Let me just say that you are not alone if you are scratching your head and asking yourself, “What’s a mutual fund?!”.
While most people have money inside mutual funds within their 401k and retirement accounts, they don’t really know the answer to the ,“what’s a mutual fund”, question.
Fear not, for this is a mutual fund 101 article written with the beginner investor in mind.
We will go over the following in this article:
- Where mutual funds came from.
- What’s a mutual fund?
- Why to invest in mutual funds?
- Mutual fund fees.
So, let’s figure out what these mutual fund things are!
Where mutual funds came from
One reason I love history is because it helps us understand the present. We can learn more about mutual funds by first learning about where they came from.
This is an excerpt from Investopedia:
“The creation of the Massachusetts Investors’ Trust in Boston, Massachusetts, heralded the arrival of the modern mutual fund in 1924. The fund went public in 1928, eventually spawning the mutual fund firm known today as MFS Investment Management.”
How interesting is this- the very FIRST mutual fund in the United States was created by a company this is STILL around to this day! You don’t hear this very often in our society of mergers and acquisitions.
Just like today, many people didn’t know much about the stock market in the 1920’s. Instead of trying to invest their money in stocks and bonds which they did not understand, they “pooled” their money inside mutual funds. A company managed their pooled money, and those people paid a fee to the company for managing their money.
To realize the company responsible for the first US mutual fund still in business is a testament to the company, as well as the industry.
Mutual funds helped people who were scared to make their own decisions regarding stocks of which they did not understand. This relationship helped build a multi-billion dollar industry that is the mutual fund industry of today.
Mutual funds were created as a way to “pool” investments for people. By the early 1950’s there were around 100 mutual funds in existence. By the end of the 1960’s there was a “…rise of aggressive growth funds, with more than 100 new funds established and billions of dollars in new asset inflows.”
Over the span of around thirty years, from the mid 1920’s to the end of the 1960’s, the mutual fund industry boomed. As can be seen today, the mutual fund industry is still extremely profitable and running strong.
What’s a mutual fund?
Just as we learned through the little history from above, we know that mutual funds are pools of money. Those pools of money are managed by a portfolio manager and/or team of analysts and managers.
There are both open end and closed end mutual funds
The mutual funds you are likely most familiar with are open end mutual funds.
Open end mutual funds allow the investor to add money and distribute money to the mutual fund with ease.
Most closed end mutual fund only allow money to be added when the fund is established, and can only be taken out at certain, specified points.
For example, you may add money to a closed end mutual fund and not have access to your money for five years. As opposed to an open end mutual fund, which you may add money to on Monday and distribute money on Thursday of the same week, if you wanted to (but not recommended).
What mutual funds invest in
Each mutual fund has a prospectus. That prospectus defines what a mutual fund can invest in. For example, the American Funds Growth Fund of America invest in the following according to its prospectus:
The fund invests primarily in common stocks and seeks
to invest in companies that appear to offer superior opportunities for growth of capital.
The fund invests primarily in common stocks of large and mid-capitalization issuers. The
fund may invest up to 25% of its assets in securities of issuers domiciled outside the
United States.
As you will see from the next example, the American Funds Income Fund of America invests differently than the American Funds Growth Fund of America. This is The Income fund of America’s principal investment strategy:
Normally the fund invests primarily in income producing
securities. These include equity securities, such as dividend-paying common
stocks, and debt securities, such as interest-paying bonds.
Generally at least 60% of the fund’s assets will be invested in common stocks and other
equity-type securities. However, the composition of the fund’s investments in equity,
debt and cash or money market instruments may vary substantially depending on
various factors, including market conditions. The fund may also invest up to 25% of its
assets in equity securities of issuers domiciled outside the United States, including
issuers in developing countries. In addition, the fund may invest up to 20% of its assets in
lower quality, higher yielding nonconvertible debt securities (rated Ba1 and BB+ or
below by Nationally Recognized Statistical Rating Organizations designated by the
fund’s investment adviser or unrated but determined to be of equivalent quality by the
fund’s investment adviser); such securities are sometimes referred to as “junk bonds.”
The fund may also invest up to 10% of its assets in debt securities of issuers domiciled
outside the United States; however, these securities must be denominated in U.S.
dollars.
