Mutual Funds

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See also List of Mutual Fund Managers.

Mutual Funds are the most popular investment among individual investors. If you have a 401(k) or work with a financial planner, you most likely own shares in a few mutual funds.

Mutual funds are popular because they offer a simple way to diversify an investment portfolio while letting a professional manager worry about buying and selling individual stocks.

Who Invests in Mutual Funds

According to the Investment Company Institute, a mutual fund industry group, the percentage of U.S. Households owning mutual funds grew from approximately 5 percent in 1980 to 45 percent in 2000, thereafter stabilizing around 43 percent. Mutual fund ownership among households also increases as household income increases.

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Source: Investment Company Institute 2008 Fact Book[1]
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Source: Investment Company Institute 2008 Fact Book[2]

Types of Mutual Funds

Mutual funds are classified based on the type of assets they hold as well as their investment strategy. Although many types of funds exist, the major categories are:

Growth Funds - These funds typically pursue large returns, resulting in greater risk and volatility for investors. Managers of growth funds are willing to pay a premium for fast-growing stocks which have often displayed considerable momentum due to their popularity. Rather than paying dividends, managers of growth-focused companies typically reinvest profits in the business by purchasing equipment, executing a merger or acquisition, or developing new products and lines of business.

While growth stocks can continue to provide high returns as long as the stream of good news and earnings continues, when the company encounters difficulties they are likely to fall harder and faster than the stocks of mature businesses with steady, albeit lower, growth rates. Some funds, termed "aggressive growth funds," may use leverage to magnify positive (and negative) returns, making such funds a still riskier investment.

Income Funds - In contrast to growth funds, these funds seek to invest in stable sources of income (such as bonds and stocks with a consistent track record of dividend payments) and typically deliver lower returns. Money Market Funds, which are required to invest in low-risk and hence low-returning fixed income securities, are a type of income fund.

International Funds - Also referred to as "global funds," these funds focus on foreign securities, often in emerging markets with growth rates higher than those of more developed nations. In addition to the normal risk of asset devaluation, international funds also face exchange rate risk.

Commodity Funds - Managers of these funds allocate assets into commodities such as wheat, oil, gold and other precious metals.

Sector Funds - Sector funds focus on one area of the economy, such as telecommunications, and are therefore subject to greater volatility than funds with more diverse asset holdings.

Index Funds - These funds aim to mirror the performance of stock market indexes, such as the S&P 500 (.SPX-E) or Dow Jones Industrial Average (.DJIA). Since many stock indexes are weighted based on the market capitalizations of their component stocks, index funds must periodically "rebalance" their holdings to more accurately track the index as stock prices (and market capitalizations) fluctuate.

Equity (Stock) Funds- Mutual funds which invest primarily in companies' stocks are subdivided based on the market capitalization of the stocks in which they invest (small, mid, or large-cap).

Bond Funds - Bond funds invest in fixed income securities issued by companies or governments. Such funds typically carry less risk and provide lower returns than equity funds.

Target Date Funds - These funds are designed to be an all-in-one fund, including stocks, bonds and possibly other investment types, to provide an appropriate asset allocation for someone retiring at designated year in the future (e.g. Target Date 2035). These funds change the allocation over time, becoming more conservative (i.e. less equity, more bonds) to reduce the risk of an investor losing a large percentage of their net worth just before needing to start withdrawing money from the fund. These funds are the simplest way for an investor to have someone 'manage' their asset allocation toward a future date. The Target Date does not have to be retirement, it could be paying for college, though retirement represents the majority of the use for these funds.

These categories are not mutually exclusive, and it is not uncommon for funds to employ hybrid strategies. Growth-income funds, for example, tend to invest in Blue Chip companies that pay steady dividends but may also provide capital gains through share price appreciation.


Benefits of Investing in Mutual Funds

Investing in mutual funds offers many benefits for individual investors. Some of the benefits are:

Instant Diversification

Although diversification, or holding several types of assets in an investment portfolio to reduce risk, is an important part of any investment strategy, investors with a small amount of capital (say $5,000) may find it difficult and expensive to purchase small amounts of various stocks and bonds. By investing $5,000 in a mutual fund, however, diversification can be achieved while avoiding the transaction costs (i.e. commissions) that would be associated with purchasing each of the fund's holdings individually.

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Liquidity

Most mutual funds are open-ended, meaning the fund sells an unlimited number of shares to its investors. Investors wishing to buy into an open-ended fund purchase shares directly from the fund (sometimes through a brokerage), and investors wishing to leave sell their shares back to the fund. The price at which investors buy and sell shares to the fund is called the Net Asset Value (NAV) and is calculated each trading day at 4:00 pm. To calculate a fund's NAV, one subtracts the fund's liabilities from its assets and divides the result by the number of shares outstanding.

By contrast, closed-end funds sell a limited number of shares one time, and shares of closed-end funds trade on open market exchanges. Since closed-end funds have a finite number of shares available for trading, their share prices are more likely to deviate from NAV based on investor demand for shares in an individual closed-end fund. Investments in both open and closed-end funds are relatively liquid, meaning they can easily be converted to cash.

Drawbacks of Investing in Mutual Funds

Investing in mutual funds also has a few drawbacks. Some of the drawbacks are:

Fees

Sales Load Fees

Funds which sell their shares through brokers typically impose fees, called "sales loads" or "sales charges", as a percentage of an investor's initial investment to compensate brokers for their services. For example, an investor who gives his broker $10,000 to purchase shares in a mutual fund with a sales load fee of 5% would pay $500 to the broker, while the remaining $9500 would be used to purchase shares of the fund.

