Mutual Funds 101

Mutual FundsThe theory of risk reward says that in order to obtain more reward, one must take on more risk.

In a recent post, I wrote about the little reward available these days in accounts that by design must be safe. For money that can and should take on risk in pursuit of a better return, investing in mutual funds is one way to do that.

The universe of more than 8,000 open-ended mutual funds have varying compositions, objectives, purposes, investing styles and expenses. Which funds are right for you depends on those factors and how they fit into your plan.

Let’s start at the beginning.

What is a mutual fund?

A mutual fund is a collection of stocks and/or bonds that are bought and sold by the fund in keeping with its stated policy. Investing in a mutual fund allows an individual investor to own a greater volume and variety of stocks or bonds than he may be able to have on his own.

An open-ended fund means that investors can buy and sell directly with the fund, and the fund’s shares are priced at their net asset value, or the value of all fund assets, minus liabilities, and divided by the number of shares outstanding. Open-ended is the most common form of mutual fund and the one we will look at here.


What kinds of funds are there?

Funds are designed to capture different sections of the market (market meaning the entire universe of stocks and/or bonds), or even the entire market. An equity fund invests in stocks, Graph With Stacks Of Coinswhile a bond fund invests in bonds. There are also funds that invest in both.

Within each of those, there are further breakdowns. For instance, there are funds that invest only in large company stock (such as Exxon Mobil or Apple), and others that invest in smaller companies, such as American Airlines or Foot Locker. Some invest internationally, and still others concentrate in sectors like real estate or health care.

Bond fund holdings may include Treasury bonds, corporate bonds, global bonds or mortgage bonds, and the bonds vary in maturity length from a short time period to many years out.

The design of your personal portfolio will likely include funds representing different asset classes, put together in a mix that depends on your financial life stage, your age, your capacity for risk and volatility, and what investment or savings assets you have in other places.

For smaller portfolios, or when you don’t want to construct your own portfolio, there are ready-built funds with prescribed mixes of stocks and bonds. These funds may have names like “balanced” or “asset allocation” funds, and typically range from conservative (less stocks, more bonds) to aggressive (more stocks, less bonds), with moderate somewhere in the middle.

Because each fund has its own twist, it’s important to look at the actual composition and make sure it’s right for you. Beyond that, there are target date funds, which match the fund breakdown to a specific goal in your life., usually retirement or college. Pick out the year that fits the goal, and the funds will change year by year to match the asset allocation appropriate for the time horizon, without any changes on your end.


Investment style

In addition to choosing what your mutual fund invests in, you’ll need to choose what kind of investing style you want in a fund. Funds hire managers or management teams to make the investment decisions; some make those investments by active management, some by passive management or indexing, and others by enhanced indexing.

Actively managed mutual funds are ones in which the manager or management team buys and sells according to where they believe the market is heading. They are being paid to find good values, dump what their research tells them are losers, and anticipate trends, all with the goal of outperforming.

You can tell by the multitude of magazine headlines that call out which funds are hot now (which sometimes end up on the loser list the next month) that fund managers win some and lose some — sometimes they beat the index and sometimes they underperform.

Passive management, or indexing, on the other hand, simply strives to do what its benchmark does. A fund that invests in the S&P 500 index, for instance, will hold the same 500 stocks that constitute that index, and only replace a stock when the index changes (reconstitutes). The theory behind using passive management is that the market will do what the market will do, and active management will lose as many times than it wins, so trying to outperform is futile and costly.

DFA A hybrid between active and passive management is enhanced index investing. Fund managers using the enhanced indexing strategy pursue greater than market returns, but rather than trying to predict where the market is going, managers apply academic- or research-based screens to their portfolios, resulting in a portfolio that changes more frequently than a true passive index fund, but changes are made only when the objective model calls for replacing certain stocks or bonds.

Dimensional Fund Advisor funds (DFA) are an example of enhanced indexing.  DFA is a fund company whose philosophy and style is based on the research of Nobel prize winner Eugene Fama, and one that resonates with me.  I’ll dedicate a post soon about DFA and what makes them unique.


What are the costs?

Mutual fund costs vary widely, and come in two dimensions. Each fund has an operating cost associated with it, called an expense ratio; this cost covers things such as paying the managers, marketing, trading costs and more.

Passive funds almost always have the lowest costs, because there is not a lot of movement inside the fund. Actively managed funds naturally cost more. Funds of funds, such as an asset allocation fund that contains several funds within it, can be more costly, too, because you are paying for multiple layers of fund operating expenses.

FINRA, the Financial Industry Regulatory Authority, has a fund analyzer to help you compare the cost of owning mutual funds:

If you purchase a fund through a broker, you may pay a sales charge, or load, or if working with an investment adviser, an advisory fee.

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