Introduction to Mutual Funds


As mentioned in a previous article, investments can be a very complicated subject.  We discussed the two basic types of investments -- equity and debt.  Needless to say you all probably recall others that don't seem to fit into these general categories quite so easy.  Here, we will discuss one of these, probably the most common -- Mutual Funds.

Mutual Funds are probably the most common alternative investment next to insurance products.  Most people who invest end up going into a mutual fund either through a retirement/401K plan or on an individual basis through the recommendation of an advisor.  There are various types of mutual funds but most will either be a bond fund, a stock fund or a balanced fund.  Within each of these there are various types, which will be discussed below.  But before we get into the various types we need to talk about the general characteristics of a mutual fund.

A mutual fund is a vehicle by which a group of investors pool their money together and use that money to buy individual stocks, bonds or other types of investments.   A mutual fund is also a legal entity and as a result it has the rights and responsibilities of such.

Things to Know

  • Read the Prospectus -- Though much of the prospectus will be unintelligible to the average person without a law degree there is important information buried once you get past the legalese.  Look for the investment objectives of the fund and the overall structure of the investment selection criteria.  Some funds will be managed by a group of lower level analyst and some are more focused and managed by an individual fund manager.  These are important things to know and you should find this information in the prospectus.

  • Expenses and Load vs. No Load -- You need to know how what the charge is for the particular fund.  Beware that often no-load funds have higher expense ratios than loaded funds.  Thus, you are still paying money only it is hidden rather than out in the open like with a loaded fund.   See below for more details on expenses.   The bottom line is to know how much the fund is costing you.

  • Performance -- You should always check out the performance history of a fund versus an applicable index.  There are many varieties of indexes so be sure you are using the proper one for comparison.  For example, it does no good to compare a technology fund against the DJIA.  There is absolutely nothing in common between the two.  So do your research and compare the performance against an appropriate index and also against other funds of similar type, which you may be considering.  Look for how a particular fund performs in certain market conditions.

  • Management -- Know if there have been any management changes in the fund as well as how much an individual manager influences the investment decisions.  Obviously this information is important in regards to evaluating past performance.

Advantages:

  • Professional Management - The primary advantage of a mutual fund is the professional management.  Ideally the manager or managers is able to make better investment choices because of experience and access to information.

  • Shared Expenses - Because the investors pool their money together the expenses are combined and shared amongst the group.

Types

  • Loaded -- Some mutual funds have a load attached to them.  This is nothing more than a sales charge for all intents and purposes.  Beware that there are BACK LOADED funds and FRONT LOADED funds.  All this means is that you pay the sales charge on the initial investment or you pay it when you redeem your money.  Obviously this is all something that should be considered before investing money.  Regardless of the load you should also find the expense ratio, which will give an overall indication of how costly the fund is as compared to other mutual funds.

  • No-Load -- No Load funds will not have a charge up front or a charge upon redemption (note that retirement funds are a special category and often have expenses related to early redemption.  See the article on retirement plans for more information on this subject).  However, as we all know there is no such thing as a free ride.  Therefore, no load funds will still charge you but it is hidden in the sense that it doesn't come out of your initial investment but instead out of the return or loss for a given year.   Sometimes no loads have a higher overall expense ratio than loaded funds, but not often.  As noted above, refer to the expense ratio for a good indication of how the fund compares to similar funds by other companies.

  • Closed / Open Ended-- Closed end funds behave very similar to stocks in that the investment company issues a certain limited number of shares and then allows trading between investors based on the value of these shares.  By comparison open-ended funds issue new shares and redeem old ones every day that there is market activity.  Open ended is by far the most common type of mutual fund.

Investment Categories
There are three primary categories of mutual funds.  There are those, which invest in bonds, those, which invest in stock, and those which invest in a combination of the two.

  • Bond mutual funds can come in a variety of types corresponding to the various types of bonds. Thus, there are municipal bond funds, Treasury bond funds, corporate bonds funds and other variations.  Often the bond funds will have a name that seems to be unrelated such as "High Income Fund" or "College Savings (insert year in future)" or something similar.  These are also bond funds.  However, the investment company is emphasizing the characteristics of the underlying investment for marketing purposes.

  • Stock Mutual Funds are probably the most popular and they also come in as many variations and types as stocks themselves.  Therefore you will find foreign or country specific funds as well as funds that emphasize a particular industry.  "Value" and "Growth" are also very popular and most investment companies will maintain at least one fund under these headings.

  • Balanced Funds are those that seek to maintain a portfolio of both stocks and bonds balanced according to the fund manager's outlook.  Ideally these types of funds are considered to be of moderate risk but there have been instances where investors have suffered large losses so as always one should read the prospectus before investing.



Information is for educational and informational purposes only and is not be interpreted as financial or legal advice. This does not represent a recommendation to buy, sell, or hold any security. Please consult your financial advisor.