There are two types of sales loads: front-end loads, in which the investor pays the load when purchasing shares in the fund, and back-end loads, in which the load is paid when shares are redeemed, or sold back to the mutual fund. Many back-end load funds have loads which decrease over time. Investors who leave the fund within one year may pay a load of 5%, while those who leave between 1 and 2 years after thier initial investment pay 4%, and so on.

Some mutual funds do not use brokers to sell their shares but still charge fees to investors purchasing shares. Such fees are technically referred to as "purchase fees" since they go to the mutual fund rather than to a selling broker. Mutual funds which do not charge sales loads are referred to as "no-load" funds. However, funds referring to themselves as "no-load" may still charge a variety of other fees, including purchase fees, account maintenance fees, and redemption fees (similar to back-end loads but paid to the mutual fund rather than a selling broker).

Annual Fees

12b-1 fees, which take their name from the SEC regulation permitting their existence, are charged by mutual funds to cover operating expenses, such as marketing, distribution of shares, printing and mailing prospectuses and responding to shareholder inquiries. Management fees are paid to asset managers and auxiliary staff for managing the fund's investment portfolio.

Comparing Fees: The Expense Ratio

Given the various types of fees mutual funds charge, a fund's expense ratio can prove useful in comparing the costs of holding various funds. The expense ratio sums all of the fund's annual (non-load) fees (including management fees, 12b-1 fees, transaction costs and other administrative expenses) and divides the total by the fund's assets. A typical expense ratio is around 1.5%. Vanguard is a mutual fund company known for providing low-cost mutual funds; its funds have expense ratios of 0.5% or even less.

Mutual funds charge annual fees regardless of the fund's performance, and the higher a fund's expense ratio, the more the mutual fund manager must outperform the market to offer investors a better return than low-cost, index-tracking funds which are not actively managed and have fewer operating expenses. The most popular index-tracking mutual fund, the Vanguard 500 Index, has an expense ratio of just 0.18%. The Financial Industry Regulatory Authority (FINRA) provides an online tool for comparing mutual fund expense ratios at http://apps.finra.org/fundanalyzer/1/fa.aspx.

Taxes & Turnover

At the end of each year, mutual funds are required to pay out all gains on investments to shareholders or pay corporate income tax on such gains. Investors receiving end-of-year distributions from mutual funds must pay capital gains tax on those distributions (unless the mutual funds are held in a tax-deferred account such as a 401(k) or IRA). Investors should be especially careful not to invest in mutual funds close to the end of the year (or distribution date), since they will be taxed on capital gains that occurred before they bought into the fund.

Since distributions are only made (and taxes paid) on gains that have been realized, funds that have low turnover typically carry lower tax liabilities for investors. In basic terms, turnover is the percentage of a fund's assets that change over the course of a year. If a mutual fund had sold all the stocks it had on January 1, 2008 by December 31, 2008, its annual turnover would be 100 percent. "Paper" gains (or losses) due to changes in asset prices are not "realized" until the fund sells the asset in question. According to John Bogle, the founder of index fund company Vanguard and a well-known champion of index funds, the average turnover for actively managed funds increased from 65 percent in 1975 to 90 percent in 2000.[3] In a widely cited paper published in the Journal of Finance, researcher Mark Carhart associated each 100 percent increase in mutual fund turnover with a 0.95 percent decrease in average return.[4] .

Tax-conscious fund managers can minimize tax liability by pairing capital gains realized by selling well-performing stocks with capital losses realized by selling poor-performing ones. Index funds, which may make only 15-20 transactions over the course of a year as stocks enter and exit indexes, typically carry turnover rates of around 5 percent and result in lower tax liability for investors.

The 'tax efficiency' of most mutual funds is calculated and reported by some fund rating organizations (e.g. Lipper).

People often hold tax-inefficient funds in their IRA or 401K accounts where there is no tax consequence, and hold tax-efficient funds in their taxable accounts.

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Churning

Since mutual funds typically pay brokers and other investment advisors on a commission basis when one of their clients buys shares in a fund, advisors sometimes recommend that their clients "churn" through various funds, frequently buying and selling shares and thereby generating more fees. Due to the entry and exit loads imposed by many funds, as well as the potentially negative tax consequences of frequently realizing gains and losses, churning funds typically reduces portfolio return.

Mutual Fund Performance

Once fees for actively managed mutual funds are taken into account, approximately 75 percent of such funds underperform the S&P 500.[5] According to John Bogle, mutual funds' average annual return from 1984 to 2002 was 9.3 percent, compared to 12.2 percent for the S&P 500.[6] Despite widespread publication of this chronic underperformance, mutual funds continue to remain popular among investors, with the Investment Company Institute reporting a record-high $12 trillion in U.S. mutual fund assets at the end of 2007.[7]

References

  1. Investment Company Institute. 2008 Fact Book 70.
  2. Investment Company Institute. 2008 Fact Book 72.
  3. David Blanchett. The Pre-Tax Costs of Portfolio Turnover.
  4. David Blanchett. The Pre-Tax Costs of Portfolio Turnover.
  5. Felix Salmon (Nov. 18, 2008). Yes, Fund Managers Really Do Underperform.
  6. John Bogle (Jul. 8, 2003). The Emperor's New Mutual Funds.
  7. Investment Company Institute. 2008 Fact Book 23.
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