of my four part series on investing, we'll take a look at mutual funds.

Most everyone with a retirement plan of some sort has mutual funds in their account. Many people also invest in mutual funds outside of their 401k or 403b accounts. But what are mutual funds, what kinds of mutual funds are there, and is there anything to watch for with some funds?

People are often surprised when they find out about how funds actually work or the multitudes of differences between them.

So to start, what is a mutual fund? A mutual fund is basically an investment vehicle where you and a bunch of other people pool their money together, hire an investment manager, and then sit back to watch the money roll in. That's basically the simplest description of a mutual fund.

So if the idea is so simple, why does mutual fund investing seem so complex? Why are there so many different variations of the same idea? Why would they bother to make closed-end funds, open-end funds, equity funds, bond funds, balanced funds, income funds, allocation funds, funds of funds - why so many different kinds of funds?

Let's start by look at the two different types of funds: open-end and closed-end. Open-end funds are the type that everyone is familiar with through their 401k plans. Every time that someone invests more money in the fund, more shares are created. Every time someone redeems shares, they are destroyed. But with open-end funds that number of shares is always in flux. Price changes are dictated by the value of the underlying assets only.

With closed end funds, they trade like stocks. They are listed on the exchange (there are quite a few on the NYSE in fact). The price per share is determined not only by the underlying asset value, but also by the expectation of future performance of those assets. So for instance, if the market thinks the Korean economy is going to do well, shares in Korean closed end funds will sell at a premium to their actual asset value. That won't happen with an open-end fund.

Within each of the two major types, you will have different classes of funds. There will be large-cap, mid-cap, small-cap, international, income, high-yield, balanced, asset allocation and many, many other classifications. These mainly become important when looking at portfolio allocation (which will be the next section of this series), but we'll look at them here real quick.

The large-cap, mid-cap, and small-cap funds are all equity or stock funds. They are investing in the owning chunks of corporations. Large-cap stocks tend to focus really on the 300-400 largest companies in America. Mid-cap looks at the up and comers, but even these are usually companies with a track record. Small-cap stocks are really where you start getting more into speculating. These are generally unproven or new companies. Great opportunity can be found in the small-caps, if you know where to look, but so can great risk also.

International funds are a special class of equity funds. Depending on what type of international fund they are, they may invest in both US and overseas corporations or solely in foreign companies. The way to tell which you have is to look for the following words: if it says "global" it invests in both the US and overseas with usually about 30-35% being foreign. If it says "foreign" it will be investing almost exclusively overseas.

Another popular class of funds are the bond or income funds. These are funds that are designed to generate a monthly cash income for the holder. There are several types of bond funds: government bond funds which invest only in government issued bonds (which are not all insured mind you), Treasury funds which invest in only Treasury issues (considered the safest), high-yield or junk bond funds (high risk) and many, many other types of income funds.

Then we have the allocation funds and the funds of funds, which are all attempting to take the mutual fund concept to the next level.

Now that brings me to the question of why would you even want to invest in mutual funds when the potential return from buying individual stocks is much higher?

Most of this discussion will be in the asset allocation section, but simply put it is risk management. If you invest $1000 in a stock that goes belly up, you've lost your $1000. If you invest that same $1000 in a mutual fund, that happens to own that same stock, when the stock goes belly up, you only lose a small portion of your investment. Your money is spread out over more investments, meaning the potential effect of each investment on your overall portfolio is small, which can be both good and bad.

Mutual funds were designed to ease diversification. Most studies that I've seen show that somewhere between 15-20 different stocks is generally a well-rounded portfolio and will allow you to fully participate in the market. Assuming each stock was only $10/share, 100 shares of 20 different stocks would cost you $20,000 to acquire. A mutual fund allows you the same diversification for as little as $1000.

But what's the deal with the A shares, B shares, C shares, X shares, Z shares, and whatever letter shares? And why would I want to buy a load fund over a no-load fund or vice versa?

Taking the second question first, there are times when each fund may be more appropriate. Mutual funds are not free. There are really three costs of ownership: the operating expense, the load, and the return (yes it can be a cost).

The operating expense is the most critical. This is the year-to-year cost of running the fund, expressed in a percentage of the total assets. Most no-load funds will have a slightly higher operating expense than a load fund. Usually, with a load fund it will take 10 years or more to overcome the costs of the load, or until the load fund becomes the more profitable investment. You do have to watch sometimes though, as I have seen funds with some pretty high loads, 4.5-5% (as compared to less than 2% normally). A no-load fund with a high operating expense may be a very, very bad deal.

But what is this load I keep talking about? Essentially, think of it like paying a retainer to the fund manager, or a commission to the broker (it's actually a bit of both). If your investment is intended to be long term, a load will usually allow you to "buy" a lower operating expense. Key thing to remember is that if a fund is a load fund, there is no no-load equal. The B shares (which will have a back end load or contingent deferred sales charge - a percentage that drops as the fund is held until it switched over to an A share usually at the end of seven years), even when touted as "no-load shares" still get their money out of you. Look in the paperwork, the operating expense is almost always 1% per year higher than the A shares.

And now what about these A shares and B shares? A shares will be shares on which the load is paid up front. B shares, sometimes incorrectly called no-loads by less than honest brokers, have a back end fee - and a higher expense ratio, C shares, which most people never buy, are designed for very large purchases and will generally have a small front end fee, a larger back end fee, and other restrictions in return for a lower operating expense.

The biggest thing to watch for is that most brokers will try to steer you towards either load funds or no-load funds without ever looking at the real load-adjusted returns. Get all the numbers. You would not believe how many people I've seen avoid a good fund simply because it had a load. It is also amazing how many people bought load funds without looking at the real return. Be sure to check the Morningstar reports before buying any fund. Giving up a return for lack of knowledge is a cost of ownership and one of the most avoidable.

Mutual funds can seem daunting and even downright scary. There are all different kinds of funds and all kinds of ways of analyzing them.

The most important thing is to not just pick funds at random. Have a purpose for the fund and the selection process becomes much, much more simple - and effective.

In the next section on asset allocation, we'll look at how to figure out what that plan might need to look like.

Resource:

Morningstar.com

To get to the other sections:

Part I - Fundamental Analysis

Part II - Technical Analysis

Part III - Options

Part IV - The Economy and The Market

Part V - Market Mechanics

Part VII - Asset Allocation

Part VIII - Bonds