Whether you are new to investing or already have holdings in mutual funds, you may not fully understand what exactly mutual funds are, how they work, or how to choose from the many options available. In this installment of “Investor Basics” on mutual funds, I hope we can answer some of your questions.
What is a Mutual Fund?
Imagine 100 people in a room each throwing a $10 bill into a basket. Now there is $1000 in the basket. The 100 individuals have mutually “pooled” their money together. A mutual fund works the same way. Individuals, companies, and organizations pool their money together in order to “mutually fund” a variety of investments. The fund manager then invests the pooled money into a variety of stocks and/or bonds and manages all the investments in light of the objectives of the particular fund. Mutual funds are available in a variety of categories depending on their investment goals, the types of securities they invest in (their portfolio), and the type of risk and return they seek.
Why Invest in Mutual Funds?
Let’s say you have $1,000 to invest. You could, for example, buy a handful of shares of Apple stock. But you will then assume all the business and stock market risk that Apple experiences. If Apple has a business or industry set-back, then you could suffer substantial losses. If, however, you put your $1000 investment into a mutual fund, your investment will be spread across the many companies that the fund owns. For example, the Vanguard Equity Income Fund invests in 198 different companies, diversifying or spreading-out your risk. Diversification helps because you are less exposed to the business decisions and risks of just one company. When you invest in U.S. Stocks you will be exposed to the risks in the U.S. economy, but the risks of any one company become unimportant when you spread your investment across many stocks.
Knowing the Lingo
Knowing the mutual fund lingo is important to helping you navigate your way through all the fund choices you will see. This list of terms and fund types is not exhaustive, but we hope will give you a general understanding.
Equity Funds: Equity mutual funds invest in a basket of stocks. They are called ‘equity’ funds because owning stock means you own a portion of the company. A stockholder has equity in a company just like a homeowner can have equity in a home. There are various types of equity funds, like growth (investing in growing companies with increasing values), income (investing in stocks that pay regular dividends), index (investing in stocks which try to mirror a particular market index like the Dow Jones Industrial Average or the S&P 500) and sector funds (investing in a particular industry such as healthcare or technology).
Fixed Income Funds: Mutual funds can also invest in bonds, which provide a regular income stream. Therefore, mutual funds that invest in bonds are often called fixed income funds or simply bond funds. These funds provide regular income typically in the form of regular interest payments and often are recommended in an individual’s portfolio to provide income when stock funds lose value as part of a diversification strategy. They tend to be less risky and therefore have lower potential returns. Like equity funds, these can also be organized by sector. They can range in risk from low risk U.S. Treasury securities to high-risk junk bonds.
Balanced Funds: These funds invest in both equities and bonds. They have more risk than a fixed income fund but less than equity funds. They can be a great place for a beginning investor to start. If there is a higher mix of equities than bonds there will be a higher risk (and higher potential gains or losses). They can also specialize in international companies or domestic. Investing in international funds can be an important part of a diversification strategy as well.
Sectors: Sometimes funds invest in a specific type of business or sector and the fund name will include the name of the sector. Sectors define what type of businesses the fund invests in like technology, utilities, food, healthcare, etc. A fund that is more diversified across various sectors will be less risky than a fund that invests in only one sector.
Large Cap, Mid Cap, and Small Cap: Sometimes funds invest in a specific size of company. “Cap” refers to a company’s capitalization which is the total dollar market value of a company’s stock. Large cap stocks are companies with $10 billion or greater capitalization. These are very large companies that tend to be well established and stable in their industry. They tend to grow slower than mid cap companies and their stocks are typically less risky than mid cap stocks. Mid cap companies have capitalization of $2 billion to $10 billion. And small cap companies have capitalization under $2 billion. Small cap stocks are the riskiest of the three, typically more volatile, but also can have significant growth potential. Based on history, they typically do not perform as well as large caps in recessions but do better than large caps during economic growth.
What fees are charged by mutual funds?
You will pay a fee for the management of the fund which covers fund operational costs, for example, the fund manager’s salary. These costs are not deducted from your account, but rather from the total assets of the mutual fund before you get your portion. If you look at the fund’s expense ratio, which can be found on the fund’s website or in the fund prospectus (or brochure), you can see what percentage of the fund goes to operational costs. The lower the ratio, the better for the investor because you are keeping more of the investment returns with less going toward administrative costs. According to Morningstar, an investment research firm, in the 2019 fee study, the asset weighted average expense ratio for mutual funds was .67%. A “load,” on the other hand, is basically a sales commission. A “front-end load fund” means that you pay the sales commission when you make your investment initially. There are also many “no-load” funds for which you do not pay a sales commission.
Which Funds Should I Choose?
There are a variety of factors to consider when you decide which funds to choose. As financial advisors, we recommend that you find an advisor you trust, such as Cedarstone Advisors, to look at your individual circumstances and goals as well as current investments, risk tolerance, and your age along with a complete financial plan to determine the best mix. There are big advantages on using fee-only investment advisors, especially Certified Financial Planners, but that’s another topic for another day.
In general, when considering a fund, look at its performance over a long period of time like 10-20 years, if possible. This will reveal how it performed in good and bad times. The performance of the fund is due in large part to its manager. If the manager is new, then he or she has no performance history, so take that into consideration as well. Also, consider your financial goals, timeline, and risk tolerance. Be sure to look at the fund costs as well.
Lastly, if you or someone you know is a beginning investor just starting to save and does not need financial planning, a robo-advisor, such as Schwab intelligent Portfolios, can “recommend” a mix of funds (of the choices they offer) based on your answers to their survey questions and can be a good way to start with a relatively small amount of savings.
In conclusion, make sure you understand what you are investing in. If you don’t understand, don’t do it. We, at Cedarstone Advisors, are always happy to help you make specific fund selections in light of your overall portfolio, specific circumstances, and financial goals for any of your investment assets, including your employer retirement plans. Let us know if we can help.