All about mutual funds

What a mutual fund is and how it works
A mutual fund is a collection of some kind of investment, usually stocks. They’re extremely popular. Your parents own at least one mutual fund if they’ve ever worked at a company. Mutual funds work like this: You pick a fund you like (e.g., growth, value, technology, international…), buy shares of the fund, and let a money manager pick the stocks he thinks will yield the best return. In exchange for this diversification and his expertise, you pay an annual fee.

Advantages: Hands-off approach means an expert money manager makes investment decisions for you. Mutual fund (ostensibly) holds many varied stocks, so if one company tanks, your fund doesn’t go down with it (i.e., it’s “diversified”).

Disadvantages: Annual fees can equal tens of thousands of dollars or more (!) over the lifetime of an investment. If you invest in two mutual funds, they may overlap in investments, yielding a less-diversified portfolio than you really think. In other words, if both funds hold Microsoft and Microsoft tanks, you get hit twice. Although you’re paying an expert to manage your money, they rarely beat the market—the mutual fund industry’s dirty secret!

The fund manager
Each mutual fund has a fund manager overseeing all investments. He’s usually a talented financial expert whose bonus is based on the fund’s performance, so he’ll get (say) a $2 million bonus if the fund returns X%. Because they actively manage your money, you’ll sometimes hear mutual funds called “actively managed funds.”

Fund managers are highly compensated but also subject to being fired if the fund performs poorly. The main reason you should care about the fund manager is that you’re basically investing in him—by putting your money in his fund, you’re betting he’ll make you money.

The different types of mutual funds
If you want to buy a mutual fund, you have some choices to make. It’s kind of like the 50 kinds of toothpaste you can choose at Target. Except there are thousands of funds and we’re talking about your life savings. Anyway, you can pick a mutual fund of almost any imaginable type, based on many factors (e.g., risk, return, sector, geographic area of investment, etc). For example, you could invest in a value fund, an emerging-markets fund, or a medical-device fund.

The key is to invest in what you understand. If I were going to buy a mutual fund, I’d get a technology fund because that’s what I know. Even though biotech sounds sexy, I don’t know enough about biotech to choose a “good” vs. “bad” fund, so I’d steer clear. You can sort through funds using ETrade or MorningStar.

By the way, one of my most popular questions is this: How exactly do you “buy” into a mutual fund? Mutual funds have ticker symbols just like stocks. Just browse the links above and you’ll see that buying shares of a mutual fund is almost exactly the same as buying shares of stock.

Mutual-fund costs
Your fund manager doesn’t come cheap. Actually, investing in mutual funds is damn expensive. Remember, you have to pay an annual fee in exchange for his expertise and the fund’s hands-off diversification.

The main fee you’re charged is called an expense ratio, which consists of the management fee (goes to your fund manager), administrative costs, and the 12b-1 distribution fee, which is used to advertise your fund. How ridiculous. Most funds charge somewhere around a 1.5% expense ratio.

Also, when you buy a mutual fund, you may be asked for a commission; this is also known as a front-end load or back-end load. Avoid commissions! You want a no-load fund. If your broker tries to convince you that a loaded fund is better, he is lying. You shouldn’t even be talking to a broker, anyway. Use a discount online broker like ETrade, Datek, Schwab, anything.

Why am I so against loaded funds? Easy: Loads cut into your profits and there’s no evidence that they produce better results. In fact, look at this data I ripped off of Yahoo Finance:

"Assuming a $10,000 investment with a conservative nine percent annual net return rate (after annual fund operating expenses) over three years…

In cumulative ROI after three years in this illustration, the 100 percent no-load fund outperforms the five percent front-end load fund by 39.3 percent and the back-end load fund by 24.4 percent -- even though a nine percent annual return rate is ident ical for all three funds!"

See. Always get a no-load fund.

One more reason mutual funds are expensive: Your manager is constantly buying and selling stocks, which incurs trading fees and HUGE amounts of taxes. This is part of why you can expect at least 2% of your returns to be eaten up by mutual-fund-related fees.

The dirty secret of mutual funds
Earlier I told you how most adults in America have mutual funds. Now let me explain why they are pretty stupid. Ok, you are paying for expert advice and a Very Smart Person to invest your money.

Stay with me. Remember when I told you that The Market returns about 11% per year?

Now, with all your Smart Money Manager’s tools and resources, you’d of course expect him to beat that. But…

Over 85% of mutual funds fail to beat the market.

Woah. Why would anyone invest in a mutual fund, which costs you tremendous amounts of money just for maintenance when you won’t even beat the market? Could it just be because people are lazy and don’t know what to do? What if there were a way to invest directly in the market?

How to invest directly in The Market: Index funds
I'm glad you asked. Index funds are a special type of mutual fund. Instead of being actively managed by a fund manager, a computer simply matches the stocks in The Market. So the Vanguard S&P 500 index fund has every stock that the actual S&P 500 has—the Vanguard index fund is an index of The Market.

There are index funds for the S&P 500, NASDAQ, and more.

The advantages are simple: YOU MAKE A LOT MORE MONEY AND SAVE ON DUMB COSTS. Because index funds don’t have money managers and other BS costs, your expense ratio is vastly lower. Compared to usual mutual funds (whose expense ratios average around 1.5%), index funds are routinely lower than 0.2%.

The differences are serious. In yet another scenario I ripped off—this time from Vanguard—let’s say you invest $10,000. You put half of it in a mutual fund with a 1.3% expense ratio. The other half goes in a fund with an 0.3% expense ratio. In 20 years, the expensive fund would cost you over $28,000. See details here.

The first and biggest advocate of index funds was Vanguard, which now has the most popular funds out there. I invest part of my portfolio in the Vanguard Index Funds 500 Index (VFINX), which has an expense ratio of 0.18%.

I’m in august company:

• "[Most investors would] be better off in an index fund." Peter Lynch, famous stock picker, Barron's, p. 15, April 2, 1990


• "The deeper one delves, the worse things look for actively managed funds." - William Bernstein, The Intelligent Asset Allocator


• "..the best way to own common stocks is through an index fund..."
  -Warren Buffett, Berkshire Hathaway, Inc. 1996 Shareholder Letter


• I was an analyst at a well known financial advisory firm. I have no idea why they advise people to buy actively managed funds. It is a scam and mathematically stupid. - John Foxworthy, July, 2002

Mutual funds sound dumb compared to index funds. Why do people like my parents still have them?
I ask myself this a lot. There are no clear advantages to an actively managed mutual fund vs. an index fund. Yes, if you happen to have a mutual fund that beats the market, you’re better off investing in a mutual fund—-but fewer than 15% of all funds do that.

The basic answer is sad but revealing. First, most Americans just don’t know how mutual funds work. Fees sound small per year (2%! So what?) but over 20 years, they add up to tens of thousands of dollars or even more. Second, nobody knows what an index fund is. In fact, when was the last time you heard of one? Finally, buying and holding an index fund isn’t as sexy as thinking of a smart New York fund manager barking instructions to his minions.

Give me a break. When my butler Jeeves is helping me recline on gold sheets and reaching for my jewel-encrusted remote control, I will be just fine with “boring” index funds.

Good reading:
http://www.fool.com/school/basics/basics04.htm

http://www.indexfunds.com