As you can see, the two funds have different parameters for what they can buy in the fund. The portfolio managers for the two funds must stay within the parameters of the prospectus when managing the pool of money.
Depending on the mutual fund prospectus, here are a few examples of what mutual funds may invest in:
- Stocks (equities)
- Stocks only paying dividends
- Large company stocks
- Small company stocks
- Medium company stocks
- Growth stocks
- Value stocks
- International
- Bonds (debt)
- Government bonds
- Municipal bonds
- Corporate bonds
- Loans (debt)
- Senior bank loans
- Subprime loans
- Real Estate
The above is just a handful of examples of what mutual funds may invest in.
Why invest in a mutual fund
Honestly, this is a question that many people ask.
In the 1970’s, something called an index fund was created. This is a fund that is not designed to outperform the stock market, but to mirror a specific market.
Related: You can find out what an index fund is here by reading this article I wrote What the Hell Is an Index Fund?
You can click here to take a look at my personal investment portfolio
With the rise of index funds in the 1970’s, it has been increasingly clear that mutual funds don’t tend to beat index funds on average.
You may ask why people invest in mutual funds if index funds tend to do better. I have a simple answer to the “Why invest in a mutual fund over an index fund” question:
You invest in a mutual fund over an index fund because you like the idea of potentially beating the index.
If you want to do BETTER than the stock market, you can’t invest in an index fund that tries to do exactly what the stock market does.
In other words, there is no chance an index fund will outperform the market it tracks; however, there IS a chance that a mutual fund will beat the market.
For this reason, there will be people will continue to invest in mutual funds over index funds.
Mutual fund fees
As was stated above, mutual funds charge a fee to the company and manager/team who manages the fund. Mutual fund fees are FAR higher than index funds.
It is, in part, because of the fees that mutual funds don’t tend to outperform index funds on average.
Mutual fund fees include:
- Management fees
- 12B-1 fee
- Load
There are different load fees for different mutual funds. For example, a mutual fund class A share may charge an upfront load of 5%. This means that if you add $1,000 to the account, you will be left with $950 in the account. The $50 ($1,000 * 5% = $50) is paid as a fee to the company and the advisor.
For example, the American Funds Growth Fund of America charges a fee of 5.75% for A shares as their upfront fee (front end load) and no load after. On top of that, it charges an annual 12B-1 fee of 0.24% and other annual fees of 0.77%.
If you decided to purchase C shares instead of A shares, there is no front end load but the fee for C shares is 1% annually for the life of the investment. On top of that, the fund charges 1% as an annual 12B-1 fee, plus other annual fees of 1.61%.
Compare this to the Vanguard index fund VFINX that tracks the S&P 500 index charges a fee (expense ratio) of 0.14%.
Because of the fees, the American Funds Growth Fund of America must earn a significantly higher return than the index fund. If the Growth Fund of America earns the same return as the index fund, it will underperform the fund because of the fee.
This is a GREAT tool that will show you fees for almost any mutual fund:
We have learned that, on average, mutual funds don’t tend to beat index funds after fees are considered.
We also understand that mutual funds must adhere to their prospectus, and can only invest according to that document.
You can choose mutual funds investing categorically. For example – only investing in stocks .
Or, you can invest in funds investing in multi-category. For example – an income fund that can invest in stocks paying dividends and bonds paying interest.
In closing, the answer to the question, “Why invest in mutual funds” has a somewhat simple answer. The reason some invest in mutual funds is because they want to have at least a chance to beat the market.
With an index fund, there is no chance to beat the market, but to only track the market.
Whatever you decide, investing your money for the long term is important. Investing in SOMETHING is better than investing in NOTHING.
So, don’t let the details hold you back for too long. Decide to invest in something as soon as possible.
Thanks for reading!
https://www.investopedia.com/articles/mutualfund/05/mfhistory.asp#ixzz50dN7hAWJ
https://www.investopedia.com/articles/mutualfund/05/mfhistory.asp#ixzz50dLh3BBf
Disclaimer: These are the ideas and opinions of the author. The author is not responsible for the actions of those who read the posts on this blog. Each individual reader has a unique situation and unique needs. This blog is not intended to solve those unique situations of the readers. This blog is not liable for decisions made by the readers of this blog.
